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A host of red flags are coming from China. We have all heard the sweeping descriptions of a possible housing bubble in China. However, the risks run deeper than simply escalating housing prices. I do not know if similar things could be happening in Canada, but I have already pointed out that bidding wars have been taking place there, so it is not out of the question.

Recently, many Chinese banks have been engaged in a circular relationship with trust companies to offer short term financing for real estate deals. Much of the boom in housing in China was funded through this process. The end result is a repackaged loan portfolio that investors buy to achieve a “risk free” higher yield. This is an all too familiar story.

Repackaged loans in China are not being called CDOs, but they could have the same impact. The investors who own these non-transparent and illiquid securities think they are getting twice the rate of interest of banks, with no additional risk. However, if those loans begin to underperform, if home owners begin to fail to pay, the end result could be devastating.

Already, China is trying to tame the possible housing bubble, but that could only worsen the impact, and hasten the implosion, if it is to come at all.

From Fitch, the largest bank in China, The Bank of China (OTCPK:BACHF), and China Construction Bank (OTCPK:CICHF), and maybe even The Agricultural Bank of China, a recent IPO, could be more sheltered. They do not seem to have engaged in the dealings with trust companies like the smaller state run banks have, but a housing crisis in China will not leave those banks unscathed either.

In the United States, we are already familiar with the ripple effect of a crisis like this. China, a country that the world depends on as much if not more than the United States, may be heading down a path of eventual contraction. The world experienced it as a result of a similar situation in the United States, and the world may feel it again if the all too familiar story plays out again in China as well.

The demise of AIG (AIG), Citigroup (C), Bank of America (BAC), and JPM Morgan (JPM), not to mention the failed firms those left standing acquired, could be a precursor to what happens to the largest banks in China once the dust settles. The Shanghai Market is already down 26% in 2010, but if the repackaged loans that have been taken off of the balance sheets of Chinese banks begin to underperform, those declines could get worse.

Disclosure: no conflicts to report.

Source: Red Flags From China