A Post Mortem On The China Credit Trust Bailout

by: Christopher Balding

Since global markets are breathing a bit easier since the China Credit Trust bailout of its ill fated wealth management product sold through ICBC, it seems appropriate to conduct a post mortem about what happened and the implications.

1. The original loan was a mega-gamble from the outset. The 3 billion reminbi loan was made to a group seeking to buy a Shanxi coal mine with 50 million reminbi in equity. There were additional loans totaling another 4 billion raising their debt to 7 billion rmb using 50 million in equity capital. For those of you keeping score at home that is a debt to equity ratio of 140. To provide some perspective, China Credit Trust and ICBC made a combined 180 million rmb for creating and distributing the product. In other words, they made nearly 4 times what the receivers of the loan put up to fund the deal! Not only was the debt level absolutely astronomical, but once fees were included, the annualized percentage rate topped 14%!(Google translate). I don't care what country, industry, or economic climate you live in: a company with a debt to leverage ratio of 140 paying 14% annually trying to buy another company is extremely high risk.

2. The collapse of Shanxi Zhenfu Energy in many ways appears to be a standard case of corporate fraud. While much has been made of coal mine consolidation and drops in commodity prices, the collapse of Zhenfu appears much more straightforward. There are reportedly numerous instances of "related party transactions (Google translate)". The commonly reported charge of Zhenfu "taking deposits" is really better understood as off balance sheet transactions designed to hide debt. In another instance, one mining asset valued at 445 million rmb ($75 million) had 415 million rmb of "intangible assets". In one deal, Zhenfu transferred one mine to an investment company valued at 754 million rmb or approximately $126 million while the origin of the investment company that received the mine remains unknown with one paper speculating it is "loan sharks". Many Shanxi based coal companies survived the past few years in fine shape without collapsing in spectacular fashion. While weakness or the consolidation did not help, they did not cause or precipitate the downfall of Zhenfu Energy.

3. ICBC's role was not simply as a distributor of the wealth management product. Though it has been widely reported that ICBC acted only as a distributor of the product originated by CCT, limiting both their financial and legal liability, what has been unreported is that according to the 21st Century Business Herald, they also acted as the trust bank and custodian of funds raised. Furthermore, CCT has stated that the ICBC Shanxi branch actually recommended the client to them and then agreed to distribute the product. Furthermore, given that some estimates for Zhenfu Energy have assets pegged at 500 million rmb and total debt at 5.9 billion rmb, the discrepancies invite questions about third party culpability. If ICBC acted as the custodian bank dispersing funds for bogus assets and related party transactions while also recommending the client to CCT, this invites a wealth of questions about the role ICBC played and whether they bear both ethical and legal liability for the Zhenfu Energy collapse.

4. China Credit Trust is not a shadow bank but a state owned company covered with conflicts of interest. Despite the frequent perception that Chinese shadow banking is run by underworld corrupt gangsters (which might still be an appropriate term), China Credit Trust (CCT) is owned by some of the largest and most well connected state owned firms in China. CCT is owned by a consortium of other Chinese state owned enterprises (SOEs). CCT's largest shareholder is the large state owned insurance company China Peoples Insurance which among other distinctions holds nearly 20% of American International Group (NYSE:AIG) and is the largest casualty insurer in China. The second largest shareholder, Guohua Energy Investment, is a subsidiary of the Shenhua Group the "largest coal producing company" in the world. The third, fourth, and sixth largest shareholders are the Yanzhou Coal Mining Group, Yongcheng Coal Holdings, and China National Coal Group which is the third largest coal company in the world. Its remaining shareholders are mostly other coal companies. In other words, CCT is owned by some of the largest and most powerful companies in China with ICBC distributing its products.

5. If you noticed a theme among shareholders…. The wealth management product created by CCT and marketed by ICBC was ultimately loaned to an ambitious coal miner. More than 50% of CCT shares are held by coal miners and related companies. However, not only are coal miners the dominant interests in a company making a failed and enormously risky loan to a Shanxi coal miner but the major Shanxi coal miners are shareholders in the company making loans to a Shanxi coal miner. The Shanxi Coking Coal Group and the Shanxi Lu'an Mining Group which also has interests in finance and solar power, are minority owners in CCT. Furthermore, most of the large national coal companies have significant interest in the Shanxi region given its importance to Chinese coal mining. To put this another way: CCT was owned by coal miners and Shanxi coal miners originated a scandalously bad loan to an unknown Shanxi coal miner at 14% apr with a total leverage ratio of 140 while putting the risk on unwitting consumers.

6. The clear implication being: this deal just doesn't pass the smell test.

a. Even in the heady days of Chinese financial lending, an unknown company does not walk into a bank and raise $1 billion with a leverage ratio of 140 to 1. There had to be a very powerful person or entity behind this deal.

b. There are obvious conflicts of interests between the originating institution, its shareholders, and the borrowers. A trust company owned by coal miners making a bad loan to a coal miner where others bear the risk is simply too problematic.

c. ICBC clearly needs to answer more questions about its role as the custodian bank for dispersing funds for non-existent assets and related party transactions and whether they recommended the client to CCT. There very well might be a reason that they have reportedly agreed to fund some of the bailout.

d. To date, I have been unable to link any of the shareholders of CCT or other vested interests to any of the transactions or assets in question. However, apparently others have had just as much trouble finding people behind the transactions or assets.

There are two final points that needs to be made about this situation. First, while the Chinese government has come under criticism, internally and externally, for deciding to bail out the trust product rather than let market forces and risk prevail, this fails to grasp a basic tenant of the social contract. Having lived in China and talked to people and sat in meetings with senior executives at Chinese and foreign institutions, I have heard the unwavering faith and demands investors and common have in the ability of the Chinese government to manage any situation. The Chinese government clearly understands the ramifications of breaking the social contract with people who expect nothing less that continued economic prosperity promised by state owned banks like ICBC.

Second, the decision to bail out CCT is obviously political, but not for the reasons most people believe. The Chinese government has to bail out as many of these products as possible because there is no greater flash point for the Chinese population than continued and expanding prosperity. An economic downturn or financial crisis has the very real potential to prompt a political crisis which Beijing will not tolerate under any circumstances. They have to bail these products out.

Zhenfu Energy, CCT, and ICBC may have brought a fright to global financial markets, but given the uniqueness of the collapse, it may not be the harbinger of events that many believe. The systematic fraud and misrepresentation on multiple levels by many parties separates it from more standard forms of credit risks that concerns most pundits. While the potential for default was real, it is important to understand the details driving these potential events and their potential spillover.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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