Have you ever felt like you weren't getting the whole story?
Sure you have. Everyone's had those moments; you know, that moment when a cursory assessment of a situation makes you incredulous regarding the veracity of the story you're being fed. In many cases, you're not even sure you want to hear the whole story because you know that once you dive down the rabbit hole, you've surrendered the blissful ignorance option and you won't be able to get it back.
Well, China's financial system fits that description perfectly. Its labyrinthine character and the long list of shady, backdoor financing arrangements that keep it afloat make the incestuous relationships that helped create the housing crisis in the US look innocent by comparison.
Lately, I've focused on entrusted bond deals. Why? Well, because they've been in the news. Sealand Securities' initial refusal to honor an arrangement with its counterparties further spooked an already frightened market in mid-December and helped facilitate what amounted to a mini-meltdown in China's bond market.
For many market participants in the US, the term "Chinese entrusted bond deal" translates to, "ok, tuning out, next story please." Mention that really, these deals are just repos and the leverage they facilitate is simply the result of piling one on top of another on top of another and you're digging yourself an even bigger hole when it comes to keeping anyone outside of China interested in your narrative.
But that's a shame, because it really isn't that complicated. Recently, I once again endeavored to outline the basics, the latest in a series of attempts to explain why you should care. In layman's terms, it works as follows.
- I'm me, and you're you. (That's a pretty simple concept to accept right off the bat, right?)
- My neighbor wants to borrow $1,000 from me at a 5% interest rate. I agree.
- I then temporarily sell that loan to you at a rate of 4%. I pocket the spread (i.e. the 100 bps difference between 5% and 4%).
- I don't record the loan to my neighbor anywhere on my personal books. So basically, I've created 100 bps out of thin air.
- Next, I take the $1,000 you paid me for my neighbor's loan and lend it to a second neighbor.
- Finally, I temporarily sell the second neighbor's loan to another person like you and once again pocket the spread.
- Rinse and repeat.
You can see why this would be a problem in the event the neighbors in this equation became unable to service their loans. The chain reaction would ripple through the entire structure starting with me and impacting you and all the other yous involved in my pyramid of leverage.
Ok, so that's entrusted bond deals. Again, you can read more and view some simple diagrams in my previous pieces.
Now believe it or not, there's another source of leverage in China's financial system that relies on repoed bonds. Remember WMPs or "wealth management products"? No? That's ok. As a refresher, banks use WMPs to get bad loans off their books. Basically, the loans are sold to a trust company which repackages them and sells the repackaged product to investors. The investors are made to believe these products are as safe (or close to as safe) as traditional deposits.
There are a number of problems with these deals, not the least of which is the fact that the assets investors' money funds are long-term loans, whereas the WMPs themselves mature in a matter of months.
That means that the viability of the whole setup depends on investors rolling their paper or the WMP sellers sourcing new demand (i.e. finding new buyers) when the notes mature.
Put simply, WMPs rely on borrowing short to lend long. In the event i) existing investors refuse to roll their paper and ii) new investors can't be found, the market will freeze just like the asset-backed commercial paper market in Canada ca. 2007. At that juncture, holders of WMPs will not be able to get their money out.
Ok, so that's bad enough right? Well, it gets worse. Guess what banks are doing with the money they receive from WMP investors? They're entrusting it to third-party asset managers who use it to buy bonds, which are then repoed and the money received in the repos is being used to buy still more bonds which are themselves repoed, and on and on. Here's Deutsche Bank:
First, banks entrusted part of WMP AUM or their proprietary investments to third-party asset managers (e.g., brokers, trust companies, mutual funds and insurers) for fixed returns of 4.0-5.0% per annum.
Secondly, the third-party asset managers invest the funds in the bond (the majority) and equity markets (a small part). When investing in the bond market, the third-party asset managers can further lever up by pledging the bonds through a repurchase transaction.
(Chart, bullets: Deutsche Bank)
Around 13% of banks' total WMP assets under management are entrusted to third parties to manage. That means you can add around CNY3.4 trillion to the total amount of money that's being used to lever up in the bond market.
(Charts: Deutsche Bank)
Basically, we can sum total pledged bond repo and estimates of over the counter repo (entrusted bond deals) to get an idea of how much money has been borrowed in the Chinese bond market.
Deutsche Bank's estimate (and really this isn't their estimate - it's derived from objective data about formal repo and an estimate of OTC repo from Caixin): around nearly CNY18 trillion.
In other words, this is a $2.6 trillion problem.
That should speak for itself, but just in case the implications of the above aren't clear, I'll close with one last quote from Deutsche Bank (my emphasis):
For the system as a whole, the overall leverage seems manageable, [but] the leverage exacerbates the liquidity and credit risks, as corrections in bond prices are increasingly likely to trigger sell-offs by investors and lead to a downward spiral.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.