China's equivalent of the CDO imploding and needs $1 trillion bailout

Reuters reports that the Chinese equivalent to opaque, toxic sub-prime mortgage-backed securities is in the process of imploding and is threatening to bring down its banking system unless the government injects upwards of $1 trillion.

The default of a Chinese investment plan has handed Beijing a tough choice: bail out investors and endorse moral hazard or let it fail and risk unnerving those who hold at least $1 trillion in so-called wealth management products.

China's bank regulators are debating what to do about the investment sold at a Hua Xia Bank branch near Shanghai, which failed to pay out on maturity late last month. 

The bank, a mid-sized lender partly owned by Deutsche Bank, says a Jiading district branch employee sold the product without authorization.... 

It's not yet clear how many, and to what extent, others have defaulted. But analysts say that if more flop and generate headlines like the Hua Xia case, a crisis in confidence could ensue, sparking a run on the wealth product market. 

"Some of these products won't be able to generate enough money to pay back investors," said BofA-Merrill Lynch China strategist David Cui. "The issue is, at a certain point, if it gets to a certain scale, you can no longer cover up the losses. Then we may have a systematic risk on our hands."

Wealth management products have taken off in the past five years, with Chinese looking for investment choices other than real estate, betting on the country's roller-coaster stock markets or parking money in bank accounts that offer state-set deposit rates. 

The majority of the products are short-term savings vehicles often created by third parties and issued through banks. The products mostly invest in stocks and money market instruments, promising returns of 4-5 percent. 

But a sizeable amount have funneled money into riskier investments, offering double-digit gains by financing anything from property and infrastructure projects, to car dealerships, pop concerts and even the sale of ham. 

The products are part of China's "shadow banking" system - or credit given to borrowers outside formal lending channels. 

Barclays estimates the shadow banking industry has nearly doubled in the past two years to 25.6 trillion yuan ($4.11 trillion), or more than a third of total lending.

To recap, the wealth management product invests in assets that the buyer cannot see and independently assess the risk of and in return the buyer gets a fixed rate of return.

This sounds like blindly betting with lousy odds.

Beijing has not forced Hua Xia Bank to pay back the estimated 500 investors hit by the default. 

China International Capital Corp (CICC), a prominent Chinese investment bank, urged regulators in a December 4 note to allow such products to fail. Most are not guaranteed by banks, analysts say. 

"If we don't take this opportunity to let a relatively small-scale contract be broken, it will only reinforce the attitude that these products have a rigid return and a limitless guarantee," CICC said. Forcing Hua Xia to stand behind these products would cause "no end of trouble", it added..... 

Wealth management products shot to prominence after China's stock markets sank during the 2008 global financial crisis. As China pumped up its economy and inflation surged past official interest rates, investors sought higher returns elsewhere rather than effectively lose money in bank deposits.... 

China's wealth products have been likened to the U.S.-invented collateralized debt obligation (CDO). That product pooled together loans, mostly American mortgages, and sold them to hedge funds. When home owners defaulted, and hedge funds stopped buying CDOs, banks were left with packaged loans they couldn't sell. That helped cause the 2008 financial crisis. 

Beijing has tolerated wealth products because they offered alternative investment opportunities and channeled credit to industries in need.

The CBRC put the total outstanding at 6.7 trillion yuan ($1.08 trillion) as of September, nearly double the year before. Fitch Ratings predicts total sales will hit 13 trillion yuan by the year-end, or more than 16 percent of total bank deposits....

Working out how many need to default before they threaten China's financial system is impossible to tell because the real threat is investor psychology, he said. 

If Chinese investors stop buying wealth products en masse, that would likely cause a liquidity crunch, and force Beijing to react, according to Werner. 

"The government will step in if social stability is at risk," Werner said. 

Cui from BofA-Merrill Lynch said any loss of confidence in wealth management products would have wider consequences. 

"This can be self-reinforcing. Once people stop buying (them) for fear of potential defaults, in addition to the solvency risk, the market will face liquidity risk as well," he said. 

Analysts suspect a lot of lenders are using new money to pay old customers that have invested in wealth products.... 

A "Ponzi scheme" is what Xiao Gang, chairman of Bank of China, the country's number 4 lender, called certain wealth products in a newspaper editorial in October. A Ponzi scheme collapses when new money no longer comes in, and old investors cannot be paid.

Around 70 percent of wealth products are tied to bond and money markets. Where the rest goes is less clear. The government has said principal guaranteed products offered by banks must be counted on a lender's balance sheet. 

That means banks are on the hook for the roughly 15 percent of products in circulation they have guaranteed. 

Analysts agree that if a host of wealth products went bust, it would cause a liquidity crunch. At the very least, banks would be expected to cover losses and pay investors principal plus interest on products that had been guaranteed....

May Yan, head of Asia bank research at Barclays, said the market needed failure to educate domestic investors about taking excessive financial risks. At the same time, the government needed to be aware of the pressure that would fall on banks should customers demand repayment. 

She predicted the banking regulator and the central bank would tighten up on wealth products and shadow banking in 2013. 

"If the product fails, it is a big step forward for risk awareness in China," Yan said. "If banks need to bail everyone out, the implications would be very negative."

The lesson to be learned is not to blindly gamble and that financial products need to provide disclosure so that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess an investment and make a fully informed investment decision.