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.

China faces hidden risk of 'shadow finance' led financial crisis

It appears that China is going to experience its version of the 2008 structured finance meltdown that almost brought down the global financial system.  The Wall Street Journal carried an article that highlights how loans made by China's opaque shadow finance sector may be coming back to haunt its banks.

The solution for China, just like it was and is for shadow banking in the EU, UK and US, is to bring transparency to the shadow finance sector.

Specifically, China should require that there be observable event based reporting for all activities like a payment or delinquency involving the underlying loans before the beginning of the next business day.

With this disclosure, investors could independently assess the risk of the loans and would know what they own.

Mr. Wang's case highlights the hidden risks to banks from their links to China's fast-growing "shadow-finance" industry, a term for all types of credit outside formal lending channels. 

Shadow finance in China totals about 20 trillion yuan, according to Sanford C. Bernstein & Co., or about a third the current size of the country's bank-lending market. In 2008, such informal lending represented only 5% of total bank lending. 

China's shadow-finance industry has experienced similar growth to the global shadow banking system in the years leading up to the financial crisis.

The sector is lightly regulated and opaque, raising concerns about massive loan defaults amid a softening economy, with ancillary effects on the country's banks. 

Just like the shadow banking system, China's shadow-finance industry is lightly regulated and opaque.  As a result, no one knows what is going on.

Banks often work with private lenders by selling loans to them or marketing investments on their behalf for a fee. 

"Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate," wrote Xiao Gang, chairman of Bank of China Ltd., in an editorial in the China Daily newspaper. 

Although China Credit has the legal responsibility to repay investors, according to Chinese law, "for reputation's sake and potential social stability reasons, a portion of these loans can be banks' contingent liabilities," said David Cui, China strategist with Bank of America Corp.'s BAC -0.66% Merrill Lynch unit. 

Just like the shadow banking system, nobody knows what the exposure of the regulated banks are to the shadow banks.  As a result, nobody knows if the regular banks are solvent or insolvent.  This sets the stage for a systemic financial crisis.

Others agree. "Banks might be held liable if bank representatives didn't adequately evaluate the products' risks for their clients," said Peng Junming, a former official at the People's Bank of China who now runs his own investment firm, Empire Capital Management LLP.

With opacity and a lack of observable event based reporting, it is impossible for the banks to have adequately evaluated the products' risks for their clients.

Just like shadow banking leading up to the beginning of the financial crisis, China's version of shadow-finance is a powder keg ready to blow up.

China experiments with securitization

According to a China Daily report, China is once again experimenting with securitization as a way to shrink the size and risk of its banking industry.  The question is did it learn the fundamental lesson from the failure of securitization in the EU, UK and US and require observable event based reporting?

Without disclosure on an observable event basis (where an observable event includes a payment, delinquency, default, modification and bankruptcy), investors do not have the current information they need on the underlying collateral performance to know what they own.

Equally importantly, without disclosure on an observable event basis, potential buyers do not know what they would be buying.  As a result, the market for these securities is illiquid.

Observable event based reporting is the foundation for a deep, liquid capital market.

China has reopened the gate on loan-backed securities, after suspending a trial in the aftermath of the global financial crisis. 

China's central bank ... has authorized a 50 billion yuan ($7.85 billion) quota for the country's lenders to securitize their loans. Lenders are required to submit securitization plans for regulatory approval. The quota is expected to be fulfilled by year-end and more quotas are likely to be authorized in the future. 

China's loan-backed securities trial started before the 2008 global financial crisis. However, the trial was suspended after financial derivatives such as asset-backed securities were seen as the culprit of the crisis. 

The country first launched a trial in 2005, when China Development Bank issued bonds based on 51 loans totaling 4.7 billion yuan. 

The quota is a pittance compared with the banks' total assets, which were at 120 trillion yuan at the end of the first quarter, but it opens a new path for lenders to get rid of non-performing loans and liquidate assets.

Like bankers everywhere else, Chinese bankers find way around regulations

Reuters reports that Chinese banks are providing local government bonds 'liquidity support' to get around a ban on guaranteeing these bonds.

This simply confirms that Chinese bankers are like bankers everywhere else.  They will create a financial innovation to get around any regulation that interferes with their ability to make money.

One of the reasons that your humble blogger has pushed for requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is it captures the exposure regardless of how the bankers package it.

Chinese banks are providing de facto guarantees to bonds issued by local government financing platforms, official media reported on Friday, raising new concerns about the risk of local government debt threatening the health of China's banking system. 

Direct guarantees of corporate bonds by commercial banks was once common practice, but was banned from 2008 in an effort to avoid excessive concentration of risk in the banking system. 

Recently, however, fundraising prospectuses for bond issuances by city investment companies frequently boast of so-called "liquidity support" from commercial banks, the official Shanghai Securities News reported. 

Such support is effectively a guarantee by a different name designed to circumvent the ban, the paper quoted industry sources as saying, enabling local governments to pay lower interest rates on the debt.... 

Concerns have risen since 2010, however, that such investments may fail to yield the cash flows necessary to service the debt, leading to a potential rise in bad loans that could threaten the health of the banking system.

Absent ultra transparency, China discovers disclosure system no guarantee of protection

Reuters ran an interesting article on how China is looking at how to improve legislation governing its developing disclosure-based securities regulatory framework.

The goal is to increase transparency and improve investor protection.

Regular readers know that disclosure-based financial systems are stable only if investors have access to all the useful, relevant information in an appropriate, timely manner so they can make fully informed investment decisions.

For all financial firms, all the useful, relevant information takes the form of ultra transparency.  Under ultra transparency, financial firms disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

Market participants need these details in order to assess the risk of each financial firm.  Then, based on this risk assessment, market participants adjust their exposure to what they can afford to lose given the risk of the financial firm.

Regular readers know that the FDR Framework is the fundamental building block for the stable disclosure-based financial system that China is looking to build.

China’s bourse regulators and the nation’s IPO watchdog, the China Securities Regulatory Commission, have been busy brainstorming improvements to legislation governing the disclosure requirements of listed companies in the PRC. 

Aiming to bring increased transparency and other investor protection merits often associated with a disclosure-based securities regulatory framework, the CSRC is contemplating models from Hong Kong, the United States and other jurisdictions where listed companies are required to publicly disclose corporate and financial statements in a timely manner.

It is ironic that China is studying US disclosure requirements in light of the recently passed JOBS Act that repealed these requirements for firms with less than $1 billion in revenue.

Previously, since the 1930s, the US had been the model for disclosure-based capital markets.

Now, consistent with the financial regulators allowing banks to hide losses on and off their balance sheet as part of implementing the Japanese model for handling a bank solvency led financial crisis, the US is adopting the idea that capital markets work better when investors do not have access to the information they need to make a fully informed investment decision.

Recent fraud allegations involving U.S.-listed Chinese companies have highlighted shortcomings in a disclosure based system, particularly where securities regulators primarily rely on companies and their professional advisors to truthfully and accurately disclose information in filings. 

Although many of the accused companies appeared to comply with disclosure obligations, subsequent investigations produced allegations of material misstatements, omissions and even forgery of regulatory filings....

This is why your humble blogger has urged China to make its financial institutions the global model for disclosure by requiring them to provide ultra transparency.

Disclosing the data from which the financial statements are constructed materially reduces disclosure errors.

Disclosure alone, without regulatory authority to verify the authenticity of documents and hold listed companies responsible for violations of disclosure rules, may therefore be insufficient to protect investors. 

As the guardians of China’s capital markets move towards a disclosure-based system in securities regulation, they may well be looking to such enforcement gaps and considering efficient alternatives to protect investors when companies are accused of lying in disclosure documents.

By requiring disclosure of each financial institution's exposure details, China can instill market discipline in bank financial reporting while efficiently eliminating lying in disclosure documents.

China should adopt ultra transparency as part of establishing a deposit insurance system

According to a Wall Street Journal article, the governor of China's central bank is urging the creation of a bank deposit insurance system.

If the Chinese government is going to prevent becoming a captive of its banking system, it should make it a requirement for deposit insurance that the bank provide ultra transparency and disclose to all market participants on an on-going basis its current asset, liability and off-balance sheet exposure details.

With ultra transparency, banks are subject to market discipline.  As a result, regulators can step in before a troubled bank incurs more losses than can be absorbed by its equity and unsecured debt holders.

With ultra transparency, it is also impossible for the policymakers and financial regulators to become captive to the banking system by adopting the Japanese model for handling a bank solvency led financial crisis as the losses in the financial system are not hidden.

With ultra transparency, China does not have to start guaranteeing deposits for a bank until market participants have had a chance to analyze all of the exposure details and determined that the bank is solvent.  Otherwise, China risks insuring deposits where the losses that the bank is exposed to already exceed the capacity of its equity and unsecured debt holders to absorb.

Banks that want deposit insurance will be happy to comply with the ultra transparency requirement.  They know that historically ultra transparency has been a sign of a bank that can stand on its own two feet.  To the extent that their banking competitors are unwilling or unable to offer ultra transparency, the banks that do provide ultra transparency gain a competitive advantage:  in this case, deposit insurance.

By combining ultra transparency, access to central bank liquidity and a deposit insurance system, banks can perform an essential function and protect China's real economy from the losses on any excesses in the financial system.

Put up or shut up time for China's banks

The Financial Times carried an article on how, despite repeated assurances from management, China's banks fail to convince market participants that they do not face a problem with bad loans.

Regular readers know that what convinces market participants is not management's opinion, but rather the market participant's own analysis when all the useful, relevant information is disclosed.

Clearly, China's banks face the same problem that Bank of America faces:  it is time to put up or shut up.

Like Bank of America, these firms are hiding their current asset and liability-level data behind opaque financial reporting.

Please note, I do not know whether China's banks or their critics are right.

What I do know is that China's banks are in possession of facts, their current asset and liability-level data, that are not available to other market participants.  If these facts were made available and they supported China's banks, then the critics would go away.  In fact, the mere announcement that these facts were going to be disclosed would tend to silence the critics as the critics would assume the facts would not be voluntarily disclosed if they did not support China's banks.

That China's banks do not make these facts available strengthens the argument of their critics.  Critics see the failure to disclose all their current asset and liability-level data as confirmation that China's have something to hide.

Like BofA CEO Brian Moynihan, it is time that China's banks either put up current asset and liability-level data or shut up.

In case China's banks elect to put up, they know how to contact your humble blogger for assistance in coordinating this disclosure.

Chinese banks have once again produced sparkling results but they were unable to dispel concerns that their good fortune might yet turn to trouble because of non-performing loans and a slowing economy.... 

The story for much of the past year has been the divergence between Chinese banks’ record results and the unshakeable doubts in the market that the bill for their past lending excesses has yet to come due....

Although Chinese bank shares jumped a touch on Thursday, they remained generally flat on the week and down heavily on the year, as investors appeared to focus less on the strong earnings and more on the cracks in the foundations of the banks’ success. 

“We continue to see decent results but the numbers will not convince the bears that there isn’t a NPL problem. It’s just that we’re not there yet,” said an analyst who wished not to be named. 

Worries continue to centre on the surge in lending in China since late 2008, when Beijing used the banks, all of which are state controlled, to lead a credit-fuelled stimulus for the economy. 

The risks of that approach have started to show in recent months as officials have tried to account for the loans given to local governments – about Rmb10,700bn ($1,650bn), according to the national audit office – and estimate how many might end up in default. 

Prodded by regulators, the banks used their first-half results to present the most thorough picture yet of these potential problem loans.... 

But the banks also tried to reassure about the health of these loans and their readiness for any defaults. 

China Construction Bank, the country’s second-largest lender, said 84 per cent of its loans to local governments were fully covered by cash flow. And with its capital adequacy ratio at 12.5 per cent, exceeding regulatory requirements, Guo Shuqing, CCB chairman, said he saw no need to raise any more equity. 

“We’ll be able to maintain a good level of capital for the next few years. This won’t be a problem,” said Mr Guo. 

At Bank of China, Li Lihui, president, said provisions had been made for 217 per cent of bad loans, also well above regulatory requirements. “We have been extremely prudent and conservative,” he said. 

But the undeniable strength of the numbers served as a reminder of the chasm between the banks’ confidence and the unease that has weighed on investors’ minds. 

“It’s somewhat a trust issue in the reliability of the banks’ due diligence and reporting,” said May Yan, head of China banks research with Barclays Capital. “From the data provided by the banks, it looks like the impact [of the loans to governments] may not be big, but it is dubious how they estimate cash flow.”