Welcome back, another quick update on Evergrande. Today I want to discuss the Ponzi like nature
of the Evergrande wealth management products and also go over what an unwind might look
like. Obviously, we will have a lot more information
tomorrow when a big interest payment is due on one of their dollar denominated bonds. Evergrande – as I’m sure you know - is
Chinas second largest property developer and they have over $300 billion in liabilities,
and as I’m sure you have seen in the news, the company is in the throes of a liquidity
crisis. Tomorrow will be a big day for Evergrande
as they have an interest payment on a dollar denominated bond of $83.5 million that comes
due. This is on an 8.25% five-year dollar denominated
bond. There is a good chance that they are going
to miss this payment, but this will not actually count as a default as according to the bond’s
covenants, there is a 30 day period before a missed payment is considered a default. They also need to pay $36 million dollars
on an onshore bond on the same day. This one is more likely to be paid (that doesn’t
mean it is extremely likely that it will be paid, just that it is likely to be more of
a priority). In total they have $669 million in coupon
payments coming due through the end of this year. $615 million of that is on dollar denominated
bonds. Now I mentioned in my earlier videos that
they have a wealth management affiliate that offers financial products to Chinese investors
backed by the company’s credit. There is about 6 billion dollars’ worth
of these products outstanding. Although 6 billion is a small fraction of
the $310 billion of total liabilities which has been rattling the global markets, investor
fury within China has made these debts a flashpoint. This type of investment is not at all unusual
in China, Other large Chinese developers have also sold wealth management products, including
Baoneng, Country Garden, Sunac and Kaisa. Most Chinese investors are very leveraged
to property investing in one way or another, as due to financial repression, there is no
where else for them to invest. Now, these wealth management products were
pitched with yields of around 12%, and investors were given gifts like Dyson air purifiers
and Gucci bags to invest. This combined with the guarantee of China's
second largest developer, meant that around eighty thousand individual investors put their
life savings into these products. In an interview with local media, an Evergrande
financial adviser said that the products were a type of “supply chain finance”. The financial advisor explained that in years
past the money from retail investors would have been used to pay Evergrande’s suppliers,
but this was no longer the case. “Proceeds from the wealth management products
have been used to bridge various funding gaps faced by the parent company.” The executive said that “There is no need
to thoroughly examine where the money actually went. Some proceeds were used to repay previous
products but then sales plummeted, making it difficult for the business model to continue.” This is basically the definition of a Ponzi
scheme. The 12% return is even the same as Bernie
Madoff paid. Evergrande financial advisers marketed these
products widely, including to homeowners in its apartment blocks. It’s managers also persuaded employees to
invest – often as a condition of their employment. One executive has been quoted as saying that
the products were too “high risk” for ordinary retail investors and should not have
been offered to them. This was said yesterday during a meeting,
with angry investors who went to the company’s headquarters to try to get their money back. The sales pitch was that these were Safe and
stable returns backed by Evergrande. “Our products were not for everyone, according
to the executive. But our grassroots salespeople didn’t consider
this when making their sales pitches and they targeted everyone in order to meet their own
sales targets.” I should note that it is not clear if Evergrande
has included this $6bil of wealth management products among the liabilities on the balance
sheet. Nigel Stevenson of GMT Research is quoted
in the Financial Times as saying that it is unclear how Evergrande accounts for the wealth
management products. “Once the lid is lifted on its financials,
it’s possible that more horrors will be discovered,” he says. OK, so what is likely to happen going forward? Well, a lot of things can happen – so essentially
- anything I say here is almost guaranteed to be wrong. (i would encourage you to of course come back
to this video in a few days and tell me that it aged like milk.” I think it is extremely likely that Evergrande
will miss their interest payment on dollar denominated bonds tomorrow - and markets might
not react well to this. This is simply because missing this coupon
won’t be counted as a default for another 30 days, and Evergrande will be trying to
buy as much time as possible to negotiate and will only make the payments it absolutely
has to. I don’t think me saying this is much of
a surprise to anyone – the company’s credit rating has been implying it for months. I do think that Evergrande will be allowed
to collapse, and that competing (and equally overleveraged) developers will buy up the
parts – most likely - with the help of loans from a consortium of Chinese banks who will
do this with the help of a liquidity injection from the Peoples Bank of China. This could be a bit like when JP Morgan was
encouraged to buy Bear Stearns. Evergrande being wrapped up should not solve
all of the problems though. According to the Bank for International Settlements
the debts of China’s companies are, relative to its economy, twice as large as those of
American companies. American companies are not known for their
prudent fear of leverage, so this could be a long-term issue for China. Evergrande’s problems are simply highlighting
this issue of excess leverage which has been building for decades. Evergrande defaulting on its own is unlikely
to cause a credit crisis in China. The main risk for China’s financial system
would be if other highly leveraged developers were to default at the same time. This is of course a real risk. Speculative excess in real estate is not,
generally, something that happens with just one developer or real estate investor. Evergrande owes a lot of money to suppliers,
if Evergrande defaults on these debts there could be all sorts of knock-on effects too
– these suppliers might need some sort of bail out in the event of a default. Over the last five years Chinese real estate
has on average gone up in value by around 50%, and of course this has a wealth effect
causing people to borrow and spend. The Chinese authorities, have been clamping
down on the real estate industry specifically because they don’t want an economy entirely
built on paper profits on houses. This is a bit of an issue all around the world,
where governments claim to be upset if housing is unaffordable, but then if there is any
sort of a dip in property prices they panic that a slowdown could kill growth. This is very much an issue in China where
real estate is the most important sector in the economy. The government don’t want a bubble, but
they also don’t want an economic slowdown Finally, to what extent will this impact markets
in the west? As we know, the global financial crisis quickly
spread from the united states to Europe, with China being the second largest economy in
the world, it could be a concern that a slowdown in China could severely impact the rest of
the world. It is worth noting though that Chinas markets
are significantly less interconnected with world markets than American markets are with
European markets. This is however a developing situation, and
your guess as to how things will work out is as good as mine. I’d love to hear your thoughts on the situation
in the comments section below. If you need more information and haven’t
watched my other videos on this topic here is a link – they are fairly short videos
like this and I aim to keep them fairly information dense. Talk to you soon. Bye.
