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Post  Posted: June 30, 2008 - 11:42 PM  Reply with quote  Back to top
Post subject: Anecdotal Evidence of Risks in China's Banking System

http://seekingalpha.com/article/83228-anecdotal-evidence-of-risks-in-c hina-s-banking-system?source=yahoo

Before I talk about the banking system I just want to mention a quick story. After the 18% hike in fuel prices last week I wondered how taxi cabs in the major cities would fare – obviously fuel is a major component of their running costs. My understanding was that they had not been permitted to raise their prices in consequence of the price hike, and in Beijing I notice that I have been paying exactly the same prices for cab rides as I had before the price hike.



Saturday Shouwang, one of my favorite local musicians (read about him in Monday’s New Yorker), had to pick me up in a taxi. As I got in he apologized for the fact that the air conditioning was not on. He had asked the cabbie to turn it on but was told that because of the fuel price hike the cabbie could not afford to do so. That suddenly reminded me that in the previous week none of my cabs were air-conditioned, where typically half of them had been in the past. It seems that from now on (at least until they allow taxi fares to rise) cabbies and their passengers are going to have to deal with the hot Chinese summers without the help of air-conditioning – yet another way to disguise inflation, I guess.



But back to banks. Saturday I had an interesting lunch with a Chinese investor. We were discussing the informal banking sector in China, and he agreed that it seems to have grown a great deal in the recent past. Interestingly enough, according to him, loans to real estate developers had become a particularly important source of growth for these banks, which is perhaps not surprising given lending caps and attempts by the PBoC to discourage the commercial banks from taking on more real estate exposure.



He told me that he believed that the highest quality real estate developers were able to obtain one-year funding for around 15% which, given CPI inflation of around 8% (probably understated by 1-2%) and PPI inflation of around 9%, represents, I think, a reasonable borrowing cost for a prime creditor in a developing economy. Lower-tiered real estate developers, however, were paying 80% for one-year money, which is consistent with some of the other numbers I have heard. Very few of the real estate developers would be considered prime enough to get the lower cost funding.



Needless to say 80% is a pretty high cost of funding, and almost certainly requires rising real estate prices in order to be economically viable. In case of an economic contraction or declining real estate prices, I would assume that a lot of these real estate developers would face severe debt-servicing difficulties. We discussed what would happen in the case of a default – besides the proverbial visit by the man with a baseball bat he suggested, with a completely straight face, it was also likely that one of your kids might be kidnapped.



This kind of collection process strikes me as a reasonably strong argument for lower default rates in the Chinese informal banking sector than in the formal sector, at least in the initial stages of a contraction, although it also suggests that the Chinese banking habit of deferring losses might not work here. On the contrary, I expect that payment difficulties would lead to significant selling pressures as real estate developers try to raise cash as quickly as possible to meet their obligations (and get their kid back). I guess that in areas characterized by large informal banking sectors, real estate price corrections are likely to occur much more rapidly than in places like Beijing, where I think the informal banking sector is relatively much weaker.



The other systemic implication I drew from this conversation was his claim that the informal banking sector gets at least part of its funding from the formal banking sector – in cities where the informal banking sector is large, the largest informal banks often have strong connections with senior bankers and senior local politicians. This means that payment difficulties for informal bank customers, if they lead to payment difficulties for the informal banks, can spread directly into the banking system, as well as indirectly, if informal banks force liquidation of assets and so put downward pricing pressure on real estate in a time of generally declining real estate prices. Unfortunately no one I speak to can estimate the size of these relationships.



On a separate but related matter, earlier this week I received an email from one of my former students, now working for a large international bank. He told me that his credit people were getting worried about possible difficulties on some derivative-related transactions involving Chinese banks and their corporate customers.



According to him, a very popular recent lending structure involved lowering borrowing costs for corporate borrowers by having the borrower implicitly sell a complex derivative (this is a common, and often dangerous, way of lowering borrowing costs). Let me explain this as schematically as I can.



A corporation borrows some notional amount from a bank, for five years, and agrees to pay 8% on the loan. The corporation and the bank simultaneously enter into a swap, for the same notional amount, in which the bank agrees to pay the corporation 1% annually, as long as the euro interest rate curve is “normal”. Should the curve invert, however, the corporation must pay the bank some amount, typically 4 bps per day according to my source.



The net result is that the corporation is able to borrow money at 7% instead of 8%, and in exchange it agrees to pay a significant penalty if the euro curve inverts – something that is extremely unlikely to occur, the CFO is probably told. From the bank’s point of view, they are still getting 8% funding, because they simply strip the option and sell it on to the foreign banks, who have the capability and expertise to monetize the option.



It sounds great on the face of it. As long as the euro curve does not invert, and I am sure the corporate borrower is given reams of data showing how rare that occurrence is, everybody is happy. The corporation borrows at 7%. The local bank lends at 8%, and makes additional fee income by implicitly buying the option from the corporation at a lower price than it sells to the foreign bank. And the foreign bank gets to sell a fairly complex derivative whose pricing formula is opaque (in investment banking jargon, “opaque” means “I can get away with charging a lot”).



Unfortunately, from what I have been told, the euro curve has inverted, and has been inverted for over a month. Furthermore, it is deeply enough inverted that there is little expectation that it will normalize soon. Corporations have suddenly seen their borrowing cost mushroom. The transaction that had previously reduced borrowing costs by 1% a year was now increasing borrowing costs by 10% a year on an annualized basis.



Many of these borrowers, apparently, are now refusing to honor the agreement. Unfortunately for the local banks, however, because they entered into mirror agreements with their foreign bank counterparts, they must pay anyway, except that the expected income from the corporations, which would have hedged their position, is no longer available. I guess that it is either embarrassing or politically difficult for the local banks to force their customers to honor the agreement.



I have been told that all the major Chinese banks have received impatient margin calls from their foreign counterparts, and that there may even be court action. My source tells me there is about RMB 170 billion outstanding of these swaps. That implies additional payments due of about $300 million per month.



The biggest problem with these transactions, of course, is not whether the banks are going to be paid for these specific losses, but rather that they occurred in the first place. I cannot think of any way in which the euro yield inversion play might have been considered a hedge for Chinese corporations, and so I can only assume that the swap was a purely speculative bet on a completely unrelated market in which the bet was concealed via a lowered interest rate. Anyone who remembers the derivatives-based debacles of the early 1990s, when interest rate markets suddenly did what everyone knew they could not possibly do, and so unleashed an explosion of losses on some truly insane derivative positions, can see where this kind of thing might lead.



I have no idea of how widespread these types of transactions are, but common sense and a little experience suggests that recent conditions have been ripe for an orgy of fairly dodgy derivative transactions sold to greedy customers, who salivate at anything that might lower their financing cost, but who lack the ability and stomach to address the risks. Of course when everything falls apart, their first recourse will be to innocence – how could they possibly have know that all this free money came with strings attached? – and the banks, preferably the foreign banks, will take the blame.



But no matter who gets blamed, the losses will be real. I cannot confirm that this story is true, but I did discuss this transaction with several knowledgeable friends and former students. They all either had heard of these and similar transactions or told me that the story was completely plausible. Unless the regulators are fully aware of the extent of these and similar exposures, there is a real risk that at exactly the wrong time for the banking system and the economy we will discover all sorts of additional and poorly-understood risks hidden away in banks’ balance sheets.



Anyone heard anything regarding this?

Phiota
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Post  Posted: July 01, 2008 - 06:57 AM  Reply with quote  Back to top

It's the same for all banks, anywhere. What matters is % of risky loans, investments, etc., not the fact that these risky deals exist. Look up the pre-2005 statistics on Chinese banks, then what steps banks have taken since then. The risk has not disappeared, it is just smaller when viewed as a % of the bank's 'net worth'.

US banks are doing the same thing now because of the housing loan crash/foreclosures. Cash rich countries in the Middle East are loaning Citibank, etc. billions of dollars to make the balance sheets look better, but the defaulted home loans still exist.