The Evergrande Crisis [TFC 109]

The Evergrande Crisis [TFC 109]

Evergrande, the second largest property developer in China, is in hot soup. News of its financial troubles erupted recently with people fearing for the worst. What exactly happened that led to the current crisis? How should we understand this piece of news, and are there any opportunities that we can take advantage of? Listen to TFC 109 as we break down the Evergrande crisis for you.

It seems improbable that a company like Evergrande can get into trouble but it is not impossible. Because of overleveraging, it found itself in debt of US$150 billion and incurred a staggering gearing ratio of 240%.

Does this mean the end for the company, or will the Chinese government intervene and buy it out? Will this be another Lehman crash like what many predicted? For opportunistic investors, how would they ride this wave (assuming they do)? Get a fresh perspective as Reggie dissects the issue in a rational manner. Some of his thoughts also run contrary to what others are thinking. Find out what they are!

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podcast Transcript

Reggie: Hey Coconuts! I get it. Everyone is concerned. What is going to happen to Evergrande, the Chinese stock market and the global stock market? At the core, people want to know how it’s going to affect my investments. The truth is I don’t really like to participate in this kind of discussions and I’m not feeling great, but I think that US mainstream media and also a lot of online people… they’re not giving a very fair assessment and they are not being very real. I just want to come in and share my perspective to be a little bit clear about where I stand. You don’t need to take my word as the end all be all, but I’m pretty sure you guys are concerned and want to hear a little bit of where I see this thing, so welcome back to the Financial Coconut! 

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Good morning, everyone! I welcome you to another day with The Financial Coconut. In our podcast, we are debunking financial myths, discovering best financial practices and discussing financial strategies that fit our unique life. You get it, ultimately empowering us to create a life we love while managing our finances well and today I’m going to interject regular programming to talk a little bit about this whole Evergrande saga and how is it going to affect your investment?

Oh, yes. My name is Reggie and I’m the Chief Financial Coconut. Recently, we have more and more personalities in the network so I thought I should name myself and give you a little bit more clarity of who I am. We are recording today on the 23rd of September and it will be releasing in the coming Tuesday. We will interject regular programming. So by then, if some of the things happened already or some things play out differently then… hey, don’t mark my word for it, okay? 

I want to come in to share with you guys my perspective and share some thoughts about this whole thing. Of course, the reality is it’s a lot bigger than what we can understand and nobody really knows what’s going to happen. There’s a lot of strategic calculation that needs to come about before you can decide some of these things, so all that jazz… I’m going to share you what I know. 

I’m going to answer three questions today. The first question is will this be a Lehman situation? Will this be a Lehman crash saga… or should I put it, will this be a 2008 mortgage derivative saga, same as the US? I will answer this question. The second question I will be answering is will it be bought out by the government? Will Evergrande be bought out by the government and what is my most probable take on this situation? And of course the third question I want to put out there is how am I going to play this? Not advice, not recommendation, but how am I going to play this situation? 

Always, when there’s a shitty situation, that tends to be opportunities, at least in my view. And also, Buffett says it. I don’t like to quote Buffett, but everybody quotes Buffett. So yeah, he said “if other people are greedy, you should be afraid. If other people are afraid, you should be greedy.” Generally, the idea is whenever there’s a shit show, whenever something’s happening, there’s always some opportunity out there that you could potentially explore. Not recommending you, but just sharing with you how am I going to play this thing. 

Also, if you cannot yet tell, yes, I’m a little bit nasally today and I’m done with the flu. I shouldn’t be recording but for all of you here, I’m going to share with you my perspective. 

So what is Evergrande? Who is Evergrande? Evergrande is not some small company. I’m sure you know by now, which is why it’s making the news all over the place, right? It is China’s second largest property developer by sales. Based on the number of sales, the number of projects that they have, they are the second largest property developer. 

Recently, their share price have come down quite a bit. Close to 80% in the past year, but this whole saga didn’t… build over time. Since about 2017, they already had this issue with the gearing ratio very high. They have about 240% of gearing ratio, which means for every dollar that you own in the company, every dollar of equity that you own in the company, the company has $2.40 of debt on top of that minus cash. Essentially, in other words, they have a lot, a lot, a lot of debt. 

They are not the only guys. Across the board, a lot of companies in China, especially property developers, real estate people have taken on a lot of debts because what is the system? The system is they take a certain amount of money, capital, they go and buy a piece of land. After they get a piece of land, they get it approved then they start selling. They start selling the property with a blueprint. With the selling, they take back about 30% because the locals, the people there actually buy property at about 20-30% down payment. 

They take that 20-30% to go and build the property and then they take this piece of land to go and mortgage and then take that extra loan from the mortgage to go and buy the next piece of land and then the cycle keeps growing. Also in between, they will sell some high yield investments or corporate bonds to raise more money to develop the project and all that jazz.

So a lot of these kind of leverage built up over time. They are not the only one and… but the central bank also knows. About 2018, they already report that this is a potential problem. The central bank of China already report in 2018 that Evergrande and some of the other companies are potential systemic risk.

In other words, the Chinese government is prepared. They have already seen this coming, which is why they’ve issued more regulations which you can go and read about online. They call it the Three Red Lines. I will not dabble in that, but the idea is 恒大, which is Evergrande, after all the suite of regulations found it very hard to get more liquidity, to get more cashflow, to continue to pile up and roll this game because what’s the game? 

You own the land. You sell to the buyer and buyer give you the deposit. You go and develop this land. Then you take whatever mortgage that you can get from this piece of land to buy the next land, so then it just keeps compounding. That is the gameplay. As and when cashflow has problem or the property value no longer goes up, the sales got issue, it’s all going to make it very hard for Evergrande to do anything which is what is happening today. That’s the broad idea.

What is the total volume of Evergrande today? This company has estimated $300 billion in asset size today and also about $150 over billion (all these in US dollars) in debt… corporate debt which has been collaterized and sold into the market.

If you own some sort of Asian high yield bond fund or Asian corporate bond fund, what have you… high yield and corporate, these two terms in your bond fund. You can go and search whether do they own Evergrande within the portfolio which definitely… I think they will. If they had the largest guys selling that and if you’re running a big bond fund, it’s very hard not to own some of this especially in a corporate high yield. But don’t be alarmed because a lot of these corporate bond funds, they are really broadly diversified and you should factor in about two to 3% default rate in this kind of high yield bond fund already.

If you have not checked out an episode that we did with Jean Paul from FSMOne, you should go and check it out under Chills with TFC, Jean Paul, which is Episode 25, Chills with TFC. Go and check it out. Learn a little bit more about corporate bonds and the Asian high yield debt. 

But throwing all these numbers around makes no sense. How do you read this thing? How do you try to understand the situation? Which brings me to our first question: will this be a Lehman crash? Everything I say from now on may come back and bite me so this is something that I think I need to put it out there that I’m going for the most probable situation. Not that other things will never happen because investing is about probability.

My view is it will not be a Lehman crash. In other words, it will not be this huge situation where the whole market will collapse and the whole world will go into some long period of depression and the government to keep printing money to save this whole shit out. That is my base case. 

Why? If you think about it, Lehman is the only one that collapsed during the 2008 financial mortgage crisis. By the way, it’s a mortgage crisis. It’s different from the developer going bust. The mortgage crisis is based on credit default swaps. I’m not going to go into the details in today’s discussion. It’s just too complicated, but the base idea is there were a lot of people borrowing in the US to buy property. As more and more people borrowed money to buy property, property prices go up which is what you’re seeing in Singapore. A lot of people are also buying a lot of property these days so property prices will move up because limited supply, it keeps growing, right? The price keeps going up. 

What happens is a lot of other people want to capitalize on this growth. As more people want to capitalize on this growth, it’s not just the investor, not just the end consumer. Even the mortgage people also want to capitalize so they started giving out all sorts of weird mortgages out to the people. Essentially, the people that are borrowing money from the banks to buy property, their credit rating… not the best, because at some point in time, you have to start to lend to other people that is not within the immediate pool of consumers that are… good credit rating and care will pay you back.

This is what happens on the ground, but one tier on top, a lot of these mortgage brokers in the banks, they were structuring all these mortgages together. They were buying all these different mortgages put together and then they go and sell it as a mortgage derivative. They go to sell it as a mortgage fund out in the market. Because the bank lend all this money to all these people, they don’t want to keep it on their books because when they keep all these debt on their books, it makes it very expensive for them to operate. They don’t have additional liquidity. They don’t have enough money in their bank account to lend more money because the bank fundamentally makes money from moving capital from lending money around. That is their fundamental business. 

What happens is after they lend all the money to all these different people, they package all their debt, all their mortgage debt together and then they securitize it. They sell it as a mortgage fund in the market. You can go and buy the fund, or some other bond funds will go and buy it, or some other asset management company will go buy those funds. That’s the second layer of structured bond funds, structured mortgages. 

As more and more people start to enter this game, other people are betting on how these mortgages will work. That is when your derivatives come in so your options, your futures and all those kinds of stuff. Of course, in this particular case, they call themselves the credit default swaps. I will not go into the detail. Please go and search if you want to find out what is a credit default swap. 

The base idea is there are a lot of derivative. Although the total asset in the particular situation, the total mortgage at that point in time was a lot smaller. It was above $7.1 trillion in total mortgage. The overall default swap was $45 trillion. That means people were making side bets and all the deriatives… everything ballooned to $45 trillion market. It definitely took some time before the economies can come together to say that “yeah, actually it’s $45 trillion.” 

It’s so big that at that point that nobody was clear what is going on. So if you think about it today, we call it the Lehman crash. The Lehman brothers died but they were not the only ones. Best, AIG. Goldman… a lot of people were barely breathing. A lot of big banks were barely breathing because they were all making side bets. They were all brokering these bets. 

Because of that, all of their books are in shit show. They were all… almost died. Citibank also almost died, but some of them got bailed out. Some of them got invested and liquidated. Additional liquidity was added to the company. Only Lehman ended its business and they closed down. But let’s not forget: Lehman was not the only one that was struggling. Everyone needs CPR. Only this guy died. Not enough ventilator. That is the situation. 

But today, why I think this whole thing will not be a Lehman situation is because two reasons. One reason is there are no big derivatives on this situation. That means the overall debt size is $150 over billion. Yes, that’s one thing. The overall assets were about $300 over billion. Yes, that’s another thing. But there isn’t all these complex financial tools that are being built on it and people are not betting on the thing yet. 

In other words, the problem is a lot more controlled and a lot more understandable. When it’s a lot more understandable, there are structured ways to go about liquidating the business, restructuring the debt and then Evergrande would disappear or split into multiple companies. The government may buy over and continue to build the projects to return to the people. 

It’s just a lot smaller than the Lehman situation. Please recognize this. This is my base idea. $45 trillion of overall credit default swaps during the Lehman crisis and $100 over billion in corporate debt and $300 billion in total assets… yes, you can say there are all these other property companies that also possibly will default following blah, blah, blah. I think not impossible, but even if you add all of them together, it’s nowhere near $45 trillion. So this is the base idea for why I don’t think it will be a Lehman crash. 

Also, there’s the other sub idea why I don’t think this will be a Lehman crash is because the company actually own real assets. They own land, they own property and people want it. They just want it at a discount. People want to buy it at a discount? It is not a derivative. It is not like some weird future, some weird options, something in the air that people don’t want. 

Just remember recently, the oil price came down. Remember? So why at a point in time, the oil prices came down was because the futures were coming, they were expiring. In other words, during that period of time, if you own the oil futures, you have to own the oil, but all the oil tankers and all the storage spaces were already full and nobody could get the product. A lot of people don’t want the oil. They just want to make money in the game which is why they have all these derivatives.

All that being said, the idea with Evergrande is that they actually own land. They actually own property and people want it. They are not buying weird things. In that sense, there will be fire sale. People will buy the land and all that jazz. There will be an orderly liquidation process where people actually want it, whether or not these other companies are individuals or small time investors or big time investors or companies other than government, they’re all okay to buy it back. You can recapitalize. In other words, put in new cash to build a property or do something about it. There are ways to go about it. It’s not airy fairy. 

So with these two sub ideas, I believe that my base case is it will not be a Lehman crash. It is not as wild as what the media is trying to make it sound like. By the time this episode goes out, maybe the media will not be talking about it anymore but I hope you get a clearer idea after point number one, which brings me to point number two. 

Question number two is will Evergrande be bought out? I think some people are interested in this. They want to find out will the Chinese government come in and buy out Evergrande? Will this be saved, in other words? I’ll answer this question after a word from our sponsor. 

A lot of people are talking about moral hazard. A lot of the US people talk about moral hazard and all this kind of thing. Should the government come in and buy it? Honestly, the government don’t care. The Chinese government does not share a moral hazard as what the US people look at the situation because the US believe in a free market. In other words, everything is bottom up. The people at the top should not disturb what’s happening in the market. 

But in China, everything is top down. It’s a central approach. The Chinese government is actively disturbing the market, putting our policies, restructuring people and closing companies and all that jazz. So the Chinese government has no moral hazard in this situation, but I don’t think they have interests to save the company in a sense of buying out the company or buying out the debt and what have you. 

I think the Chinese government wants the company to default, wants the company to fall from grace. It’s a good lesson for the people running businesses in China. It’s also a great platform for them to let people know if you want to do business in China, this is the situation. They don’t want to be seen as buying out all these companies and oh, you are too big to fail. You can just do all sorts of shit.

So this is the base idea. I think it’s very likely Evergrande may exist in parts so they may be broken down into different parts and sold to local government or sold to its competitors. Also, their assets underneath the land, the property, the half baked stuff, they will all be distributed across. That is one way to go about doing it. 

There’s also this other part of trying to save their supply chain, so all your people that do steel, do sand, manufacture all the by-product operating all the big equipments… all these guys will get some sort of support in terms of liquidity. It means the bank will lend them extra money or give them mortgage moratorium or loan moratoriums where there’ll be an extended period of time where you don’t need to repay a loan. But all that jazz, it’s not important. 

All you need to understand is that Evergrande highly likely will not be saved because the government does not want. Also, because this whole thing is very much in RMB, the Chinese government actually has a lot of control. So they can do a lot of magic. They can do a lot of pattern. They will save the broader industry but they will unlikely save Evergrande.

So if you are thinking of “oh, should I buy Evergrande or should I buy into the bonds, buy into the debt?” and what have you, I would say may or may not. I will not do it, personally for me. Because all these is about probabilistic. My most probable case is they will not save it. They will save the broader sector. They will add more liquidity into the space to make sure they can tide through this whole situation. That is my idea. 

Which brings me to question number three: how would I play this situation? The truth is you don’t need to play. You don’t need to participate. You can just chill and do your thing and live your life. The market will correct itself if you are broadly diversified. But if you are a little bit more opportunistic, like I am… not a recommendation, this is how I would do it. 

First thing is I will not be in any other property developers. I will not be in their supply chain. I will not be in the financial companies that are directly within this space. All the big banks with a lot of exposure or all your financial firms which have exposure in this space, I’m out although I say highly unlikely, there’ll be a Lehman-like crash, highly unlikely Evergrande will be saved. The most probable situation is the government will come in to save the broad sector, but not the company. They will provide liquidity and all that. 

Even though I say that’s the most probable situation, I don’t think you should go in to the space thinking that oh, you can capitalize on the sector itself because the sector will be very debt laden. There’ll be a lot of problems and a lot of peripheral earthquakes that will happen that you don’t know what’s going to happen.

There will probably be smaller defaults here and there. There will be more bubbles that come up. There will be problems in the sector so I will stay away from property. I will stay away from anybody that is within the supply chain. I also will stay away from the financial companies in general. 

But if I am looking at the situation, I am looking at the Chinese tech companies. I’m also looking at the Chinese consumers, consumer companies, consumer brands and consumer staples. These two sectors, specifically. Of course, consumer brands… very broad: restaurants, fashion, all those other things. You can put them together as consumer brands. 

But the broad idea is I want to be in spaces where I think don’t really have that much exposure in the space and can continue to ride up the Chinese economy because I’ve already established that my most probable situation is the economy will not crash. The company will crash. The sector will get reformed, but the whole economy will not crash. The thing will stay stable. 

In other words, I want to go into spaces where you can continue to ride this wave and also unfairly sold in the situation because… why do I think it’s unfairly sold? Because I don’t buy into the idea that it will be a spiral downwards. Because if I don’t buy into the idea that there will be a spiral downwards, this will be a sectorial problem. 

So all the angmohs (foreigners) out there telling you that “oh, you know it’s going to blah, blah, blah. This whole shit is going to blow up. China’s going to end.” I don’t really think so, based on the thought process that I’ve laid out. With that idea, I want to buy it to all these other companies that are unfairly sold. 

Tech is definitely a thing. They’re already very low in price relative to where they were and also, they have all these slew of regulation which we talked about it in a few episodes down. You were here, my take on the Chinese tech market. So yes, I definitely am looking at tech. I’m definitely looking at consumer staples. 

In other words, you don’t need to be in this space but you want to be in spaces where… or you potentially want to be in spaces not directly within the peripheral of this earthquake, okay? That is my base case. 

I’m going to sum it up today. The three questions are: will this be a Lehman crash such that it is a whole country problem or an international financial market problem? I don’t think so because it is based on a relatively small corporate debt size compared to the derivative markets of $45 trillion during the 2008 mortgage financial crisis in the US so I don’t think that’s going to happen. 

Number two is will Evergrande be saved in this situation? I doubt so. I don’t think Evergrande will be saved. It will be chopped up, it will exist in a different name or it may exist in smaller fraction. The government has no interest in saving the company but they have interest in saving the sector so they will come in to save the supply chain, save the financial companies in the space, not in the sense of buying over them, but really just giving them liquidity and support so that they can ride through this problem. 

Number three is how will I play it? Because I believe that this will not be a financial crash situation. It will be a sectorial earthquake. Within the sector, there’ll be problems so I’m staying away from all the people in the space. Your property developers, your supply chain guys and your financial guys, I’m out. But I am looking at all the other spaces of consumer brands, consumer staples and also your big tech, your Chinese tech companies. We will talk about this in another episode. More importantly, I hope you learnt something useful today. See ya!

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Yes, I hope you learnt something useful and I’m sorry for my substandard presentation because I just have a very bad flu if you cannot yet tell. It’s very cute. But yes, I think a lot of the angmohs, a lot of Americans, they don’t understand what’s going on in China. They don’t understand the situation that everything they see from data… top-down, but they don’t have the narrative to match the data so they only see the market based on their own view. 

One of the worst things that I’ve heard in terms of accuracy of understanding is that there’ll be a lot of homeless people in China. The truth is it will not be the case. A lot of Chinese people own very big house in their kampung (village). They leave their family in the rural parts of China and they themselves or they as a couple go to the city centre to make the city wage and then arbitrage it back to the family in the kampung. 

During the Revolution in early days, actually a lot of the locals, they took back the land so there are a lot of rural land owners, unlike the situation of the US where there were a lot of slaves, very little owners. So all the slaves had to go to the city centre to work and they got nothing to base themselves on. 

A lot of the Chinese rural population actually own the land so they have a way to go about… and if you have friends that are from China, you go to their hometown, the house is so big, macam like mansion. It’s like GCB everywhere, Good Class Bungalow at every single corner. Please go and learn a little bit more about how the Chinese economy works, what’s happening in China. I think a lot of the Americans don’t understand it. 

All that being said, I’m not discounting the fact that this is a problem and it may be a situation where it’s only one of the problem. You may see other defaults come in. You may see other problems coming which previously there were already quite a few defaults from state banks to smaller financial institutions, a lot of problems already… Insurance companies. The Chinese government has consistently been able to provide liquidity and tide through and restructure the market.

They have no moral hazard. They are not interested in that. They only care about the long-term growth of the company so as long as they’re not owning money to other people, they can do everything they want to keep the company going. So all your angmoh talk of homelessness. moral hazard, blah blah blah… they don’t exist in China. They don’t understand China. 

With that, I hope you learnt something useful. I will also be talking a little bit about Chinese tech, which was already recorded in the next few episodes coming. If you have any questions specifically, do let me know. 

But I’m also saying that this is not a crystal ball. I’m not saying that this will definitely be the case, but I just want to put out my view, my perspective and for you to make a more informed decision, make your own positions. If you’re unsure, broadly diversified, don’t need to be too opportunistic. Just chill, go and have a muffin, have a cup of coffee, enjoy with your friends and that’s about it, okay? Take care.

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