One lesson from the 2007-08 crisis was that the vast majority of financial market participants, never mind the general public, were unfamiliar with subprime mortgages until the crisis was underway. Even now, we doubt many have much understanding of repo, the divergence between LIBOR and Fed Funds from 9 August 2007 and Eurodollar liquidity. In a similar way, when China’s bubble bursts, we doubt the majority will be that familiar with “ghost collateral” and “yin-yang” property contracts either.
A second lesson from the 2007-08 crisis was that as the value of the collateral underpinning the vast amount of leverage declined, the surge in margin calls led to cascading waves of selling in a downward spiral.
A third lesson was that the practice of re-hypothecating the same subprime mortgage bonds more than once, meant collateral supporting the most vulnerable part of the credit bubble was non-existent. It only became apparent with the falling prices and margin calls. Few people realised the bull market was built on such flimsy foundations, as long as prices kept rising.
A fourth lesson was that in order for the bubble to reach truly epic proportions, key financial institutions, especially banks, needed to conduct themselves in a negligent fashion and totally ignore increasing risks.
Each of these warning signs from the 2007-08 crisis exists in China’s property market now – and other parts of its financial system – bar one…falling prices leading to cascading waves of selling. However, as we’ll explain, we think it’s only a matter of months away now.
We should note that our thesis that China’s bubble would eventually be undermined by a “black hole” of insufficient collateral is one that we have been developing for several years. What we came to realise is that insufficient collateral is nothing more than normal business practice in the Chinese economy. It doesn’t matter whether it’s related to commodity-backed loans, property speculation or managing redemptions in the Wealth Management Products (WMPs) sector.
The first sign of this practice to received worldwide attention came to light in 2014 with the collateral fraud at China’s third largest port, Qingdao, which spreading to another port, Penglai, before it suddenly got covered up stopped. Numerous borrowers were found to have pledged the same copper and steel inventory as collateral to obtain funding from various banks, including state-owned Citic Resources, as well as Citi, Standard Chartered and others.
Not long after the scandal emerged, media attention began to wane, as commentators either assumed it was fixed or were distracted by other issues. However, it wasn’t fixed and we had a shocking reminder last month with the first major publicly announced loss. ED&F Man took an $80m hit after acting as a broker between Australia’s ANZ Bank and two Hong Kong-based trading companies in a sale-and-repurchase financing deal. The trade was backed by storage receipts for about $300 million of nickel stored in Glencore-owned warehouses in Asia. The problem was that the warehouse receipts were forged. As we said,
What is surprising is that it has taken over three years for the first serious hit from China’s “ghost collateral” to emerge. Or perhaps not: in a time of generally rising prices, few if any traders actually bother to check if their pledged collateral ever exists. The problem emerges when prices decline, which courtesy of China’s bubble machine, has so far not been an issue.