My Blog

June 29, 2008

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.

Yesterday Shouwang, one of my favorite local musicians (read about him in tomorrow’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.  Yesterday 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. 

Comments (12) for "Some anecdotal evidence of r...

Even with all 300 mio default evey month i assume thats only a small percentage of the total income for the banking industry? By Jarod - 6/29/2008 11:58 AM

Jarod, the issue is not the amount of loss on this particular transaction. It is the possibility that there are many other transactions of this nature. Whenever derivative fiascos in the past have occurred in the US and elsewhere the first revealed losses were "manageable". Most importantly this cannot by any means be considered a smart trade for the banks' customers -- it was nothing but a completely speculative bet hidden deep inside a "normal" banking transaction. By Michael Pettis - 6/29/2008 12:10 PM

Haha thats why they are customers and how the banks make their money. Banks actually understands the risk(as they hedge it out) so from banks point of views are fine but the customers will suffer should the reverse happens. And clients might save money in 9 out of 10 cases but will lose on the other although big. I dont hv mercy for that though. Its just like another trading loss. By Jarod - 6/29/2008 12:34 PM

But from what I hear the customers are backing away from the commitment, and it is difficult for the banks to pressure them, so the banks may indeed be taking on the losses. Anyway the fact that traders can profit from stupid customers does not mean that the regulators should ignore it. H ha you have become too much of a trader, kid. By Michael Pettis - 6/29/2008 2:25 PM

So these constructs are effectively based on euro carry trade, aren't they? Euro carry trade might be over, but the dollar curve is rather steep now. So they could go on with such derivatives using the USD, which has steepened up just recently or even if Bernanke hikes later, they can go for the JPY carry. By Gabor - 6/29/2008 6:24 PM

Mr Pettis Fascinating, have never quite understood the informal banking system, somehow it has always sounded like an underground operation with several cigarette men involved, sorry, too much x-phile flashback there- except the players involved are very human, humane however, is another question. It's interesting 'cos as recently as april/may, interviewees on financial news programmes were claiming interest rates at 22%. As for derivatives and bad boy trading styles, hmm, c'mon, the ones who get stiffed are usually those who get into the deals with their eyes closed, blinded by the shine of profits but tihs time, whether it is "face" , political factors or simply business worries (would other nasties appear if they had regulators breathing down their necks?!) , the informal banks seem like to be the sacrificial goats this time round, not much pity required there! Hey, the taxi situation seems pretty much the same all the time, those sweaty summer rides - how nostalgic! look at it this way, given the dodgy state of engines and air-conditioning systems, you might be saving yourself from some carbon monoxide poisoning! By Judy Yeo - 6/29/2008 8:36 PM

Well, I had mentioned the advantage of informal banking system here before. They can enforce the customers to honor their obligations pretty effectively. For the other story, not every customers would default on these transcactions. By fatbrick - 6/29/2008 9:13 PM

Gabor, funny you should say that. My source tells me that they used to play this game with the USD curve, but it got so steep that there was no juice in the trade (i.e. the value of option was too low). So they switched to euro. Judy, the cynic (and former banker) in me says that they get what they deserve. Anyone who gets "free" money must know that it cannot possibly be free, and if he's getting a nice salary as CFO he has no right to claim ignorance. I also know that any "good" banker who advised against the deal would simply see the deal go to his less generous competitor -- the client pays you to be sharp, cuts you out if you are not, and then complains when his bankers are all sharpies. Still, I also know how these things are sold and I would say that it doesn't behoove a bank in an advisory role to give such bad advice. By Michael Pettis - 6/29/2008 9:55 PM

Great financial journalism - I agree that these "tea leaves" are exceedingly important since the money world tends towards endemic themes! Also, it was nice seeing your quote in this week's "Economist". J.P. By Jean-Paul St.Germain - 6/29/2008 10:35 PM

Nice anecdotal data points on Chinese banking. Due diligence in China almost always produces some interesting surprises. How's Beida these days? I was there about 10 years ago. By Adam - 6/30/2008 2:35 PM

Mr Pettis it doesn't behoove a bank in an advisory role to give such bad advice not that that has ever stopped anyone?! remember the bad advice dispensed by analysts who put out buy pieces when proprietary dealers were trying to offload the same purchase-worthy instruments. business overlap is hardly new. betcha some of those muni victims are gearing up to claim the same innocence as those cfos you mentioned. frankly, no one in this dramedy is truly innocent and it is funnily all down to that same deadly sin:greed. Thought byou might see another aspect of hot flows this week; the 2 way exchange of Taiwan dollars and RMB- guess those tourists might just make extra cash on their holidays! By Judy Yeo - 6/30/2008 7:39 PM

MP, I'm not sure that the informal sector is working the same way as it did in the past (I have no real evidence, just based on anecdotal conversations). My understanding is that even in the informal sector, the liquidity providers are simply trying to make a spread and I'm not sure the money is coming from the old investors (the politicians, powerful businessmen) but rather a lot comes from outside the country. If this is true, those dire scenarios about kidnappings and bats wont come to pass. But an actual financial system shock very well might, as lending dries up or money tries to flee the country. And it will likely all happen at the same time as (and because) the economy slows. I do hear of some lawsuits against banks in India where naiive CFOs were sold currency derivatives (bets not hedges), so not likely that a similar situation exists (and possibly at a greater level due to the bigger economy, level of FDI, investment banking presence) in China as well. These are indeed financial WMD. As in the US, the risk is not the massive loss of one or two clients (survivable situation). The risk is to the financial system and that of a counterparty collapsing leading to loss of confidence and massive unwinding of positions as liquidity dries up. By MC - 7/2/2008 1:45 AM