The Chinese property market – is it Lehman Brothers part II?

In 2007, one of the world’s biggest investment banks, Lehman Brothers, collapsed into bankruptcy after suffering months of share price declines amid rumours of its subprime mortgage exposure. For those readers of a more tender age, the investment banking system had basically loaned funds to property investors that were fundamentally incapable of keeping up with repayments. The basic premise of a mortgage is that the bank lends a borrower the majority of the capital required to purchase a property upfront, to be repaid in instalments over 10-35 years. Most mortgage lenders offer attractive ‘introductory’ rates that are much lower than their regular rates (usually less than 50%). Once these rates expire, the mortgage rates default back to their normal rate, increasing repayment costs and usually causing the borrower to move lender (using another bank to repay the first and benefitting from a new ‘introductory’ rate in the process).

To protect their chances of repayment, lenders usually offer funds based on a multiple of income and with a deposit of cash up front to ensure the borrower has some equity in the property. In tight mortgage markets, these expected deposits can be as much as 25%, and repayment terms come with higher rates of interest than in ‘easy’ markets. Then, to increase the number of mortgages issued, the banks cut lending standards, reducing the initial deposit required, offering ludicrous introductory offers such as multi-year grace periods at zero percent interest, and greatly pushing the multiples of income they would lend. Inevitably, this led to a mortgage market packed to the gills with no money down, low or no income borrowers with multiple mortgages. The banks then decided that the best way to guard against the risk of individual default was to package up thousands of individual mortgages in a single bond, spreading the risk across thousands of borrowers and individual properties. Based on the idea that ‘noone ever stops paying their mortgage’, they decided that this was “good enough” protection, and got the rating agencies to mark the bonds as AAA safe, when in fact, they were some of the riskiest lending products in the market.

Lehman Brothers traders, being some of the “smartest guys in the room”, managed to load up the bank’s balance sheet with hundreds of millions of dollars of these bonds and the bank’s management simply looked the other way, as the bonds were hugely profitable to trade. When interest rates began to increase, the borrowers began to default. At first, the effect was slow, as the grace periods took effect. When these ran out, borrowers scraped together the funds needed for the increased payment, but as rates continued to rise and unemployment with it, many began to default on their mortgages and hand their keys back to their lenders. The ensuing crisis would go on to force Lehman Brothers into insolvency, almost taking several other major Wall Street institutions with it, and precipitated what would go on to be known as the Great Financial Crisis.

The Chinese Property Crisis

Fast forward 15 years and history looks to be repeating itself on the other side of the world in China, where an overheated property market caused the Chinese Communist Party to launch a clamp-down on debt in the property sector with their “Three Red Line” policy. The three red lines after which the policy are named refer to debt levels taken on by property developers in relation to their cash, equity and asset values, which once breached, mandate action be taken to reduce debt.

Unfortunately for the developers, the entire industry has been built on a mountain of debt which has been accrued to such a level as to be almost unmanageable. The largest of these developers, Evergrande and Country Garden, have hundreds of billions of dollars of borrowing, with tens of thousands of properties owed to customers, and even more that they are currently trying to sell. Raising cash quickly is not a position most businesses want to be in during even ordinary market conditions. In a world with interest rates shooting through the roof it’s potentially a killer.

The executive teams for these businesses have a limited number of options available to them. In a crisis, daily liquidity becomes critical – it only takes one miss-forecast payment to cause a default and in a crisis, everyone is stressed, worried and more likely than ever to miss one. A payment from a debtor arriving late, or a creditor requesting a larger repayment than planned is disastrous.

Increasing cash flow into the business will be one of the top priorities. The problem is that Chinese borrowers are already stretched to the hilt – many cannot afford to pay more than they already are, with studies showing that Chinese families are already relying on multiple generations to afford even a single residence. In this instance, the executive teams will be increasing billing cycles, offering early repayment discounts, discounting excess stock (of which there is a significant volume) and attempting to offload redundant assets (anyone fancy a football stadium?).

The challenge here is that they can only push so hard. Demanding too much cash too fast will result in forced defaults as stressed borrowers simply bow to the inevitable and hand back the keys (or in many cases walk away from the rights to properties that haven’t even been finished yet). In addition, many of these levers decrease margins – and when interest costs are soaring, many lenders have limited ability to absorb shrinking margins.

Secondly, the management team can attempt to hold off repayments. Delaying and restructuring payments, negotiating reduced interest rates, putting a hold on certain payments – anything and everything to help slow down the rate of cash pouring out the door. Again, this comes with problems. Put a halt on the wrong supplier and they might simply down tools, halting operations of the business. Attempting to push a creditor too hard could also spook lenders to the company resulting in demands for increased repayment and making the company’s position even worse than it already was. Panicking suppliers and lenders can trigger a run on the company as lenders suddenly realise that they’re in a queue of individuals that all have a claim to limited capital that can’t fully cover the liabilities.

The ability to incur further liabilities also needs to be tightly monitored and barriers put in place to limit the ability of the company to create more of these. If one half of the business is focused on reducing debt but the other half continues to operate as normal, the company will achieve little, despite working hard to improve the situation. Again, the problem here is that if command and control becomes too centralised, the business will grind to a halt, making it harder to bring cash in the door.

In short, these businesses are facing a terrific problem and have been for a very long time. Much like Lehman Brothers, the world seems to be split between commentators insisting there is a huge problem and others that are adamant that the situation is under control and that we have nothing to worry about.

What happens next?

So what do I think? Well, let’s look at some facts:

  • According to reports the property sector is responsible for approximately 25% of China’s GDP. The largest of these include companies such as Evergrande and Country Garden.
  • The largest developer, Evergrande, filed for Chapter 15 bankruptcy during the summer of 2023.
  • Another of China’s largest, Country Garden, has begun missing debt repayments.
  • Multiple Chinese, UK and US banks have suffered from bank runs since 2022. These include the Bank of Cangzhou, Henan Bank and Baoshang Bank which declared bankruptcy.
  • Reuters has reported China’s largest banks are making significant write-downs to their property portfolios.
  • Multiple globally significant banking institutions are showing signs of equity distress, with the worst of these, Credit Suisse, being forced into an acquisition by UBS, their largest national rival.

Reading the above list, you may be of the opinion that I think we’re all doomed. When Lehman Brothers collapsed, it was a disaster for shareholders and symptomatic of a far greater rot in the financial system than the majority of investors appreciated. Having said this, eventually the markets recovered and met new heights. If you had invested £10,000 in 2009 and held it to 2023, you would have over £67,000, a 577% cumulative return or over 14% annualised. You just had to hold your nerve.

The missing ‘x’ factor in this equation is of course, what happened as the Great Financial Crisis kicked off. In other words, one of the world’s most insane financial experiments – a multi-year combination of record money printing and zero percent interest rates – which acted to greatly inflate the price of assets including the stock market. The pinnacle of this madness was a global lockdown thanks to the COVID-19 pandemic, which has largely destroyed the commercial property market (perhaps permanently), and caused governments around the world to hand out cash to actively discourage economic activity (paying people to stay at home and forcing employees into ‘furlough’ schemes) and then wondering why people don’t want to go back to work.

Inevitably, printing endless amounts of cash and shutting the economy down proved problematic – inflation was eventually sparked and is proving challenging to quell. Central banks are now attempting to drain the excess liquidity from the banking system and have hiked interest rates in an attempt to get the ‘inflation genie’ back in the bottle. Unfortunately, many of the world’s developed economies have gotten used to allowing record spending deficits where citizens want every service to be provided by the government but don’t want to pay for any of it. We have allowed billions of pounds of economic value to be sheltered in tax havens, reduced tax rates for the most wealthy, and allowed vast amounts of capital to be allocated to economically irrelevant activity. See Non-Fungible Tokens, Bitcoin, and “growth” stocks like WeWork and Uber, which provide the merest nod to “innovation” while failing to solve any problem and incinerating vast amounts of capital along the way.

At the same time, governments have taken on an increasingly desperate funding position, accruing enormous liabilities whilst reducing their tax bases to the point of insanity. In the US, debt costs have nearly doubled in just two years to over $650 billion annually. If rates remain elevated, experts are forecasting that interest payments on the debt could reach an enormous $2 trillion per year by the end of the decade, consuming nearly a third of total government income.

Against this backdrop, China’s property market woes are yet another crack in a system that hardly looks to be the pinnacle of health. Although I am certain that the Chinese authorities are attempting to downplay the situation, it feels increasingly obvious that the problem is out of their hands, and that billions pounds of balance sheet ‘assets’ will simply be destroyed in a system that inevitably has to realise the true economic value of an oversupplied commodity.

Add in the cryptocurrency losses around the world, currently estimated at around $2 trillion dollars of a $3 trillion dollar market, losses from NFTs, losses from equity valuations, and continue write-downs in the property market, and I can see a great many investors feeling much poorer for some time to come.

Patient capital and keeping calm in difficult markets

So what is an investor to do in times like this? Hide under the bed with a bar of gold and a bottle of whiskey? Buy the dip? Sell everything and move to cash? Naturally, I do not think that any of these are the right response by default, but instead feel that keeping a calm and considered attitude is essential. Mentally prepare yourself for continued, significant market volatility – mostly to the downside – for the foreseeable future. If you are likely to need the capital you are investing within the next five years, then keep it in cash and real assets. By real assets, I mean assets that you can hold and which would likely have value to another person in all but the most desperate of scenarios.

Your mindset towards investing is critical at this time. When markets rise and assets inflate, it is easy to hold and gains are easy to come by. As an investor, however, your mindset should be to acquire high-performing, valuable companies that generate strong and consistent free cash flows and return these to you in the form of capital gains and dividends. In some markets, the proportion of returns will favour capital gains and in others they will favour dividends. Personally, I have always felt more comfortable with dividends, which provide me with a ‘locked in’ return independent of the share price. Although this is never guaranteed, if well-selected they provide me with a regular stream of returns no matter what the animal moods of the market are.

Once I have received my dividends, it is then at my discretion where and how to reinvest these. During some time periods, I allow dividends to accrue in my account as cash, periodically reinvesting these in bonds as a long-term store of capital. During other periods, I will regularly reinvest these, usually back into the companies I already hold, but occasionally building new positions. My managed portfolio is just one of the ‘assets’ I hold on my balance sheet however, including cash, real assets, mutual funds and pensions, real estate, and my own time as an employee. Each of these assets serves an independent purpose to grow and protect wealth and can include:

Liquid CashInstantly liquid currency holdings. Includes physical cash and current account holdings.Immediate expenditure requirements such as monthly living costs.
Illiquid Cash & BondsSavings accounts and bonds with a range of maturity profiles over 1-5 years. Includes regular savers, limited access savings accounts and savings bond products.Designed to increase savings rate and manage ‘expenditure to income’ ratio.
Real AssetsArtwork, gold, jewelry, watches etc. These are assets which can be sold for currency or traded for goods and services. May be not be instantly realisable for capital but should have value to a range of buyers within 1-3 months.Store of value, can be liquidated to increase cash float. Primary goal to match inflation.
Financial AssetsFinancial assets are legal ownership rights such as equity rights and debt ownership. During times of low market liquidity and in bull markets, attempting to sell these assets can result in significant capital losses. Should be held for the long-term and infrequently sold.Equity investments, managed funds and financial instruments. Intended to beat inflation significantly and provide exposure to independent income sources. NOT to be liquidated wholesale.
Real EstateReal estate, including a primary residence, is highly illiquid and can incur significant financial liabilities including maintenance costs. Although these can provide exposure to capital gains and independent income sources, these assets can be high value and difficult to liquidate quickly during stressed market conditions.Includes primary residence – can be store of value but not intended as immediate investment. May keep up with inflation but low returns relative to inflation over time.

Building a balance sheet that contains a combination of these asset types is essential to building and protecting your ‘patient capital’ mindset. It is tempting, during markets like this, to watch the declines on a daily basis and scare yourself into selling valuable assets at discount prices. It is absolutely critical to avoid doing this and to undertake careful, accurate valuation of the assets you own and to ensure that you aren’t forced to sell the family silver priced as pewter.

Whatever happens in China is out of our control as investors, but the way we manage our assets is something that we can and should take great care over.

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