Invest: History Rhymes?
If a butterfly flaps its wings in China, can it cause a global hurricane?
Three rural Chinese banks have collapsed in the last six months, could this presage a more global issue?
Baoshang Bank - May 2019. First bank failure in 20 years.
Depositors are guaranteed, creditors take a haircut.
Bank of Jinzhou - July 2019
Hengfeng Bank - November 2019
Does history rhyme?
In 2007 (when I was working in London at a private hedge fund), a UK bank by the name of Northern Rock was offering mortgages at 110% of loan to value (yes, for every GBP100,000 of property value, Northern Rock would loan GBP110,000). The bank would then consolidate these loans into securities and sell them to the broader market. These securities were underwritten by… Lehman Brothers. In August of that year, the broader market said ‘no’ to NT’s new offerings and the bank encountered liquidity problems.*
In September 2007 depositors lost confidence and Northern Rock was the first British bank in 150 years to experience a bank run (I remember the lines of depositors shown on the evening news). The Bank of England provided ‘liquidity support’ for its operation and depositors were made whole as the government guaranteed all deposits.
On February 17, 2008 Northern Rock was unable to operate further in the marketplace and was nationalized (taken over by the Her Majesty’s Government).
Strangely enough, less than a month later on March 14th, 2008 Bear Stearns, a legendary Wall Street bank and buyer of massive amounts of securitized mortgage debt, was rescued by the Federal Reserve (and subsequently sold to JP Morgan for what was then a deep discount).**
Fast forward to September 2008 and the subsequent failure of Lehman Brothers, the guys who were underwriting Northern Rock, remember them? Their failure, the largest bankruptcy in American history, was the final straw that ignited a full on financial crisis.
Could these Chinese bank failures be a ‘butterfly’ flapping its wings?
The parties involved in both 2008 and 2019 both used the existing debt markets to lever their firms to a level that caused them to fail. The investments and loans they were undertaking were considered ‘safe’ in that current marketplace and very quickly stopped being ‘safe’.
These banks are decidedly small players in the overall Chinese system, but the ownership of smaller regional banks is spread among opaque financial holding companies and the true extent of their cross holdings (and the underlying risk) is not fully known. In 2007 markets, and regulators were surprised to see the high levels of mortgage backed debt securities held by banks across the world.
The Bank of China has characterized 13% of its 4300 lenders as ‘high risk’. Moves by the bank to stave off ‘moral hazard’ (the taking of risk with the assumption that failure will be covered by another party) could result in other banks being denied funding by other market participants which, in the end, was the root cause of Bear Stearns and Lehman’s collapse. Any contagion in debt markets can spread quickly and affects all sectors, not just banks.
Ironically, the Chinese authorities have, by only recently allowing foreign ownership of Chinese banks, made this almost an exclusively Chinese problem. The chances of this becoming a global contagion seem low.
The Chinese economy is overseen by a one-party state which can implement reforms and direct resources immediately if needed. There’s no need to ‘negotiate’ between different players in the market and any support needed can be coordinated centrally.
The main question here is what effect does this have on Chinese growth and consequently global economic growth? This is potentially the first year of sub-6% GDP growth since 1992. A meaningful reduction of the availability of credit for economic expansion could send ripples throughout the world economy.
For more on this see: https://haddamroad.com/insights/why-does-china-matter-scaleWhile not the same ‘hurricane’ as the debt led crisis of 2008, it is still worth our attention.
Ask your advisor about their opinion on the current state of Chinese finances. If they are not sure what you are talking about, are they really paying attention to your money?
* This negative loop started in August 2007 when three German banks (Sachsen, IKB and WestLB) all reported substantial losses in mortgage-backed securities which created funding stress for Northern Rock.
** My experience the day Bear Stearns failed is a big reason why I’m a financial planner and portfolio manager. I was in London trading for a private firm when the news came out of Bear Stearns fate. It shook me. I had relatives visiting from the US that week and when I returned home that night told them ‘I will get on the phone with you and your advisor and we can ask where your money is being invested.”. And their reply, “Oh I wouldn’t want to bother him, he’s very busy” and left it at that. I called some other relatives and suggested they shift to a very defensive stance and maybe ‘stay out of the market for a bit’. They did just that and were thankful six months later. Not so my other Relative. It irks me to this day that someone would feel they are bothering their advisor by asking questions about their money. It’s your money, ask questions. If you don’t understand, ask again!
Brian Kearns, CPA
Haddam Road Advisors
Ph: 312 636 3067
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Northern Rock image: REUTERS/Toby Melville