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China's banking system is engaging in dangerous practices
that could lead to significant problems down the line, says a report from
ratings agency Fitch.
According to The New York times: "A report released on Wednesday by Fitch, the
credit ratings agency, said Chinese banks were increasingly engaging in complex
deals that hid the size and nature of their lending, obscuring hundreds of billions
of dollars in loans and possibly even masking a coming wave of bad real estate
and infrastructure loans." In what sounds as if China is taking a page from the
Enron book of doing business, the Times added: '"The report also said that Chinese
regulators understated loan growth in the first half of the year, by 28 percent,
or about $190 billion, and that many banks continued to secretly shift loans
off the books, creating a “pervasive understatement of credit growth and credit
exposure.”'
In fact, Fitch, who like other ratings agencies missed the whole subprime mortgage
credit default swap mess seems to be trying to get ahead of the curve here. According
to The Times: '“The growing amount of credit moving out of the banking system
through these channels is one of the most disconcerting trends we’ve seen in
China in recent years,” Charlene Chu, a Beijing-based banking analyst at Fitch,
said of the practice of repackaging loans and moving them off bank balance sheets.'
In case you haven't noticed, moving bad assets off of the balance sheet is what
Enron did, and eventually the company disappeared while its CEO went to jail
and its chairman died of a heart attack as he awaited trial. If there is bad
news on your balance sheet you should show it or dispose of it by adding something
of value. You shouldn't hide it or create fake reports to confuse analysts. But,
that's what Fitch alleges is going on in China, essentially a Ponzi scheme of
sorts.
Here's the problem. As The Times notes: "While China’s economy remains robust,
the report is troubling because the country’s recovery has been fueled by aggressive
lending and soaring property prices. Lending by state-run banks was one of China’s
most aggressive forms of stimulus last year, but analysts constantly warned that
banks could face the risk from overbuilding and nonperforming loans." Lots of
loans were made in order to boost the economy. Now, as the economy grew too hot,
the Chinese government is trying to cool it. It's that cooling that is leading
to a potential increase in loan non payment.
But instead of dealing with the problem, such as by restructuring loans, the
loans, if Fitch is to be believed, are being hidden. In fact, China seems to
be publicly trying to show that it's trying to cool its economy, when the economy
is not cooling at all. According to The Times: "Fitch said on Wednesday that
lending had continued to be aggressive — powering the economy, but raising the
risk of nonperforming loans. Much of the lending through off-balance-sheet channels
is fueled by trust companies, mostly privately owned, that are partnering with
banks and engaging in complex deals that involve repackaging loans into investment
products — akin to an informal type of securitization."
In fact "The deals are essentially disguised loans, analysts say. Beijing has
tried repeatedly to stop the practice, but analysts say that banks and trust
companies have come up with innovative ways around the rules."
In fact, if this sounds familiar, it's because it's similar to what was happening
in the U.S. before the subprime mortgage crisis imploded. Bad loans were being
packaged into CDO's, and sold to investors. When the payments that were backing
the CDO's became delinquent, the CDO collapsed and the investors were left with
nothing, sparking the subprime mortgage crisis.
According to The Times: "trust companies raised hundreds of billions of dollars
in 2009 and the first five months of 2010, partly because depositors were frustrated
by low interest rates at banks, and trust companies were willing to offer double
that amount with principal guaranteed."
Here's how it works: "Analysts say that last year the process worked something
like this: a bank would hand over a big loan, say $50 million, to a private trust
company in exchange for $50 million in cash. Then the trust company would create
a wealth management product out of the loan and give it to the bank to sell to
investors and depositors. The money raised would be given back to the trust company.
Investors would receive as much as double the regular saving rate and their principal
when the loan was repaid. That $50 million would then be given to the trust company
as if it were an investment; in fact, it was a short-term, high-interest loan
to finance a real estate project."
To us it sounds as if money is exchanging hands. But if the original loan is
$50 million, and banks and trust companies count the $50 million more than once,
then it creates the illusion that there is more money in the system. In fact,
the $50 million is still $50 million. And even if everyone is counting the money
on their ledger as existing, the $50 million is still depending on someone paying
the loan.
As with subprime mortgages, this is o.k. until enough people miss their loan
payments. At that point the whole thing collapses.
Conclusion
If Fitch is correct, the next disaster is coming out of China as funny money
is working its way through the system. Think of it this way. If there is only
one gold fish in a fish tank, but the observer counts the fish every time it
swims by as an individual fish, then it seems as if you have lots of fish.
What you have is one fish that is being counted multiple times, creating the
illusion that you have many. When the one fish dies, the fish bowl is empty.
And the counter wonders what happened to his fish farm. In fact there was no
fish farm in the first place, only the illusion of a fish farm.
It sounds as if China is about to experience some kind discomfort, as reality
eventually will set in.
We'll be on Twitter
some time today before the market closes with some updated comments.
Know when to sell and how to make money when the market falls. Get
a detailed trading plan in your pocket. Read Dr. Duarte's All
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The falling U.S. Dollar is boosting shares of the U.S.
Dollar Bear ETF (NYSE: UDN).
Chart Courtesy of StockCharts.com
Rising U.S. deficits and the recent announcement
from the Federal Reserve that it is concerned about
the U.S. economy weakening have combined to dampen
the rally in the U.S. dollar. And the U.S. Dollar
Bear ETF is reaping the benefits of the situation.
It's not unexpected. Currencies respond to three factors, interest rates, economic
strength, and political stability. While the U.S. is in no danger of collapsing
as a country, its politics are increasingly unstable as partisanship is on the
rise, and there is a feeling that November's election will shift Congress toward
the conservatives.
Interest rates are not likely to rise any time soon. And the economy is starting
to show signs of weakness. That means that the dollar's fall should come as no
surprise to anyone, unless you consider the fact that Europe is not in much better
shape, all things considered.
Maybe it's just the fact that for now, the dollar's rally needs some profit taking.
No matter what, UDN makes sense for now. Dr. Duarte owns shares in UDN.
Follow Dr. Duarte on Twitter
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