China’s Version of ‘Too Big to Fail’

China’s Version of ‘Too Big to Fail’
Andy Xie
07.16.2012 11:14



Western-style finance has lost credibility in recent years, but some aspects of this country’s financial system are cause for concern


Europe recently had something to cheer about with the apparent discovery of the Higgs boson particle at CERN, the European Organization for Nuclear Research. It is the biggest scientific discovery in decades. In the strange world of quantum physics, the Higgs boson particle that Peter Higgs theorized in 1966 endows basic elements in the universe with mass. Without it, everything would zip around at the speed of light. You and I wouldn’t be here without it. This is why it is called “the God particle.”

With this discovery, the European model that emphasizes the government’s role in society has its best side on display. The European governments poured US $10 billion into this effort. In contrast, the U.S. government pulled the plug on a similar project a decade ago on cost concerns. In the large scheme of things, US$ 10 billion isn’t a lot of money for such a discovery, considering that the world spends US$ 1.5 trillion on military expenditures every year.

At the same time, the euro debt crisis reminds us that when governments try to do too much things can go really bad. European governments have gone too far in guaranteeing living standards. They not only engage in large-scale income redistribution, but also limit competition through work-hour regulations and erecting market entrance barriers. This model isn’t competitive in the era of globalization. European governments have run up debts to support the model. As the financial market worries about getting paid, the model bursts. The debt crisis is basically the process during which European governments come to grips with this.

The ugly story was on display in London. The British Parliament held a hearing on the Libor rigging scandal. Libor is the average borrowing rate of the leading banks in London in the interbank market. It covers all the major globally traded currencies. Most corporate loans in the world are linked to Libor. Even mortgages in Hong Kong and many other places are priced off the Libor. It is not an exaggeration to say that Libor is the most important price in global finance. When it can be manipulated, is there anything in finance worth trusting?

Evaporating Credibility

There are a lot of apologists for the Libor scandal. One is that the manipulation didn’t impact prices significantly. But how would we know? What we know is that it can be manipulated. Considering how greed drives finance, it is reasonable to expect that it could occur again and again to benefit insiders.

Finance depends on the credibility of financial institutions. Otherwise, financial products are mere pieces of paper with no value. Since 2008, we have watched the credibility of global financial institutions crashing one after another. The Libor scandal is the latest and likely not the last.

In 2008, arcane names for derivative products came to the fore. The terms credit default swap, collateralized debt obligation (CDO) and others became synonymous with the crisis. Derivatives were supposed to be the greatest invention in finance to help investors control risk. They turned out to be smokescreens for hiding risks and trapping investors.

The once august Wall Street investment banks were exposed for their ignorance and malfeasance after the bubble burst. The complex mathematics models that supported the derivative products turned out to be worthless, designed to fool the ratings agencies and investors. While these banks recovered from 2009 to 2011 on bailouts and stimulus, they have fallen on hard times again. This is not a coincidence. Wall Street is derated for years to come. Investment banks have become nuisances in the global economy.

The latest scandals involved two universal banks, JP Morgan and Barclays, which survived the 2008 global financial crisis intact. Indeed, through taking over Bear Stearns and Lehman Brothers, they came through the crisis stronger. Now, they have joined those who fell earlier. The latest development shows that the whole global financial system is rotten. It’s not just a few apples.

Together with investment banks, ratings agencies lost their credibility. They rated the derivative products, worthless in hindsight, with investment grades, sometimes even AAA. People are not talking about their role in the financial crisis anymore. One cannot exaggerate the damage they did to modern finance. The three ratings agencies are the pillars of the global debt market. Pension funds, insurance companies and even foreign exchange reserves invest on their recommendations. There are suspicions that they were selling their ratings for fees during the bubble. It is amazing they are still alive, though what they do has little market impact, i.e., they have no value.

The euro debt crisis is another loss for the credibility of modern finance. In the 1990s, Wall Street went massively into convergence trade-borrowing in low interest countries like Germany and invested in high interest rate countries like Greece and Italy. The theory was that a common currency would remove the devaluation risk premium. Hence, Greece and Italy should have low interest rates like Germany. This ignored the fact that devaluation was a form of default and, without that option, default would actually happen. At the time, it was easy to argue that Western developed economies wouldn’t default. That myth has been punctured.

The Libor crisis is the latest, but not the last, nail in the credibility coffin of modern finance. Western finance, a big force in globalization, has lost so much credibility that its role in the future is seriously in doubt.

Banks Must Be Split Up

After the 2008 crisis, banks have become bigger because failed banks became part of surviving ones. There was a great deal of reform zeal after the crisis. The notion of “too big to fail” was acknowledged as the most important factor that drove banks to speculate. Reform enthusiasm waned with time, as the financial industry’s lobbying efforts paid off. The latest scandals involving JP Morgan and Barclays again demonstrate the harm of “too big to fail.”

I have never believed in the model of a universal bank. Investment banking is a high-risk business. When it is mixed with commercial banking, it is impossible to prevent the former from dragging the later into high-risk activities. This is why the United States instituted the Glass-Steagall Act that separated the two after the 1929 market crash. The series of crises demonstrates that repealing the act a decade ago was a big mistake. The right solution to today’s crisis is to bring it back.

While the solution is obvious, to implement it has become extremely difficult. Global finance has become so big that rich and powerful interests are motivated to defend the status quo. This is why scandals continue to pop up five years after the global financial crisis. Until we see big banks split, the crisis won’t truly end.

The Next Bubble

While the financial world as a whole has been tumbling, one of its cornerstones – the private equity industry – has been rising. In the first half of 2012, PE fund-raisings increased 4 percent in the United States and over 80 percent in Europe. China’s PE industry has cooled a bit this year after surging to thousands of funds in recent years. The issue is that private equity funds are investing in illiquid businesses at prices above comparable businesses in publicly traded markets. Many funds have been understandably investing in the public market. But, why would investors pay PEs a 2 percent management fee and 20 percent carry to invest in illiquid and more expensive assets or in public market. They could do the latter themselves at no cost.

At the top end of the financial industry are pension funds, insurance companies, sovereign wealth funds, etc. They are usually bureaucratic behemoths that follow an asset allocation model, i.e., spreading money over all financial instruments out there. Private equity is a major one. In recent years, private equity funds have reported better performance than publicly traded markets. That, I believe, is mostly an illusion. Private equity funds, before cashing out, report mark-to-market value subjectively. From what I can see, they have vastly overstated their performance.

A bad global economy decreases returns on capital for all businesses, probably the small and unlisted businesses more than the large, listed companies. Prima facie, private equity funds have probably performed worse than publicly traded stocks. That story only comes out when these funds liquidate. Of course, they will never liquidate to reveal bad numbers. This bubble will burst differently.

Some private equity funds have been buying publicly traded stocks. Their positions are concentrated, unlike the usual mutual funds that spread out. In a global economy, big problems are bound to pop up in such investments. Stay tuned. The PE bubble may pop in 2013.

China’s CDO Market

The fixed income market has grown rapidly in China. The trading volume of the Shanghai bond market has caught up with the stock market. The total assets under trust companies seem to have surpassed 5 trillion yuan, quintupling in five years. In the first five months of 2012, according to the central bank, one-tenth of total social financing was from corporate bond issuance. China’s banking system still accounts for two-thirds of total social financing. As banks enjoy a wide regulated lending margin, there are strong incentives for companies to get financing in the bond market.

As the primary market for fixed income products surges, various instruments have mushroomed in the secondary market. Many fixed income funds promise high returns, relative to bank deposits, for a short and fixed time frame while investing in longer term bonds. They have term mismatch and poorly understood credit risks. They sustain their liquidity by rolling over, sometimes by promising higher returns. Some funds may have taken on Ponzi scheme characteristics.

One worrying phenomenon is an unregulated CDO market. Some funds pool different bonds together and issue synthetic bonds on them to different classes of investors who have different seniority in access to the return on the pool. This market has the same characteristics as the CDO market in the United States.

The so-called innovative fixed income products work on the theory that pooling decreases risk, the same as what occurred in the United States before the crisis. Because most of the funding ultimately goes to property developers, pooling really doesn’t decrease risk. Land price is a macro phenomenon. Pooling lending to different property developers won’t decrease the overall risk.

Like in the United States, these products ultimately maximize lending to the property market. The techniques are really marketing ploys to suck in financial investors with promised low risk. I’m afraid that something bad will happen in this market soon.

Ultimately, China’s fixed income market functions on the expectation that the central government will bail everyone out. Hence, whatever crazy products mushroom in the market, when they go bad, the government will make investors whole. Unfortunately, this expectation is not unreasonable. When all these products go bad, the government would be forced to bail out everyone to save the economy.

The expectation that the government will bail out everyone encourages speculation. As everyone is incentivized to speculate, the financial system will suffer a big crisis. It is self-fulfilling. But, the bailouts are not costless. The government has to print money to fill the hole in the banking system. That means devaluation and inflation.

If China wants to check speculation and avoid devaluation, it must strengthen supervision of financial markets and discourage speculation.

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