Day of reckoning approaches

In 1901 Sigmund Freud wrote of the “peculiar feeling we have, in certain moments and situations, of having exactly the same experience once before”.

The observation appeared in his classic work The Psychopathology of Everyday Life, originally written in German. But when the French version came out, the sensation was translated as ‘déjà vu’, a term likely coined by Emile Boirac, a philosopher, who first used it in a letter to the Revue Philosophique in 1876 describing a similar phenomenon.

By some estimates, déjà vu is the most frequently used ‘French’ term in English and has been for quite some time (the Merriam-Webster dictionary reckons usage began in 1903).

WiC readers may be wondering why this is being recounted. Well, we couldn’t resist – based on our own sense of déjà vu. Almost a year ago, one of our Talking Points (issue 177, January 11) described problems with trust companies and their wealth management products ­– as well as the likelihood of financial defaults. The cover image, showing a rickety structure, was titled ‘Trust deficit’. One year on, the warnings of a year ago are ever closer to becoming a reality…

The latest case to hit the headlines?

Last week news emerged that a potentially serious default is looming. And while some of the players involved aren’t household names, one party definitely is: ICBC, the world’s biggest bank by assets.

The case involves a wealth management product distributed by an ICBC branch to its private banking clients. The Rmb3 billion ($496 million) note was issued in 2011 and offered investors a lucrative yield of 10% – a much higher return than the prevailing deposit rate of 3%.

WiC has covered the shadow banking industry quite extensively in these pages, so many readers will know what’s coming next. The issuer of the product was a trust company (see WiC98 for more on these institutions) called China Credit Trust (CCT) and what was being created was a highly leveraged loan. Known as Credit Equals Gold No 1, the wealth management product channelled Rmb3 billion to Zhenfu Energy, a privately-held entity intending to invest in five coal mines in Shanxi. The firm’s stated intent: to create a large, integrated coal producer, with annual output of 3.6 million tonnes.

That plan quickly unravelled, reports 21CN Business Herald, especially when Zhenfu’s majority shareholder Wang Pingyan used much of the money for private lending of his own. A wave of loan defaults proved a financial disaster for Wang and police detained him in May 2012.

Meanwhile, production at the mines ceased, in some cases because they didn’t hold the necessary operating licences.

Zhenfu’s cashflow difficulties soon undermined the viability of the CCT notes. Investors began to become alarmed when the coal firm failed to make a coupon payment on December 31. If nothing changes in the coming days it will default on the wealth management product on the last day of this month.

Who is responsible for the debacle?

In retrospect, loaning the money to Zhenfu for its acquisition binge looks foolhardy. 21CN makes the point that CCT was well aware of the risks from the outset – indeed, the deal was rejected when the trust’s management committee conducted its first internal review.

A key reason for its reluctance? CCT executives were concerned about one of the core assets set to be acquired: Shanxi Sanxing Coking. Due diligence had uncovered a fairly fundamental problem – its Baijiamao coal mine lacked a permit, making it unlikely that Zhenfu could start production and generate cashflow.

Other concerns included doubts about management risk controls, difficulty in assessing contingent liabilities and uncertainty about the amount of leverage involved. Zhenfu’s assets amounted to just Rmb1 billion and yet it was being lent three times that.

The anxiety turned out to be accurate. The Baijiamao mine was a dud and Zhenfu became involved in eight pieces of litigation which saw courts freeze assets or suspend mineral rights at five subsidiaries.

Given its grave reservations, why did CCT go ahead and structure the wealth management product? This is the crux of the matter. Caijing magazine comments that the trust firm feels “aggrieved” by what has occurred “because it was encouraged by the bank to undertake the scheme”. This fits with earlier descriptions of relations between China’s biggest banks and the trusts. In response to regulatory restrictions on new lending, the banks have directed many of their clients towards trust firms. The practice sees corporate loans shifted ‘off balance sheet’ via the trusts, which then create wealth management products – backed by such loans – for the banks to distribute. In a mutually beneficial relationship, both sides generate fees from the resulting transaction.

What we are seeing now is the implosion of what was always a flaky sort of partnership. ICBC management has moved to distance itself from the failure of Credit Equals Gold No 1, saying it has no responsibility for ensuring repayment. ICBC insists that it made clear that the risks lay with the trust – not the bank – when the product was sold through it’s private banking network, and that it was solely acting as a distributor.

But CCT is “reluctant to take the bullet alone,” according to 21CN. Caijing adds that it couldn’t even if it wanted to. Should it bailout the scheme, it would go bankrupt. And if both parties refusing to rescue the product, Caijing says investors will lose 80% of their principal.

Are the investors shocked?

They claim so, yes. But are they to be pitied? Most have been readily purchasing toxic wealth management products for a while, happy to earn the extra yield, but without acknowledging the accompanying risk. Instead, they seem to have taken the calculated gamble that the notes are implicitly guaranteed by the banks that distribute them.

Truth be told, no such guarantees were ever given in writing. So rather than carry out proper due diligence, these wealthy individuals bought products with exotic names like Golden Elephant No.38 largely on faith.

Analysts have been forecasting for a while that many of the sorrier structures will go bust. But investor confidence was buoyed by the lack of defaults – even when things went awry. Exhibit number one: in December 2012 we reported on repayment problems on a product distributed by Huaxia Bank (see WiC176). It looked like it might be the first default but Huaxia and the local government was terrified about the reputational fallout. A solution was engineered: a third-party guarantee company called Zhongfa Investment rode to the rescue and reimbursed the 91 investors.

Exhibit two: early last year a Rmb1.3 billion trust product sold by Citic was also heading into the abyss. But it too was brought back from the brink, when an alternative source of financing emerged.

Will the same thing happen once again in Shanxi? If it doesn’t, China’s first such default will occur on the first day of the new lunar year. Not an auspicious start to the Year of the Horse.

Debt doomsday ahead?

An industry insider told Caijing that it’s a watershed moment. “Whether for the bank or the trust, they’ve both been taught a heavy lesson,” he warned. “For the trust company, they now know they cannot take it for granted that – even though the scheme is led by the bank – the bank will foot the bill if something goes wrong. And for the bank, they cannot just ignore the scheme’s risks because they play the role of distributor. After all, they have given an ‘invisible’ credit endorsement to their customers and those clients will make problems for them if the product fails.”

Emboldened by the CCT case, journalists have been dredging up other cases where defaults look inevitable. It’s a worryingly long list, and incorporates not just wealth management products, but also troubled bonds, difficulties in the peer-to-peer lending market and even a default for investors trying to redeem a private equity fund investment.

China Securities Journal, a newspaper run by Xinhua, calculates that 8,547 trust products, valued at Rmb1.27 trillion, are due to be redeemed this year. It predicts that 2014 is going to be an “explosive year for credit events” owing to slower economic growth.

The Hong Kong Economic Journal agrees that the “myth of zero defaults” will be laid to rest in 2014 as more companies find it impossible to roll over their debts.

Already in January a series of cases have soured the tone. Early in the month Shanghai-based tech firm TJ Innova Engineering failed to transfer cash into accounts designated to pay interest and principal on bills issued in 2011. It looked like being the first bond default by an SME (small and medium-sized enterprise). On January 21 a last minute recapitalisation by shareholders rescued the situation.

Wind turbine giant Sinovel also has a troubled profile. Last week it made a regulatory disclosure admitting that it was under formal investigation for infringing securities laws. The risk is that two of its bonds – worth a combined Rmb3 billion – could be suspended from trading.

Concerns also grew when Wintafone Chemical’s debt was downgraded to junk status in January. That was after it failed to repay Rmb36 million of credit notes. Default was avoided when the local government in its homebase of Changzhou stepped in with emergency funding.

Meanwhile, National Business Daily says that three peer-to-peer lending platforms in Hangzhou, Shanghai and Shenzhen have been shut down. They belonged financier Cheng Xudong who has fled to Hong Kong. Police believe he embezzled Rmb100 million.

Finally, there are jitters over Beijing Roll-in Investment Management after the Rmb1 billion private equity fund defaulted on redemptions. Its financial difficulties relate to a real estate project it sank Rmb240 million into in 2012. According to 21CN, a lawyer told an investor gathering: “If you ask where is the money, I can only tell you that all of the funds have failed to meet the contractual redemption obligations.”

But the Zhenfu situation is the most serious?

Given the size and opacity of the sector, the first failure of a wealth management product could have a chilling effect on the wider market.

The Wall Street Journal notes: “If the products default, the impact on confidence could be severe. Savers everywhere would question high-yield investment products, and as they pull the money away, trust companies will find it harder to roll over loans to the country’s property developers, coal miners and other risky borrowers. A wave of defaults could likely follow.”

But with the stakes so high, will the Credit Equals Gold No 1 be allowed to fail? HSBC thinks not. A research note published earlier this week concluded: “The case of CCT is bigger in scale and more complex, but the solution is likely to follow previous practices, i.e. the trust company, local government or another party will pay the bill. Even if the trust was allowed to default, we believe the authorities would almost certainly ring-fence the problem to ensure that it was regarded by the market as an isolated event.”

Meanwhile, the various participants in the debacle are waiting to see who blinks first. “Right now CCT, the local government and ICBC are definitely at the state of intense negotiation, like a chess match,” a senior banker familiar with the case told the South China Morning Post.

On Thursday there were indications that local officials were indeed scrambling to find a solution. Time Weekly reported that the province had issued permits to Zhenfu to restart production and thus generate cashflow. The report added that the local government might pitch in rescue funds as well, on condition ICBC and CCT did too. This would avoid default (the idea being that both financial institutions would eventually be repaid from Zhenfu’s resuscitated production as well as the sale of two of its coal mines).

Despite risking an investor panic, would default actually be a better long term outcome? China Securities Daily quotes one fixed income fund manager as saying product failures are inevitable, and that they would teach investors some welcome lessons about credit risk. Speaking of the escalating moral hazard, he added: “If there aren’t a few defaults, investors will continue to chase returns that are too low in relation to the underlying risks.”

There is also at least one other potential benefactor of the current debacle: Cinda. We reported on the asset management specialist’s IPO in December (see WiC220). Currently it is the only one of the ‘bad banks’ that is allowed to buy compromised real estate assets from trusts. Given what’s happening with Zhenfu and the possible knock-on effects, there’s a real possibility that Cinda could hoover up troubled trusts property assets at discounted prices in the months ahead. That helps to explain why Cinda stock is rising. Readers will recall that Cinda’s shares spiked 25% after its IPO. As of last week they were up an even-more-impressive 50% on their offer price.

Keeping track: it didn’t happen. Our Talking Point last week looked at the possible default of a wealth management product issued by China Credit Trust and distributed by ICBC to its clients. We said a default – on February 1 – looked unlikely, given the loss of confidence it might trigger in trillions of renminbi of similar products. That turned out to be the case, with last minute negotiations between the institutions and local government providing a makeshift solution. On Monday it was announced that a third party had intervened, and investors would be repaid their principal but not their third year’s worth of interest. How had this been achieved? The wealth management product had loaned money to Zhenfu Energy, and when the coal firm defaulted it seized its shares as collateral. The mysterious white knight has bought these, presumably hoping to recoup its money now that Zhenfu has got government approval to restart mining. (Jan 31, 2014)

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