Special Report: Commenting on China Evergrande
Lessons on leverage, drawdowns, and liquidity risk...
“There’s a Lehman in China every 36 months... Is Evergrande a Lehman event? We sincerely doubt it.” Nordea Bank
“The market sell-off… is primarily driven by technical selling flows… our fundamental thesis remains unchanged, and we see the sell-off as an opportunity to buy the dip.” JPMorgan
Keeping Readers Informed & Equipped
We are not experts on the specifics of the Evergrande situation, but we pulled together research on the topic. The situation is fluid, so things could change, but we are striving to offer a reasoned viewpoint in a timely manner to keep our readers informed with insights and relevant talking points.
In addition, we reflect below on leverage-related risks in general and lessons learned from past financial/liquidity crises.
Who is Evergrande?
China Evergrande Group is a China-based real estate firm. It develops, manages, and invests in residential real estate properties and related businesses.
Evergrande has an estimated $130 million in interest payments due this month. If they are unable to meet those obligations, the issuer would go into default.
According to UBS, Evergrande has total liabilities of approximately $315 billion. Evergrande had borrowing relationships with 130 banks and 120 non-bank financial institutions.
Bonds and loans issued by Evergrande are held by banks, mutual funds, possibly ETFs, and other investment funds, according to Reuters. It’s unclear to us where the debt securities are concentrated, but reports suggest a majority of the bonds/loans are held by mutual funds.
What is Happening?
In August 2020, China announced its “three red lines” regulatory mandate to reduce leverage across its real estate industry. Authorities were targeting over-leveraged property developers like Evergrande, according to Christopher Wood, Global Head of Equity Research at Jefferies. Guidelines were established and firms were expected to get their balance sheets in compliance sooner rather than later.
By enacting strict guidelines, Wood believes Chinese policymakers effectively “induced” Evergrande’s debt default. The process was set in motion a year ago.
Since China’s leaders induced the financial stress, Wood believes they have a solution in mind. Specifically, Wood feels several of China’s large SOEs (state-owned enterprises) will purchase assets from Evergrande at discounted prices. Thus, the government will take ownership, expand its balance sheet (directly or indirectly) and a risky over-levered property developer will be eliminated or scaled back.
What Other Research Experts Are Saying
Nordea Bank, 9/19/21: “We tend to get a round of ‘China is melting down’ with an interval of 2-3 years and they usually always occur when Chinese credit impulse is negative. China is a credit-fueled economy and there are always casualties when the authorities decide to take the foot off the pedal… Financial Twitter is accordingly (again) full of China doom-mongering from people who have never even visited mainland China as it is a ‘cheap sell’ to the bear crowd, but it seems like another one of those popular ‘China is going bonkers’ narratives to us… There’s a Lehman in China every 36 months... Is Evergrande a Lehman event? We sincerely doubt it. It is (way) easier to contain Evergrande than Lehman, but it doesn’t mean that the Evergrande blow-up doesn’t come with repercussions.”
Goldman Sachs, 9/20/21: "Evergrande is large (total assets of RMB2tn, or 2% of China’s GDP) and complex (with over 200 offshore and nearly 2000 onshore wholly and non-wholly owned subsidiaries). But it accounts for only 4% of China’s total property sales and its 123,000 employees and 3.8 million contractors make up a fraction of China’s over 400 million urban labor force. In the event of an orderly default of Evergrande and limited spillovers to both the financial market and broader property sector, the macro impact should be manageable"
Marko Kolanovic, JPMorgan, 9/20/21: “The market sell-off that escalated overnight we believe is primarily driven by technical selling flows (CTAs and option hedgers) in an environment of poor liquidity, and overreaction of discretionary traders to perceived risks. However, our fundamental thesis remains unchanged, and we see the sell-off as an opportunity to buy the dip.”
Bespoke Investment Group, 9/20/21: “No one knows if the sell-off is over, but the obsession over Evergrande today in the financial media, the typical pattern of Turnaround Tuesdays, and the passage of [options expiration] last Friday are all good reasons to expect a short-term bounce… As for credit, the linkages between what’s going on in China and broader dollar credit markets are tenuous at best, and while it makes sense for credit spreads to widen on broader risk appetite pausing, it’s hard to describe this sell-off as being credit driven.”
The Market Ear, 9/20/21: “Regular readers of TME know our long-standing stance on hedging and protection: You buy insurance before the house has started burning. Otherwise you end up paying rich premiums... Here we are, VIX exploding to the upside, and investors having abandoned hedges just before this downturn. Chasing VIX here is only for the people that think we are crashing further. Most people tend to confuse direction with pace. Before grabbing rich protection here, you must ask yourself at what pace will things move…”
Theorizing on Potential Impacts
Aside from the Evergrande particulars, but based on experience with past events, a potential pattern comes to mind. This is strictly a conceptual playbook and we are not making predictions:
Direct loan/bond investors are facing losses. Equity shareholders might be completely wiped out as often occurs in severe default situations. Holders of bonds/loans will see losses, but losses will surely be less than 100% given normal recovery rates.
For investors in mutual funds or other broadly diversified portfolios, losses should be mitigated.
Other investors could be effected indirectly, assuming correlations across related market segments. For instance, certain areas could “trade down in sympathy” including HY bonds/loans, Emerging Markets debt, and/or EM equities. Any outflows from these asset classes could amplify price declines.
For banks and lenders with direct exposure, there is always a risk of forced-selling to meet equity capital requirements, but probably only for groups with heavily concentrated exposure to Evergrande, the leveraged Chinese property sector, or HY bonds/loans in general.
Similarly, leveraged mutual funds or hedge funds with heavy exposure to HY credit and/or EM debt could face losses, followed by margin calls and forced selling. All that could amplify near-term price declines. As always, such risks would be magnified for any funds facing client redemptions.
Potential larger implications might entail a widening of credit spreads across HY and Emerging Markets debt; tighter lending standards from banks for certain industries. For US investors, perhaps a rotation from certain value/cyclicals (like Emerging Markets) into quality/growth assets.
None of this can be adequately quantified at this point, and frankly, it already feels like we are being far too speculative. That said, when equities trade down by 2-4% in a single day — especially when the prevailing environment is showing such low realized volatility — then it makes sense to assess the situation an offer comment.
Again, the idea here is to reflect and apply our experience in order to help readers compile an informed view. In fact, we picture ourselves sitting around a conference table with an investment committee discussing the issues of the day. Essentially, we are outlining a playbook to consult as we move forward — in this situation or others.
So, does Evergrande explain why the S&P 500 (SPY) declined today? Only in a very broad sense, but the catalyst probably could have been anything for this market. From what we can gather, there are no clear connections between Evergrande and the vast majority of the US equities market…
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Lessons on Drawdowns & Liquidity
In our latest Weekly Briefing, we discussed equity market drawdowns. Drawdowns measure the percent decline from a peak to trough.
We’ve seen lots of chatter in recent days about sell-offs and how the S&P 500 is due for a drawdown of at least 5-8%. A drawdown could happen at any time for virtually any reason, especially after an extended period of robust gains. (Again, take a look at our latest briefing referenced above for details on drawdowns over the last 30+ years.)
To a certain degree, it feels like markets already wanted to sell-off — and Evergrande simply provided the justification.
To a certain degree, it feels like markets already wanted to sell-off — and Evergrande simply provided the justification. Or at least, financial media have latched onto Evergrande as a convenient narrative. Be careful of this behavioral phenomenon. It sometimes leads to erroneous decisions.
Based on our past experience, we define drawdowns in two distinct ways: fundamental-driven and liquidity-driven.
Fundamental Driven: Tends to be pervasive over an extended period as it takes time to rebuild damaged balanced sheets, replace lost income, and restore shattered investor confidence. It takes time to repair fundamentals.
Liquidity-Driven: Tends to be violent and abrupt — the result of forced selling by over-leveraged entities facing margin calls, investor redemptions, etc. These drawdowns tend to recover relatively quickly once the liquidation process for the weak players runs its course. And the surviving firms with financial strength tend to be the big winners as a market or industry consolidates itself.
Some drawdowns have elements of both.
Case Study: Mortgage Securities in 2020
In 2020, we witnessed a liquidity crisis in the US mortgage securities market.
In short, over-leveraged fund managers faced massive redemptions and margin calls. Problems were most acute for mutual funds and exchange-traded closed-end funds.
In fact, several daily-liquid mutual funds were operating with a severe duration mismatch between their liabilities and assets.
Liabilities were represented by investor capital; fund shareholders could redeem their investments on a daily basis. As the COVID-shutdown unfolded, losses mounted, and investor redemptions escalated.
Assets, unfortunately, were concentrated in lower-rated mortgage securities, including esoteric and less liquid mezzanine or equity tranches.
In March 2020, fund managers were forced to sell mortgage securities at steep discounts in order to meet redemption requests. Trading volumes surged into a bad liquidity environment. Prices plunged, especially for less liquid securities.
The surviving “structured credit” fund managers — and their patient investors — were the winners. These were the firms with strong balance sheets, strategic and durable financing relationships (which cost more) and proper asset/liability matching. The survivors were able to purchase attractive assets at discounts of 20-40% or more. Robust gains were delivered over the balance of 2020 as liquidity conditions stabilized fairly quickly.
As a footnote to this episode, the underlying fundamentals of the US housing industry were never an issue. Multi-year positive trends remained in place: Home prices were appreciating, loan-to-values were declining, and consumer/homeowner balance sheets were strengthening. In other words, the crisis was purely liquidity-driven and technical in nature — amplified by the role of over-leveraged investors.
Aggressive short-term capital suffered losses, but patient capital was rewarded. This lesson that plays out over and over again. Elements could be at work in the current situation.