Evergrande is Dead. Long Live Evergrande!

Evergrande is dead. There, we said it.

The equity and cash can no longer support it’s mountain of debt. Game over.

Thing is, in today’s China, massively over-levered financial institutions don’t die, they grow, sprawl, and then dance with default, usually just enough to get bailed out or bought out by one of the plethora of quasi-sovereign financial institutions. Which to be clear, is not that different than the American, British or Hong Kong financial system on which the system was designed.

First came the small regional banks, Shengjing, Jinzhou, using the implicit government backstop to gobble up assets on unstable interbank funding.

Then came HNA, originally a regional *airport*, using the implicit government backstop to engage in a massive spree of *dollar- based* acquisitions.

This year Huarong. Originally one of the ‘bad banks,’ created in the 90s to clean up the big 5 state banks after the last crisis. Like the rest, relying on their implicit government backstop to borrow and spend way in excess of its original mandate and to the point where it all crumbled.

Which brings us to Evergrande. Not to be confused with Everbright or Evergrowing or Evergreen. Heaven forbid.

On the surface, Evergrande is one of the world’s largest property companies. They buy/lease land from local governments, borrow massive amounts of capital (~$300bn at last count) from both domestic Chinese banks and foreign dollar investors. While those projects are being built, they sell those properties forward to households, taking those claims as further paper to backstop…more leverage.

Meaning at its heart, Evergrande is a bank. One that, according to debt markets, cannot generate sufficient liquidity to meet the demands of its creditors.

Equity investors are historically a bit slow to wake up to systemic credit issues.

“$50bn of losses after all, isn’t that much when compared to that electric vehicle (EV) company they own!”

Turns out it’s a little harder to find a buyer for $100bn of startup equity when you need it.

If at this point, you are wondering why the world’s biggest property company ALSO owns an electric vehicle startup, welcome to the magic of the modern Chinese financial system. List in Hong Kong[TA1] , borrow in Shanghai and London, let her rip.

Which is why the news reports of local lenders refusing to finance or accept Evergrande projects was the real death blow. For any real estate with $200bn of ‘work in progress’ (aka inventory) that it needs to move to satisfy ~$125bn of short term financial commitments , the news that they can’t turn their existing projects really means game over.

The proposed sale of their $1.5bn HK/Shenzen headquarters in this context is yet another signal that the treasure chest of liquid/saleable assets is bare.

Putting these together yields a simple conclusion, the losses *already discounted by markets* are now more than 2x the remaining equity in the entire group. We calculated this by taking the implied losses from the bonds, and passing through an estimate of the losses for the total balance sheet. By these metrics, the losses on the balance sheet (negative book equity) is now greater than the entire market cap of the broader group.

Ok, so what?

Sounds like just another in the long line of over-levered Chinese financial institutions which borrowed and invested their way to ruin.

A classic tale, and one the British-American financial system has been playing back for centuries.

What different this time?

1. Size — As opposed to some of the other examples in this list, Evergrande is BIG. Similar to how the Chinese financial system is now much, much bigger than the last time they had a systemic banking crisis.

2. Sector — Real estate is the beating heart at the core of the Chinese economy. Whilst Evergrande is one of many major developers, the possibility of a firesale of their existing portfolio has the potential to destabilize both the asset side (via land/real estate prices) and the liability side of the balance sheet.

3. Losses to passive/beta investors — Evergrande is one of the largest borrowers in the developing world, let alone China. Before the recent woes, Evergrande bonds represented 11% of the Barclays/Bloomberg Asia-ex Japan High-Yield USD portfolio. Losses on these bonds hit international investors which then reprice this risk in a way that traditionally raises borrowing cost for other high yield borrowers.

4. Dollar debt — As opposed to the small onshore financial institutions, Evergrande has taken out tens of billions of *dollar debt.* This means not only will losses hit international investors first, but that the relative cost of a bail-out for Evergrande is much higher than if all of its debt was in local currency. Where for example, the government officials can command the banks to ‘roll the debt,’ as it appears they already have.

5. Shadow Balance Sheet — Not long ago, Evergrande actually bailed out of Shengjing, what we once called ‘the worst bank in China.” Meaning, the stack of assets/liabilities underwritten by their capital is implicitly 50% higher than most analysts and investors typically consider.

At this point, you would be forgiven for saying ‘it’s big and going bankrupt, so what’?

And, to some extent, history has taught us that this is the right response. For the last 20 years, policymakers in China have conditioned western investors to not only expect a bail out, but price one in.

Which brings us back to the banks.

Because in the end, for a credit issue to get systematic, it has to go through the banking system, in particular the biggest and least stable banks. In China those tend to be private or regional banks, which act a critical conduit to channel mainstream household savings into repackaged real estate and industrial loans. Sometimes these are called “investment recievables”, sometimes DAMPs, WMPs, Structured Deposits. All functioning the same, to channel saving from the blue areas, to red. (Feel free to ask us if you would like the data under any of these rankings!)

Setting up this ‘waterfall of pain’ (the banks ranked by their provincial exposure, asset quality, growth, and dependence on interbank funding channels.

Take it or leave it, this analysis sets up a pretty simple framework for tracking how an Evergande bankrupcty could ripple through the financial system.

As of now, we don’t see two of our biggest/baddest banks under pressure. If the pain from Evergrande spreads, and spreads to these guys, in particular Industrial (a $1tr ‘medium’ bank), and Minsheng (one of the biggest creditos in Evergrande), run for the hills.