More on the China Property Bust

As demonstrated in the chart below, April home prices in Beijing rose by a staggering 95% year-over-year vs. a nationally reported figure of 12.8% (though dividing total sales value of homes—384.6 billion yuan ($56.3 billion) in April—and the floorspace sold (72.4m square metres) yields growth of nearly 18%).

While there is little doubt that home prices are set to decline in China, low levels of personal and government debt should help lessen the damage from a property bust. As highlighted by the Economist (“China’s Economic Boom Can Survive a Property Bust”), the ratio of mortgage debt to GDP is only 15.3% in China, compared with a peak of 79% in America. The article highlights the example of Hong Kong’s late 1990s property bust to demonstrate that huge equity cushions should mitigate substantial damage to China’s banking system (unlike in the US and Europe). More specifically, in Hong Kong, where regulators bar mortgages of more than 70% of a home’s value, prices fell by almost half in the three years after the Asian financial crisis, yet mortgage delinquencies peaked at 1.4%. Finally, while mortgage books have grown by more than 70% for certain Chinese lenders, mortgages represent less than 20% of loans for most big banks, and loans to property developers account for perhaps another 8%. As such, banks have substantial capacity to absorb losses in the property sector, even if prices decline on the order of 25-30% (which is a distinct possibility given the massive run up we have seen).

While local government debt represents another distinct threat to the overall economy, particularly since they are heavily reliant on the property sales to fund their budgets, the article suggests these concerns may be somewhat overblown. According to Vincent Chan of Credit Suisse, land sales and property taxes should account for less than 17% of their revenues this year. Further, even if one uses an aggressive estimate of the debt carried by these local entities (11.4 trillion yuan as per calculations done by Victor Shih of Northwestern University), total public debt to GDP would be a manageable 50% of GDP, hardly alarming for an economy growing at over 10% in nominal terms and possessing $2.5 trillion of foreign currency reserves.

China's Property Market Slowing Down Sharply

Further evidence is emerging that China’s property market has begun to slow, as suggested in the chart below (see: China’s Property Market Freezes Up”). As discussed before, the Chinese government implemented several measures in April, including raising minimum downpayments on second homes to 50%, to help cool the market. On average, the number of residential property transactions in the four weeks after the curbs were unveiled is down 40% compared with the four weeks before the measures, according to figures covering 24 major cities from real-estate consultancy Soufun.com. The sharp slowdown comes as Beijing considers additional measures to push down prices, including imposing new taxes on residential property (though I suspect this will be reconsidered in light of the sharp slowdown already impacting the market).

Similar to the beginning stages of the US property bust, real estate agents and local investors are dismissing the slowdown as a short-term phenomenon. While they recognize that business has slowed, one gets the sense they view the dip as a buying opportunity. This quote from a Chinese real estate agent captures the complacency of the average Chinese person about the potentially serious consequences of a protracted property bust.

“What’s really dampened the market is the uncertainty. That overhang is what’s driving everyone to wait,” said Kevin Yung, executive vice president of IFM Investments Ltd., which runs the Century 21 real-estate agency franchise in China. “We think this could last another three to six months,” he said, a rough forecast shared by other industry executives. “We think prices are going to come down, probably by about 20%, but it will happen over time because this adjustment is driven more by policy than demand” he said.

Warren Buffett Comment on Muncipal Bonds

Warren Buffett famously called derivatives “financial weapons of mass disruption” way before anyone realized the systemic danger they posed. Regarding municipal debt, I think the following statement spoken at yesterday’s Financial Crisis Inquiry Commission will prove equally as prophetic:


“If you are looking now at something that you could look back later on and say, ‘These ratings were crazy,’ that would be the area,” Mr. Buffett said about state and local government bonds. “If the federal government will step in to help them, they are triple-A. If the federal government won’t step in to help them, who knows what they are.”

Strategic Defaults Threaten Housing Recovery

One of the biggest concerns weighing on the housing recovery remains the threat from “strategic defaults” by underwater homeowners (estimated at 25% of US households). With the backlog of foreclosures overwhelming the capacity of banks and mortgage servicers to deal with them, many homeowners are able to live rent free for months and potentially years on end. As suggested in the chart below, the average time it takes for a defaulting household to actually lose their property through a foreclosure has increased 75% since 2008 from 251 days in January 2008 to a staggering 438 days as of April 2010. The most egregious state is New York where the average homeowner spends 561 days in foreclosure, following closely by Florida at 518 days. Understaffing banks, government pressure to offer modifications, and incessant legal challenges have allowed millions of homeowners to live rent free, which in my opinion is creating an artificial boost to consumer spending, despite persistently high unemployment. With $2,000 or so freed up from not having to pay one’s mortgage, much of that money is being directed into other parts of the economy.

Some great quotes from a New York Times article (“Owners Stop Paying Mortgages, and Stop Fretting”) on the subject include the following (note how easy the profiled people are able to rationalize walking away from their contracts):
- More than 650,000 households had not paid in 18 months, LPS calculated earlier this year. With 19 percent of those homes, the lender had not even begun to take action to repossess the property — double the rate of a year earlier.
- One reason the house is worth so much less than the debt is because of the real estate crash. But the couple also refinanced at the height of the market, taking out cash to buy a truck they used as a contest prize for their hired animal trappers. It was a stupid move by their lender, according to [the homeowner] Mr. Pemberton. “They went outside their own guidelines on debt to income,” he said. “And when they did, they put themselves in jeopardy.”
- Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino. “Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”
- In Pinellas and Pasco counties, which include St. Petersburg and the suburbs to the north, there are 34,000 open foreclosure cases, said J. Thomas McGrady, chief judge of the Pinellas-Pasco Circuit. Ten years ago, the average was about 4,000. “The volume is killing us,” Judge McGrady said.
- About 10 new clients a week sign up, according to Mr. Stopa, who says he now has 350 clients in foreclosure, each of whom pays $1,500 a year for a maximum of six hours of attorney time. “I just do as much as needs to be done to force the bank to prove its case,” Mr. Stopa said.

Leveraged Loan Index Declines for First Time Since December 2008

The leveraged loan market is poised to post its first loss since December 2008, with the benchmark S&P/LSTZA Leveraged Loan index down 2.33% for the month. While modest relative to the equity markets, the index had posted 16 straight months of positive performance and has risen over 50% from its December 17, 2008 trough. Unlike the equity markets, the leveraged loan market generally shows a great deal of stability so a 2.3% decline represents a meaningful change.

As I have reported on several occasions, the loan market has gotten very pricey, with leveraged buyers driving incremental demand. Many hedge funds have employed total return swaps (“TRS”) to leverage their positions (essentially, borrowing a meaningful portion of the purchase price from investment banks). With LIBOR less than 50bps and current yields of only 3-4%, the only way to generate mid-teens returns (the hurdle for most credit funds), was to employ meaningful leverage in one’s book. An improving economy and significant liquidity in the credit markets enabled leveraged buyers to outperform the market. Many of those trades are breaking down and should continue to do so as credit spreads widen.

While we have gotten a bit of a reprieve over the last few days, liquidity in the market remains very low and suggests that a great deal of caution is warranted as investors look to bargain hunt. As is often the case, a slowdown in liquidity generally precedes true price discovery in the credit markets and I firmly believe that the worst is far from over. While we could get a bounce in credit over the next few weeks given May’s sharp selloff, rallies should be used as opportunities to lighten positions rather than increase exposure.

Another data point that should signal caution is the sizable outflows in high yield we have experienced over the last three weeks. Last week we saw a massive $1.4bn exit from the high yield markets, on top of a cumulative $2bn withdrawal over the prior two weeks. Cumulative year-to-date inflows are now only $534mm vs. the nearly $4bn we had seen before problems in Greece began making front page headlines.

Here is a good chart from BofA that shows the weekly flows into high yield since late last year. With the exception of two weeks of declines in Mid-February, we have experienced consistently strong inflows into the riskiest parts of credit.

China Reviews Eurozone Bond Holdings

As discussed in my post on May 11th (“Foreign Exchange Reserves by Currency”), a big trend over the last several years has been an increasing shift in foreign currency reserves from the US dollar into the euro. From 2004 to 2009, the euro’s share of foreign currency reserves has increased from 24.0% to 27.4%, while the US dollar’s share has declined from 66.9% to 62.1%.

Not coincidentally and as reported by the Financial Times today, China has begun to review its sizable holdings of eurozone debt, which the article suggests could be as high as $630bn (~25% of the country’s total reserves). While the US may benefit in the short-term as China reallocates some of its reserves to dollar-denominated assets, I continue to believe that gold will ultimately be the biggest beneficiary as the yellow metal represents a paltry ~1.5% of the country’s reserve assets (as opposed to the dollar and the euro which collectively account for 95% of the country’s reserves).

Here are a few key paragraphs from the FT article:

China, which boasts the world’s largest foreign exchange reserves, is reviewing its holdings of eurozone debt in the wake of the crisis that has swept through the region’s bond markets.

Representatives of China’s State Administration of Foreign Exchange, or Safe, which manages the reserves under the country’s central bank, has been meeting with foreign bankers in Beijing in recent days to discuss the issue.

Safe, which holds an estimated $630bn of eurozone bonds in its reserves [the country’s foreign exchange reserves totalled $2,447bn at the end of March, up $174bn in just six month]., has expressed concern about its exposure to the five so-called peripheral eurozone markets of Greece, Ireland, Italy, Portugal and Spain.

Any move by Safe would mark a significant change in direction, as Beijing has been trying to diversify away from the US dollar in recent years by buying a greater proportion of assets denominated in other currencies.

Another Spanish Bank Fails

As I reported on April 4th 2009 ("Spain Bails Out First Bank" - hard to believe over one year ago!), the bailout of Caja de Ahorros Castilla La Mancha (known as CCM) by Spain’s central bank, served as the canary in the coal mine that significant problems resided in the country’s banking system. This was particularly the case for the nation’s cajas (small, mutually owned banks controlled by depositors, employees, religious organizations and politicians), which had grown their market share from 10% to nearly 50% and continued to lend aggressively in 2006 and 2007, even as Spain's larger banks pulled back.


Over the weekend, we received another data point highlighting Spain’s troubled banking sector, when the central bank took over a Church-controlled savings bank, CajaSur. While the bank accounts for only .6% of the nation’s banking assets, future takeovers and forced mergers are imminent. In fact, yesterday four savings banks – Caja de Ahorros del Mediterraneo, CajaStur, Caja Extremadura, and Caja Cantabria – signaled their intent to eventually merge their operations. By consolidating, the banks are likely to receive financial support from Spain’s central bank, which will be necessary to sustain their operations.