Opinion: Why I Didn’t Invest in Evergrande – Deception, Leverage and Cycles

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As an investor, I am convinced of the monetary nature of real estate in China and have held many high yield heavyweight real estate company bonds. But I never ventured into buying bonds issued by Evergrande. Why?

There are three reasons for this. The history of the issuer of deception. The constant of the company want to be in the spotlight, which can blind him to his problems. And finally, companies that operate in a exaggerated way tend to have a low result.

From an investment standpoint, it was a tough choice to resist getting involved in a business once shrouded in a halo like Evergrande. In theory, as long as the bond is released before a problem arises, and as long as you can offload yourself on time, it’s a good investment. There are bound to be such winners in the market. However, these investment operations should not be encouraged.

The myth of the too big to fail

Since the 2008 crisis, many Chinese companies have learned the trick of being “too big to fail”. They realized that if they made their corporate debt heavy enough to pose a systemic risk, their own debt would become a national problem.

For example, as many joke in the market, a debt of 2 million yuan worries the borrower himself, while a debt of 20 billion yuan worries the bank, but a debt of 2 trillion yuan arises. a problem that must be resolved by national authorities.

It is generally difficult for companies to expand their financing scale, but Evergrande was a leader in this regard.

Evergrande skillfully took advantage of its abundant collateral and high profit margins in the real estate industry, and knew the tricks, as well as the mindset, of financial institutions. Whether it was thanks to its AAA rating which helped Evergrande gain recognition from financial institutions or the investment in football teams which allowed it to make a good impression with the public, the real estate giant has always seemed be able to control the narrative with the public and financial institutions. , and always choose the perfect time. It was like a player in a poker tournament who could accurately know the hands of other players and predict how they would interpret his behavior. And the only recourse for the other players was to refuse to play with him, like me. In business, it is better to avoid getting involved in too deceptive companies. However, the credit reporting system compiled by general financial institutions does not include the ability to control underhand tactics.

In the current credit reporting system, the most important factor is the size of the asset. This assumption also involves the logic of “too big to fail”. In general, Chinese financial institutions believe that the larger a company, the less likely it is to go bankrupt; and the more popular a business, the less risk it runs. Any problem faced by this type of giant business will become a common problem that many financial institutions face. This will not be a risk that individual decision makers in financial institutions should be concerned about, but a problem for the country.

Furthermore, the main problem facing the functioning of financial institutions is not risk control but the pressure of scale and investment. If financial institutions fail to invest, they will not be able to grow and generate income, which will affect their survival. Consequently, financial institutions have little incentive to prioritize risk control. Companies like Evergrande are “good partners” for financial institutions in the pursuit of large-scale development.

There is a strong incentive for businesses and financial institutions to expand their size. But not all businesses can do it. It takes extraordinary financing capacity for a private business to turn into a systemic risk business like Evergrande.

The inevitability of cycles

Surviving a cycle is always easier said than done.

There is a kind of business that seeks to work sales miracles by squeezing employees. If one year is too long for the performance appraisal, then three months; if three months is still too long, then a month. They pay no attention to future development. Such companies can indeed create excellent performance in the upward phase of the industry cycle and even avoid risks early in their epidemic, leaving people under the impression that “bigger ships sail easier”.

However, when cyclical changes occur, large companies usually do not have enough space to transfer or adapt.

The real estate and financial sectors are cyclical. If house prices rise and higher profits are made, they can create high leverage with little risk. But if house prices don’t rise, then they can only resort to off-balance sheet financing to keep the show going, and high financing costs immediately become a heavy burden. For all financial institutions, the most effective means of controlling risk is always to “mortgage houses and land”. Therefore, whether house prices rise or not is crucial in deciding the risks of mortgage borrowers. If house prices aren’t rising and no one is buying homes, even with the best risk controls, banks still can’t avoid the build-up of bad debt.

The cycle of the finance and real estate industries depends on house prices. And house prices in China have yet to see an inflection point – the only direction is up.

The blind faith that the price of housing never goes down is the biggest source of risk and the fundamental reason some people maximize their debt. When financing costs are constantly increasing and financing becomes more and more difficult, the net result of financing continuously decreases. It only ends, probably messy, if someone forcibly presses the stop button.

The collapse of a 2 trillion yuan indebted company like Evergrande will undoubtedly have a major impact on the entire industry and Chinese financial institutions.

Isn’t that the inevitable part of the cycle? After having climbed for so long, it will finally come back down.

History teaches us that each cycle ends with the collapse of a symbolic company. Evergrande is certainly big enough to be symbolic. And once the old cycle with real estate is over, maybe a new cycle with technology will begin.

Government intervention

How much debt does Evergrande have? What about its off-balance sheet financing? How many of his mortgaged properties have been sold? These are key questions.

Among its creditors, the most vulnerable are individual investors and home buyers. If not all of Evergrande’s debts are frozen and “off-site” negotiations continue, vulnerable groups are likely to become the final payers of its eventual insolvency.

Only by clarifying the total debt as soon as possible can all creditors be treated fairly. Regulators should take responsibility for stabilizing its finances and managing its debts fairly, rather than allowing powerful creditors and debtors to negotiate privately and be paid off first.

Evergrande’s own management having lost the confidence of its investors, only the intervention of the public authorities can maintain market equity and social credibility. If managed well, it could even be an opportunity to set up a debt management model and put the financial market on a healthy course.

The final solution to Evergrande’s debt problem can only be supported by credible and complete accounting of its assets and liabilities. The later the debt freeze is carried out, the less fair and credible the settlement will be, and the more likely it is to raise public controversy. This situation does not allow any delay in public intervention.

Zhuo Yi is a seasoned investor based in China.

Contact editor Joshua Dummer ([email protected])

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