The Credit Dominoes Are Falling Again; Northeast Faces Deflationary Collapse Without Bailout

"The profit model is an important reason for the large-scale collapse of credit guarantee firms, a 2% profit is not sufficient for taking on 100% of the risk."
(Source: Credit Guarantee Firms Go Down Like Dominoes)

The long simmering problem of credit guarantee companies is finally coming to a head in China. What is a credit guarantee firm and what do they do? Their profit model is above. They operate on the AIG business model of providing what is effectively credit insurance on risky loans. What they effectively allow is subprime lending to all manner of borrowers, including home buyers. Oh yes Virginia, there are subprime mortgages in China.

If you can think of any big credit bust stories in China in recent years, most have a credit guarantee at the heart of the story. In some cases they form a web of mutual guarantees, such as in Xiaoshan, Hangzhou. From April 2014: Rumored Mass Death of Companies in Xiaoshan District of Hangzhou If Banks Collect on Debts; Government Tells Banks to Sit Tight or Leave
..these companies are tied together because they have given each other loans in the past to bail people out, or they are tied together by mutual investments and projects. What was a hodgepodge of individual bankruptcies has turned into a systematic crisis in this small district because there is no one left to save them. The banks are concerned about risk and may call in loans, taking the stronger companies down with the weak. The government told the banks, if you pull the loans then you ought to leave town.
See also: Ye Tan's Commentary on Xiaoshan: Get Government Out of Credit Markets and China's Credit House of Cards.

Sometimes, credit guarantees are used for epic Ponzi finance. Steel Trade Lawsuits Explode; Banks' Unceasing Nightmare; Defendants Flee
Shanghai has more than 80 guarantor companies and nearly 40% of them were opened by Zhouning, Fujian steel trading companies (aforementioned Xiao Jiaoshou is from Zhouning).
What these guys in Zhouning figured out is you take out some loans for steel trading, but then use the money to open a credit guarantee company. Then you guarantee the loans for your steel trading buddies, who divert a portion of their proceeds into credit guarantee firms to do the same. Pretty soon, the Chinese banking system has made a lot of loans that they think are good credits because they have a guarantee.

In truth, the borrower is effectively guaranteeing his own loan. If the credit goes bust, the guarantee is gone too. Like the AAA garbage sold during the housing bubble, once the fundamentals give way the whole house of cards tumbles. If a credit guarantor goes down, then all his guaranteed loans are in trouble and it kicks of the daisy chain of default that wipes out an entire local economy. Or in the case below, an entire province.

One of the reasons why steel is collapsing is because the government didn't press harder for reform. A big reason for that was credit guarantees and bad debts. From earlier this year: Steel Collapse
The reason for the government's failure to tame the steel industry became crystal clear in 2014, when credit guarantees became a major issue. As with other industries, mutual credit guarantees form a web of interlocking liability. If one steel mill is shuttered, it sets off a chain reaction that shutters several more. In March 2014, Haixin Steel ceased operations with ¥20 billion in debt owed to 33 different lenders. Disaster fell on other steel and energy companies that had guaranteed Haixin's debt. This daisy chain of mutual guarantees tied the government's hands, restricting their actions for fear of setting off more bankruptcies.

If ¥20 billion can wreak havoc on the industry, imagine the problem facing the government today. In addition to the ¥1.3 trillion in bank loans, much of it short term, the industry's top 80 firms also owe ¥1.7 trillion in short-term high interest loans. Firms are borrowing to repay old debt, for instance a Xinjian unit of Baosteel saw its short-term debt climb 13.3% last year, even as long-term debt fell 29%. This increases the risk of default should credit conditions tighten.

Other posts:
Beijing Residents Use Consumer Credit to Speculate on Baoding Real Estate; Yet Another Source of Bad Debt (if you don't believe there are subprime mortgages in China, read that)
Credit Guarantee Nightmare; How The Qingdao Port Scandal Goes Viral
Credit Guarantee Firms Go Down Like Dominoes
Credit Guarantee Firms Continue to Implode, Private Bonds Default
Wenzhou Tries to Restructure Credit Guarantee Firms; More Than ¥50 Billion in Bank Loans At Stake
Trust Disaster Unfolding In Sichuan
Textbook Credit Implosion Underway in Sichuan Province
Liquidity Evaporates As Credit Conditions Worsen
Xi‘an Credit Guarantee Firms Go Bust
SMEs Wonder Not How to Live, But How To Die As Borrowing Costs Spike

With that as background, on to the latest case. Back in April: Hebei Credit Collapse: State Owned Credit Guarantee on the Brink as AIG Business Model Falters
The largest loan guarantee company in the northern province of Hebei has been in trouble since investors discovered it did not have enough capital to back its guarantees.

At least 50 financial institutions – ranging from banks and trust companies to securities firms and peer-to-peer lending websites – are worried their investments are in trouble, several employees from those financial institutions said.

The employees said the company has guaranteed at least 50 billion yuan worth of loans. Starting in July, some borrowers have defaulted on their loans and investors have been unable to get repayment from the guarantee company, they said.

...An executive from a fund investment company said it would not have lent to some projects if it were not for the guarantee the state-owned enterprise (SOE) provided.

"These are projects that we normally would not do," he said, "but because they were guaranteed by the company, we took them on anyway."

..."We believe that an SOE will not really default," a manager from a trust company in Shanghai said. "But no one knows how much longer the suspension will last."

Today: China shadow banks appeal for government bailout
Eleven shadow banks have written an open letter to the top Communist party official in northern China’s Hebei province asking for a bailout that would enable the bankrupt credit guarantee company to continue to backstop loans to borrowers. If the guarantor cannot pay, it could spark defaults on at least 24 high-yielding wealth management products (WMPs).

Analysts worry that a series of bailouts in recent years has encouraged irresponsible lending by fuelling the perception the government will not tolerate default. The latest appeal for a bailout will again force officials to choose between ensuring short-term financial stability or imposing market discipline on investors, which should improve lending practices in the long term.

Hebei Financing Investment Guarantee Group has guaranteed Rmb50bn ($7.8bn) in loans from nearly 50 financial institutions, according to Caixin, a respected financial magazine. More than half of this total is from non-bank lenders, mainly trust companies, who lent to property developers and factories in overcapacity industries.
The Northeast was in recession in Q2 and the latest industrial production figures don't change the outlook as of July. Credit defaults are more common due to the economic slowdown in the rust belt, but there's nothing special about the finances of the northeast. This has been a problem all over China as the links above show. The web of connections would take years in court to untangle if this firm went bust, it could drag in companies across the province and set off more credit implosions in cities across Hebei.

I haven't even touched the issue of WMPs. Often, instead of borrowing from banks, SMEs and real estate developers unable to obtain bank credit borrowed from trust companies. These trust companies raise money from unsophisticated investors, offering high yields, then loaned money to borrowers at high rates, but considered the loans good because they have credit guarantees. Here's an example of how this Ponzi pyramid grew in recent years, from the the "Textbook Credit Implosion" link above:
Rent no doubt was high due to growth in investment management/ advisory firms. At end of December 2013, there were nearly 5,000 of these financial firms, an increase of roughly 4000 from June of the same year! Sichuan's provincial government counted 509 firms involved in credit guarantees at the end of 2013, with a ¥233.8 billion guarantee balance and 730,000 households served, making Sichuan province the second largest market in the country. Central bank data from the end of June 2014 counted 326 small lending companies in Sichuan, ninth in China, with ¥59.7 billion in loans, fourth in China.

41.4% of western Chinese SMEs need credit and 57.2% of those credit needs are met with private fundraising (shadow banking). Average interest rates are 19.1%, well above the 9.7% annual rate for bank credit. Since they have no credit guarantee or collateral, 72.1% of small businesses are forced to use private fundraising. In Chengdu, there are investment products on the market today offering 15% to 18% returns, well above the 7% offered by bank trusts and WMPs.

Are you ready for the punchline? One insider estimates that 80% of this private credit flowed into real estate. Thanks to the rapid growth of the real estate industry, some developers were (successfully) paying 100% annualized interest rates and even the common people were spoiled, with investors refusing to even look at wealth product yielding under 20%.
In Handan last year (in Hebei province), a credit guarantee bust froze the real estate market. See: Another Credit Guarantee Gone Bust, One Month After Backing A Trust and Handan Credit Bubble Affects Entire City Economy.

Bailouts are coming. Lots and lots of bailouts.

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