This Is The $3.5 Trillion "Neutron Bomb" That Keeps Kyle Bass Up At Night
Earlier today, CNBC invited Kyle Bass, the man who correctly predicted and profited from the subprime collapse, to discuss what he thought was the biggest threat to the global financial system.
Here is the highlight of what he said:
What I think the narrative will swing to by the end of this year if not sooner, is the real issue in China is not simply that profits have peaked. The real issue is the size of their banking system. Do you remember the reason the European countries ended up falling like dominoes during the European crisis was their banking systems became many multiples of their GDP and therefore many, many multiples of their central government revenue. In China, in dollar terms their banking system is almost $35 trillion against a GDP of $10 and their banking system has grown 400% in 8 years with non-performing loans being nonexistent. So what we are going to see next is a credit cycle, and in a credit cycle you see some losses, but if China's banking system loses 10%, you are going to see them lose $3.5 trillion.
He then puts this number in the context of China's "massive" foreign reserves:
What's the magic number in their FX reserve pile today? When you look at banking system assets divided by their foreign exchange reserves, China is 7x, it's one of the worst in the world. I think people are mypoically focused on a giant number of reserves, of $3 trillion or thereabouts, and no one is really paying attention to the size of the system and what's about to happen.
Actually that's not true: we first pointed this out more than 2 years ago, when we showed "How China's Stunning $15 Trillion In New Liquidity Blew Bernanke's QE Out Of The Water."
A few weeks later we followed up with another stunning chart showing "How In Five Short Years, China Humiliated The World's Central Banks." However, we do agree fully with Bass that virtually nobody else is paying attention to this epic question of scale, especially as it relates to another topic we have been covering for the past two years: China's soaring, and dramatically underreported non-performing loans.
More on that in a second, but first a quick reminder that as we also reported over the weekend, for Kyle Bass, "The Greatest Investment Opportunity Right Now" is to short the Chinese currency: a trade which just in the past week has generated tremendous returns (using the embedded FX leverage), and which we are confident will continue to be very profitable, especially since as we first said in August, days before China's devaluation, the only thing that could save China's economy from an even harder landing, is to rapidly devalue their currency. China did just that, and has been doing that ever since.
Earlier today, even Goldman - with a huge delay - finally came to see things correctly, when it said that:
"We are adjusting our USDCNY forecast weaker, to 7.00 on a 12-month horizon (our twelve-month forecast was 6.60 previously) and 7.30 by end-2017 (from 6.80 previously). Though markets have been moving quickly, and today's lower USDCNY fixing suggests the possibility that policymakers may want to stabilize expectations for the CNY, this puts us back on the weak side of market pricing over a twelve-month horizon, consistent with our view that 2016 will be a year of continued “bumpy deceleration” and significant policy easing in the Chinese economy, and that the potential for greater CNY depreciation remains a large source of uncertainty."
So going back to Kyle Bass' thesis, it a relatively simple one: China has been avoiding a credit, or non-performing loan cycle, and fabricating the data, but the time has run out.
"China many years ago attached its currency to the dollar: they hitched their wagon to our star very smartly because back then our goal was to depreciate our dollar through inflation. So we issued debt to the rest of the world to depreciate the dollar. And so now the real problem is China has hitched their wagon to our star, and their currency has effectively appreciated about 60% versus the rest of the world since 2005 and it's killing them... China's effective exchange rate moving up versus the rest of the world made their goods and services a little bit more expensive each year and now that labor arbitrage is gone. And if that labor arbitrage is gone, and the banking system has expanded 400% in 7 years without a nonperforming loan cycle, my view is we are going to see a non-performing loan cycle."
So what exactly is this non-performing loan cycle that Kyle Bass is referring to, and where does he get a $3 trillion potential loan loss - a quantum step in admission of economic failure which we first dubbed China's neutron bomb" in October 2015 - number?
Luckily, we explained all of this two months ago when we showed how "China's Banking Sector Is Sitting On A $3 Trillion Neutron Bomb." For those who missed it, here is the explanation behind what could be the best trade of the next 12-18 months (the best trade of 2015 incidentally was to be long Glencore CDS, as we suggested in 2014) according to Kyle Bass:
* * *
We’ve long contended that official data on bad loans at Chinese banks is even less reliable than NBS GDP prints. Indeed, the lengths Beijing goes to in order to obscure the extent to which banks’ balance sheets are in peril is truly something to behold and much like the deficient deflator math which may be causing the country to habitually overstate GDP growth, it’s not even clear that China could report the real numbers if it wanted to.
We took an in-depth look at the problem in “How China's Banks Hide Trillions In Credit Risk: Full Frontal”, and we’ve revisited the issue on a number of occasions noting in August that according to a transcript of an internal meeting of the China Banking Regulatory Commission, bad loans jumped CNY322.2 billion in H1 to CNY1.8 trillion, a 36% increase. Of course that’s just the tip of the iceberg. In other words, that comes from a government agency and although the scope of the increase sounds serious, it still translates into an NPL ratio of just 1.82%. Here’s a look at the “official” numbers (note that when one includes doubtful accounts, the ratio jumps to somewhere in the neighborhood of 3-4%):
Source: Fitch
There are any number of reasons why those figures don’t even come close to approximating reality. For instance, there’s Beijing’s habit of compelling banks to roll over bad loans, and then there’s China’s massive (and by “massive” we mean CNY17 trillion) wealth management product industry which, when coupled with some creative accounting, allows Chinese banks to hold some 40% of credit risk off balance sheet.
Well as time goes on, and as market participants scrutinize the data coming out of the world’s second most important economy, quite a few analysts are beginning to take a closer look at the NPL data for Chinese banks. Indeed, if Beijing continues to move toward “allowing” defaults to occur (even at SOEs) and if China’s transition from smokestack economy to a consumption and services-driven model continues to put pressure on borrowers from the manufacturing sector, the situation is likely to deteriorate quickly. If you needed evidence of just how precarious things truly are, look no further than a recent report from Macquarie which showed that a quarter of Chinese firms with debt are currently unable to cover their annual interest expense (as you might imagine, it's even worse for commodities firms).
Just two weeks after we highighted the Macquarie report, we took a look at research conducted by Hong-Kong based CLSA. Unsurprisingly, it turns out that Chinese banks' bad debts ratio could be as high 8.1%, a whopping 6 times higher than the official 1.5% NPL level reported by China's banking regulator.
We called that revelation China's "neutron bomb" but it turns out we may have jumped the gun. According to Hong Kong-based "Autonomous Research", the real figure may be closer to 21% when one takes into account the aforementioned shadow banking sector. Here's more from Bloomberg:
Corporate investigator Violet Ho never put a lot of faith in the bad loan numbers reported by China’s banks.
Crisscrossing provinces from Shandong to Xinjiang, she’s seen too much -- from the shell game of moving assets between affiliated companies to disguise the true state of their finances to cover-ups by bankers loath to admit that loans they made won’t be recovered.
The amount of bad debt piling up in China is at the center of a debate about whether the country will continue as a locomotive of global growth or sink into decades of stagnation like Japan after its credit bubble burst. Bank of China Ltd. reported on Thursday its biggest quarterly bad-loan provisions since going public in 2006.
Charlene Chu, who made her name at Fitch Ratings making bearish assessments of the risks from China’s credit explosion since 2008, is among those crunching the numbers.
While corporate investigator Ho relies on her observations from hitting the road, Chu and her colleagues at
Autonomous Research in Hong Kong take a top-down approach. They estimate how much money is being wasted after the nation began getting smaller and smaller economic returns on its credit from 2008. Their assessment is informed by data from economies such as Japan that have gone though similar debt explosions.
While traditional bank loans are not Chu’s prime focus -- she looks at the wider picture, including shadow banking -- she says her work suggests that nonperforming loans may be at 20 percent to 21 percent, or even higher.
“A financial crisis is by no means preordained, but if losses don’t manifest in financial sector losses, they will do so via slowing growth and deflation, as they did in Japan,” said Chu. “China is confronting a massive debt problem, the scale of which the world has never seen.”
As a reminder, here's a look at the scope of the "problem" Chu is describing:
And here's a bit more on special mention loans and the ubiquitous practice of "evergreening":
Slicing and dicing the official loan numbers, Christine Kuo, a senior vice president of Moody’s Investors Service in Hong Kong, focuses on trends in debts overdue for 90 days, rather than those classified as “nonperforming.” Another tactic some analysts use is to add nonperforming debt to “special mention” loans, those that are overdue but not yet classified as impaired, yielding a rate of 5.1 percent.
Banks’ bad-loan numbers are capped by “evergreening,” the practise of rolling over debt that isn’t repaid on time, according to experts including Keith Pogson, a Hong Kong-based senior partner at Ernst & Young LLP. Pogson was involved in restructuring debt at Chinese banks in 1998, when their NPL ratios were as high as 25 percent.
So let's just be clear: if 8% is a "neutron bomb", a 21% NPL ratio in China is the asteroid that killed the dinosaurs. Here's why:
If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion.
That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven't done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall.
In the end, we would actually venture to suggest that the real figure is probably far higher than 20%. There's no way to get a read on how the country's vast shadow banking complex plays into this but when you look at the numbers, it's almost inconceivable to imagine that banks aren't staring down sour loans at least on the order of a couple of trillion.
To the PBoC we say, "good luck plugging that gap" and to the rest of the world we say "beware, the engine of global growth and trade may be facing a pile of bad loans the size of Germany's GDP."
We close with the following from Kroll's senior managing director in Hong Kong Violet Ho (quoted above):
"A credit report for a Chinese company is not worth the paper it’s written on.”
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I'm just burnin' doin' the neutron dance. (Pointer Sisters, 1984)
Just 10-20% fucking percent... Why not more?
I think he didn't want to expose the depth of his trading strategies. He was being conservative.
s&p and Dow johnes are more than 5 percent down both over 52 weeks. Let's hope that you are right. Each prominent investor says something different. If you have to believe Mark Spitznagel than we are going to see a drop of 40%...
Any way this guy talks only about China. The EU got some problems to deal with. The same hold for Sout-America. and North-America is in I think also in deep trouble.
The market did not care much about those positve US data so I hope that the market goes down further.
Allow me to reiterate, I think Kyle Bass was holding back.
mr. bass, please read this article, http://www.zerohedge.com/news/2016-01-08/how-low-will-yuan-go-deutsche-b...
it might make you sleep worse. try to understand China’s new trade-weighted RMB index, which is similar to us$ index. therefore china has a plan.
The hallmark of a great ZH article is when you have to reread 3-4 times.
I'm still going back and forth to the chart porn article from earlier!
the pboc is honest unlike the fed. they will backstop their economy with all the yuan it needs because the counterparty of first and last resort for much of this debt is the infinite abyss of the pboc's balance sheet.
remember the chinese invented fiat. they know how worthless it is and how internal printing is just a math lesson and the error term does not matter even if it is huge. it is just a number. the only part of the chinese economy that matters is the part that shares counterparty risk with the outside....and they will be fucked painfully first.
They've seen the end game years ago. IMO, they are going to strategically default. Now, are they going to pull the plug before the US has their ducks in a row or for some other reason/goal? We know they've been importing gold to beat the band these past several years so when the fiat goes tits up they are positioned well. I think there is a secondary geopolitical game afoot that is hidden behind the scenes which affects the timing.
That makes sense. Fiats go down, they back some portion of their currency with all the Au they have been squirreling away. The old Yuan crashes along with other fiats, then the New Yuan with Gold Leaf on it appears!
Or, maybe they will do it through a trade window.
Who knows? All I know is they appear to have Moar Gold.
So Sorry, our currency is no good.. we barter for trade, ship load for ship load, Ok Commoties only, Have Gold.. that is ok we take that also,
China has all the gold and factories. They'll get energy and food from Russia. When this thing gets pulled, they'll come out on top.
Eaxctly. They'll just leave it all get evaporized. All fiat, paper, loans, debt-based instruments just vanish. Jubilee! Real assets will rise out of the ashes.
Germany thought the same thing in the early 1900's.
Couldn't being nuclear powers change that narrative? ;-)
Germany had coal when the world was fast migrating to oil. Not quite the same as what was posted above.
Germany was stuck paying massive reparations .. as usual.
CAT is a bad comparison, vs crude.
Let's overlay the manufacturing ETF's?
"That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven't done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall. "
Which is exactly what happened in the US, as revealed by the ongoing record-low monetary velocity. The Fed shoves dollars into the system that the banks sit on. Now the PBoC does the same thing.
Massively deflationary.
China was the last major economy standing, since Europe lead with the NIRP nonsense and the Fed has been doing stealth recapitalization for seven fucking years.
All of this is reflected in the shit prices of commodities, oil in particular. We're seeing crisis-based jumps in prices the past week or so, but I wouldn't count on that being a floor. I don't see a viable alternative to holding cash/cash equivalents and I'm personally holding off on any PM buys (but I have some water-logged lake assets already, so the risk of staying cash is lower with that insurance policy in place.)
Man, this economy is fucked.
Seek, you might want to avoid staying on the sidelines too long re the PMs. I agree the paper price may have another leg down to go but I think phyzz may have bottomed. Premiums here in NZ are running 20-25% over spot. Plus we have to juggle the potential exchange rate movements. I am almost fully invested but keeping a bit of dry powder out of the banking system in case there is one more buying opportunity.
As China goes broke they will stop buying so much gold from the world. They might even get desperate enough to dis-hoard.
Deflation means asset prices go down as fewer dollars chase the assets. I think it's likely we'll see a steep dip in gold prices.
Right after deflation comes a loss of faith, and it's safe to say assets, rather than cash, is going to shine when that happens, especially hard assets. Timing it all is a bitch, though.
"I think it's likely we'll see a steep dip in gold prices."
Where have you been??
China knew exactly what they were doing when they printed paper, and bought 10 or 20 thousand tonne of gold...The plan wasn't to give it back once the world realized they were robbed.
A plan in China is different than here in the US. Americans look for an immediate result. For China, a 100 year plan is short.
The decline of oil is indicative of the death of the petrodollar. If fiat is dying and soon dead, I don't think we'd care whether it's inflationary or deflationary. ;-)
Deflation then hyperinflation.
Two periods. Not one or the either.
No one can predict when. We may still be undersestimating the powers that be's ability to keep the circus plates spinning on the dowels.
Sometime during our lifetime. My belief: we're entering the main deflationary phase we've been expecting.
We entered it in '08 (peak credit). The banksters need a Chinese crash, now, as the FED is raising rates (a deflationary act) to defend the dollar. Time to suck them clean, like a Hoover. China's inflationary tide has turned back out to sea as if someone(FED) pulled the plug in the bathtub.
"Deflation then hyperinflation"
But the timing. . . Deflationary pressures could hold sway for quarters,even years, before the hyperinflation.
To the average Joe out there looking to preserve wealth, it's a brutal environment. UST, for all the Fedcoat nonesense, might not be a bad place to be. . . It wont ever be the best annual performer, but for wealth preservation . . .
10% ? please. 20 if a dime.
Well, I think we may well be at an inflection point where reality meets expectations. The 'doom porners' were wrong for the past 7-8 years because they failed to understand the power of the central banks to levitate the markets at will. Now we have a confluence of forces in both the U S, China, and the EU that the central banks may not be able to control. We will not know for a few months, but the potential for wide spread carnage is huge if people just assume the CBs will engage and make it all go away. No one knows when that point will be reached, but rest assure you cannot predict it. You may be lucky to get out of your positions by dumb luck, but seems to me everyone is just trying to catch falling knives here. Good luck, gentlemen and may Godspeed be with you.
What I am not clear on is how many or what percentage of failures will it take to put the banks into receivership. It is not 100%. Surely the dire 20% if not 10% NPL rates will do it.
When the crowd pounding on the doors looking for their cash becomes a mob.
Imagine that the most important thing in your life was managing non-existent fiat chips for someone else. Ya think ya'd want to just slit your wrists.
Nope.
Their chips, not mine.
That's why money mgt. is so much fun.
Down 10% this ...hell it's only 5 days and were alread half way there ......
War is good for Alcoa Jimmy. Come on? You can do better...
Teledyne? What about all those wonderful TelCom calls [literally] you made last year?
How's the time shares in Mexico treating you, Jimmy???
Bug- meet Windshield.
Jimmy Crack-Pot is talking about VOL?
The VIX has been riding the 12-15 handle, for how many years?
Great post Tyler.
What does "Kyle Bass" - and "Its ilk - contribute to the general prosperity?
NOT an F'ing thing!
Is "It" part of the problem, instead of the solution?!
"It" is a "trader/invester" - NOT a worker/creator of [real] goods!
Wake up People!
Exposing the nature and degree of ongoing worldwide CB-Fed-Political bubble-blowing and unsustainable Keynesian debt corruption, is what Bass is contributing.
+100 And that's where the -5 downgrades come from. The +4 are from folks who refuse to believe that the government (CB's can do no wrong) - the same fucking clowns whose eyes glaze over when you tell them that interest rate suppression, the process of completely pricing risk to zero is a fucking financial disease and not a sustainable route to prosperity. Instead they will tell you its all Capitalism's fault.
China is what happens when you let idiots run the banking system. China is what happens when its people think that the government knows better how to spend money it doesn't have to keep people producing shit that nobody wants. Preferences demonstrated in the voluntary production and exchange of scarce resources determine value. Nothing else.
I won't ever forget the interview Dylan Ratigan had with Ron Paul back in 2009/10, asking "if you were chair of the Federal Reserve, right now, what would you do to fix the economy?" Ron Paul: "I would first not conduct any of the bailouts to the banks and/or automakers and let the market sort out the malinvestment." Ratigan: "but the market isn't showing up to to do this - thats the problem sir." Ron Paul: "then there's no value there - is there."
Ratigan: silence.
I invested some of my savings in his fund and he greatly increased my savings and my prosperity.
Isn't your complaint really about yourself, that you are a nothing ?
nice article. thanks
What do ya say: wish the scum-sucker many more sleepless nights?
I recall reading that the size of the Chinese government is equivalent to the population of Great Britain (or ~ 64 million)...
Standard Disclaimer: That's a lot of palms that need greasing. Or a lot of Chinese named Tran Che...
Which also means (cough Apple) is that if you have profits in China that you haven't repatriated back to the US, you're about to take a 40-50% haircut. Just cut your loses now and pay the corporate taxes in the US.
This thing is going to 9/dollar.
So, an extrapolation from an official default ratio of 1.5% to an 'estimated' default ratio of 21%? It's very interesting how ZH, whoever they are, seem to support the itended destruction of not only China, but Russia as well. This is becoming the biggest financial war in history. We should know by June.