For a few days last week, Chinese equity investors discovered that stocks can go down as well as up.
That likely came as a surprise to the many millions of newly-minted, semi-literate day traders who have entered the market in droves this year helping to fuel one of the most monumental equity rallies in recent memory. As documented here, and subsequently everywhere else, margin debt has played an outsized role in supercharging Chinese shares.
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As you can see, China's margin loan balance sits at around CNY2.2 trillion, and while that’s certainly impressive, there’s every reason to believe that at least another CNY500 billion in margin lending has been funneled into the Chinese stock market via the country’s shadow banking complex.
Essentially, brokerages are only allowed to facilitate margin trading for investors whose account balances total at least CNY500K, and even then, traders can only lever up 2X. Clearly that’s no fun, so brokerages naturally looked for ways to skirt the rules. Umbrella trusts offered a way around the restrictions and while the mechanics can be made to sound complex, the idea is actually quite simple. An umbrella trust is set up like a CDO. The senior tranche is sold by banks to clients who receive a fixed payout (like a coupon payment), only instead of CDS premiums (in the case of a synthetic structure) or cash flows (from a cash structure), the ‘coupon’ payments are generated by equity investments in the subordinated tranches, which are used by brokerages to skirt margin restrictions. In other words, the guys holding the senior tranches are financing the stock trades of the guys in the junior tranches (this is probably a horrible idea for any number of reasons, but we’ll save that for another day).
Back in April, China cracked down on brokerages’ ability to tap umbrella trusts and now, some suggest restrictions on the shadow banking complex’s ability to finance leveraged equity trading are putting pressure on Chinese stocks. FT has more [8]:
China’s shadow banks, increasingly wary of lending into a slowing economy, have turned to the stock market, fuelling a surge in unregulated margin lending that has driven the market’s dizzying gains over the past year.
Now regulators are cracking down on shadow lending to stock investors, a campaign analysts say is partly to blame for last week’s 13 per cent fall in the Shanghai Composite Index — the largest weekly drop since the global financial crisis in 2008.
“The price of funds has increased, the flow has shrunk, and transaction structures are getting more complicated,” says a Chongqing-based shadow banker who provides grey-market loans to stock investors.
“We’re no longer in a growth period. It’s more like, feed the addiction until you die, earn fast money. No one treats this as their main career.”
In the murky world of grey-market margin lending.. few rules apply. Leverage can reach 5:1 or higher, and there are no limits on which shares investors can bet on.
The money for these leveraged bets comes mainly from wealth management products sold by banks and trust companies..
Traditional WMPs are backed by credit assets such as bonds, loans and money-market instruments. Ultimately much of the funds have flowed to property developers and local government infrastructure projects.
But with China's property market suffering a slowdown and the central government focused on curbing the rapid run-up in local-government debt, this form of shadow banking has receded. Meanwhile, monetary loosening has fuelled an equity boom, attracting WMP funds into the market.
“The flourishing of financial markets has caused ‘ersatz fixed income’ products that invest in secondary markets to become the preferred target for wealth management funds.”
There is no reliable data on “umbrella trusts” — the most prevalent structure — but Haitong estimates that between Rmb500bn and Rmb1tn in margin lending from trust companies has flowed into the stock market.
With a touch of financial alchemy, trusts transform an equity investment into a structured product that yields a fixed return — that is, unless something goes wrong.
In the case of umbrella trusts, banks purchase the senior tranche, which guarantees a fixed return. They then slice up this tranche and distribute it to clients as WMPs.
Hedge funds, brokerages and other institutions subscribe to the subordinate tranche, which absorbs the first losses from stock investments but also enjoys all profits once the senior tranche holders have received their fixed return.
Subordinate-tranche investors are effectively borrowing money from senior tranche-holders to make leveraged stock bets. The interest that subordinate tranche-holders pay on the margin loans comprises the fixed returns paid to the senior tranche.
With the flow of margin finance now slowing, investors can no longer rely on flush liquidity to drive the market.
It's not entirely clear which is worse, the fact that between CNY500 billion and CNY1 trillion in margin trading is being conducted through a mutant CDO structure that sounds like it could have walked out of some nightmare a sellside risk manager had after a long night of drinking or the fact that there really isn't any way to accurately assess what portion of Chinese banks' off-balance sheet credit risk (which amounts to as much as 40% of total credit risk) is somehow connected to these vehicles.
Trade accordingly.
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For all the structured credit fans out there, we'll leave you with the following clip which sums up how we feel about using depositors' money to fund hundreds of billions in retail margin trading in Chinese brokerage accounts by chanelling cash through a CDO that's not really a CDO:
