Back in the summer of 2017, just when we thought there were no more surprises left in the arsenal of the world's foremost incubator of "financial engineering" - i.e., China - we got a stark lesson in never underestimating Chinese market manipulating ingenuity. The reason, as readers may recall, is that last June we reported, that according to Caixin, over two dozen Chinese companies had offered their employees a deal: buy company shares while guaranteeing that any losses would be covered.
The reason was simple: company founders and major shareholders had found themselves engaging in partial cash outs by pledging large batches of their stock as loan collateral and pocketing (and spending) the loan proceeds immediately, a practice that according to Reuters' estimates had quadrupled in China over the past two years, and which worked great as long as stocks were rising, but once they started falling - as Chinese equities did early last summer - those who had taken out stock-collateralized loans were subject to escalating margin calls, forcing them to liquidate. Or rather, liquidating would have been the honorable thing to do, what they did instead was the most unethical and illegal option: shareholders and management encouraged their own employees to bail them out by buying the stock while guaranteeing to cover the downside - pushing the stock price higher, boosting the value of the pledged underlying asset, and stopping the margin calls if only briefly.
As we also noted at the time, while employees were lied to believe they were getting an unbeatable deal - who can say no when your own employer guarantees you all the upside and no downside if you just buy the company stock - the reality is that participants in such scheme were merely locking in their fates with that of their soon to be insolvent employers, who desperately needed to raise the price of their stock to fend off terminal margin calls. Furthermore, as analysts noted at the time, the promise to take any losses wasn't legally binding and depended on big shareholders' "virtue" which in China does not exist.
Calling this process yet another bootstrapped ponzi scheme, we said that it unveiled a deeper threat facing China's smaller publicly-traded companies:
If markets continue to slide, there could be a surge in margin calls on these loans, potentially triggering a vicious cycle of share selling, increasing the risk of broader financial instability. "If stock prices fall, but shareholders don't have enough capital to replenish their collateral, the pledged shares would face forced selling," said Meng Shen, director of Chanson & Co, a Beijing-based boutique investment bank. "That would develop into a negative spiral; as the more you sell, the lower the stock price, which would then trigger more forced selling."
Fast forward to today, and that's pretty much where we are.
And while regulators have long since halted the practice of management being able to ask employees for a bailout, the problem with Chinese loans pledged against stock has only deteriorated, and as the FT reports, "listed Chinese companies are being forced to halt trading as their owners attempt to unwind risky bets they have made pledging company stock for loans."
This is precisely the contingency that we said would happen if the broader Chinese market did not rebound sharply. Well, it did not, and in fact Chinese stocks - especially in recent weeks - have been some of the worst performers in the world. The result now is a brewing market crisis, as countless shareholders face self-reinforcing margin calls, which force liquidations, which send stocks lower, which prompt even more liquidations, which send stocks even lower, and so on.
The basis for this toxic loop first emerged in early 2017, when China tightened access to credit to address its mounting corporate debts; finding many of their traditional "shadow funding" pathways blocked, controlling shareholders in many smaller listed companies used their shares as collateral for credit. Then, following the market swoon late last spring, we got the first indication of just how bad the pledged loan problem could get in China, when the story described above took place.
It is now time for round 2, because just like last June, market jitters since the start of this month have pushed companies to warn their shareholders that they could face margin calls as share prices fall.
And since this time around, no simple "100% guaranteed" Ponzi schemes are available to bail shareholders out, companies are doing the only thing they can: halting trading to avoid further liquidations and even more margin calls.
That's what happened to Shenzhen-listed Shenwu Environmental Technology, which is one of at least 20 groups in February that has stopped trading because of the risk of a margin call, where a share price decline triggers a demand to top up any money borrowed to buy the stock.
Some statistics from the FT:
China’s tighter controls over credit last year led to a wave of share pledges by listed groups: as of mid-December, shareholders in 317 Shanghai and Shenzhen-listed companies had pledged at least 40 per cent of their stock, compared with 224 companies a year earlier.
But why engage in such risky behavior as pledging shares? Mostly because as a result of Beijing's crackdown on shadow banking, there are few other unregulated ways of extracting cash that do not involve actual selling.
The FT confirms as much, noting that "pledged shares for loans is one means that the companies have to access funding outside the traditional banking sector. Many others have borrowed from “shadow” lenders, often at high costs."
“This is all part of the deleveraging campaign,” said Hong Hao, head of research in Bocom International in Hong Kong. “The owners of these companies have had to pledge shares just to get access to capital.”
In the case of the abovementioned Shenwu, the company announced that its controlling shareholder has pledged more than 40% of the group’s shares and was now in discussion with the margin lender.
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Meanwhile, almost a year after we first warned that the practice of extensive stock pledging would have an unhappy ending, China’s securities regulator has finally started looking into the use of stock as collateral for loans, the Securities Times reported. In some cases, companies have simply noted in regulatory filings that the securities regulator is investigating the shareholders that have pledged the stock.
Making matters worse are two tangential issues:
- Fisrt, many of the smaller listed companies in China - those where share pledging dominates - are facing a slowdown in growth, alongside that of China itself, which due to its aggressive deleveraging campaign will see its GDP decline to in 2018, a factor that has weighed on the performance of many of Shenzhen’s small-cap companies;
- Second, whether due to liquidations - or their frontrunning - Shenzhen’s tech-focused ChiNext index has been falling gradually since 2015, but fell around 12% between January 25 and February 9. And as a result of the declining collateral value, the Loan To Value on the pledged loan keeps rising until it hits and/or surpasses 100%, at which point it's game over.
“Some of these companies are heading toward dangerous territory,” a Shanghai-based analyst at a global bank told the FT, adding that it was not normal for companies to halt trading because they faced the risk of margin calls, and yet that's precisely what is going on.
Still, some managed to find a silver lining: Bocom's Hong said that the halting of trading to deal with problems could be a good sign. You see, he explained "in the past, shareholders facing margin calls would likely have been forced to sell off the stake without warning, he said. But China’s securities regulator has recently given companies permission to allow shareholders to work through problems with debtors instead of selling up to pay back loans."
Which of course, is an odd definition of a "good sign": because instead of facing reality, and selling, the entire market simply becomes hijacked by a handful of greedy executives. Meanwhile, the money of anyone who invested alongside them, well, as South Park put it best "it's gone... it's all gone."