Rehypothecation. It’s a strange word. It doesn’t mean you’ve got asthma and it has nothing to do with the meaning of life but your financial well-being now depends upon understanding what it means. The Wikipaedia definition is as good as any:
Rehypothecation is a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing.
Rehypothecation is at the heart of the China stock crash shock and its wires run directly into the heart of the Australian economy as well.
What is happening right now in the Chinese stock market is an unwind of rehypothecation. The boom was in individuals and firms pledging assets multiple times as collateral against leverage used to punt on Chinese stocks. As those stocks now collapse in value or are frozen with unknown value, the leverage is being called in in a process of de-hypothecation that forces distressed asset sales to repay debt because underlying collateral is no longer considered a store of value.
A Chinese margin call in other words but one with a very large difference for Australia.
I have described elsewhere today why the Chinese stock market crash is worse than first thought owing to this process being unleashed across Chinese stocks, property, commodities and anything else that is not bolted down. I do not especially fear for China in the long run because it is a large, diverse and competitive enough economy to adjust through such a shock and come out the other side bowed but not broken.
But the same cannot be said for Australia. Indeed us Aussies are uniquely rich owing to a daisy chain of rehypothected assets that leads directly to what are now live Chinese cathodes.
The first layer of leverage is the Chinese property market which accounts for anything up to half of Chinese hard commodity consumption. As Chinese dehyothecation spreads into its housing market, the results will be a shock to iron ore and coal demand. I don’t expect Chinese housing to entirely bust but it doesn’t need to. Three-quarters of Chinese residential construction is in sub-tier 2 cities that are already witnessing falling prices and construction freezes. All the stock market crash needs to do is prevent any recovery in these jurisdictions and steel commodity demand will crater (even worse than expected!)
The next link in the chain is Australian (and global) miners. They have rehypothecated Chinese housing construction into a massive capacity expansion. Fortescue Metals, Roy Hill and Rio Tinto have leveraged up into the boom in order to build and buy shiny new assets that will now tumble in value along with a steel commodity price crash for the ages.
But that is only the beginning. These mining assets have, in turn, been rehypothecated across the entire Australian economy, largely via the property market. Not just via rich miners buying investment properties hand-over-fist based upon assumed endless high income, but via the whole financial system. Banks have borrowed hugely in offshore debt markets based upon the income boom emanating from rehypothecated Chinese assets and dumped that debt into household and investor borrowing for housing, many of whom are also rehypothecating multiple properties with zero interest loans.
Worse, the banks have done this using an internal mechanism of rehypothecation that enables them to keep the capital that they set aside for each mortgage to a minimum. Under APRA APS-112 guidelines, banks are required to revalue collateral if “it becomes aware of a material change in the market value of property in an area or region”. Each time property prices rise, therefore, banks reduce the LVR in their mortgage books and can set aside less capital which can then be loaned again as another mortgage (you read much more about this here). The catch is that if we see an extended fall in property values then ipso facto the process reverses and more capital is required and less lending is possible.
The end result after fifteen years of this is an economy that is one giant rehypothecated Chinese asset that can’t compete on any other basis. Indeed such an economy can rightly be compared to a ‘synthetic CDO cubed’ Chinese structured asset!
Surely, you beg, if the worst happens, the government can keep it afloat?
Perhaps in the past but not now. Unfortunately the government is now at the absolute head of the same rehypothecation daisy chain. Owing to the above system threatening to unwind in the GFC, the government guaranteed the lot by rehypothectaing tax revenues that are derived from miners, banks and households into more borrowing offshore to stimulate the economy. In essence it became the rehypothecator of last resort and having re-pledged all of Australia’s Chinese dependent assets to borrow, it now faces pressure from rating agencies to limit further rehypothecation. Indeed, they want to see a surplus, that is dehypothecation, if Australia is to retain a high sovereign rating.
In summary, then, China’s current margin call is quite possibly (likely even) going to arrive Downunder in due course via the following dehypothecation chain:
- collapsing mining income and asset values;
- increasing pressure on broader asset values as those directly exposed to mining income see debts called in;
- wider asset price pressure as Chinese forced sales and cancelled developments in Australia slow the property boom;
- rising unemployment putting more pressure on asset prices which triggers its own cycle of dehypocation most especially within the ranks of highly-geared recent property investors;
- banks being forced to raise capital and restrict lending as asset prices begin to fall more swiftly and finally,
- government being unable to borrow and spend enough that it can re-inflate the asset value chain, not least because it will be very busy borrowing money to bail out the banks.
The good news for investors is that this process is not so much a trend break as it is an acceleration of the Australian economic adjustment that has been underway since 2011 with the collapse of the commodity super cycle. Investors should, therefore, already be positioned for what is coming in much lower interest rates, a much lower dollar and a bond bull market (at least at the short end of the curve).
Those who have gone long property for the same reasons need to get out. It is impossible to know precisely when the more intense phase of the Chinese adjustment will arrive in Australia but it could well be swift and the next casualties will be national property markets and the banks.
