Cross-posted from Investing in Chinese Stocks.
“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.
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 borrowers 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.