Rebel Traders – Analysis Without The Hype

Part of the astounding growth in the Chinese stock market has been fueled by an unbound lending by the Chinese banks. In addition, the government stimulus also took the form of loans, which in some case were not required at all, but have been made nonetheless.

Now this unrestricted lending is giving some sleepless nights to the Chinese regulators. The lack of risk management and of controls on the lending brought the Chinese regulators to restrict the rules: Chinese banks will not be allowed to integrate to their capital subordinated bonds issued by other banks (in short: no way for the banks to securitize their loans and sell the problems to other banks), over the next year. The question now is if these changes won’t happen too late as the bad loans have been rising. However, lending has slowed down since the beginning of H2.

Worried that the rapid credit growth this year might aggravate risks for the banking sector, China’s top banking watchdog on Friday reiterated that domestic lenders should enhance their risk management capacity and adhere to regulatory requirements.

“With bank loans growing rapidly, all kinds of risks are rising in the banking industry,” Liu Mingkang, chairman of China Banking Regulatory Commission, said in the statement posted on the regulator’s website.

Chinese banks advanced 8.15 trillion yuan ($1.19 trillion) in new loans in the first eight months, far higher than the 4.91 trillion yuan ($719 billion) it extended during the same period last year, sparking wide concerns of rising default risks at banks and asset bubbles in the capital market.

Liu said the ongoing global financial crisis has triggered a worldwide reflection on overhauling the financial supervision system, which includes revising and improving rules on capital adequacy, provision, leverage ratio, liquidity, as well as corporate governance and compensation system.

Chinese banking industry should strengthen their compliance management and get prepared to follow up the upcoming changes among the global financial institutions, the statement said citing the chairman’s remarks at an annual banking conference on compliance management in Shanghai.

In face of the explosive lending growth this year, CBRC has been urging banks to stick to the regulatory requirement for capital adequacy and be vigilant on signs of rising bad loans.

Earlier this month the regulator announced plans to implement stricter capital requirements for lenders, forcing them to deduct holdings of subordinated bonds issued by other banks from their supplementary capital over the next few years.

Many Chinese banks have promised to slow down lending in the second half. With new loans reaching 410.4 billion yuan in August, the flood of lending has been eased so far, echoing Liu Mingkang’s recent remarks that bank lending would be more stable in the second half.

However, the nation’s top policymakers have pledged to maintain stimulus spending and a “moderately loose” monetary policy as the economy is at a critical phase of recovery. With the effective help of the massive bank lending in the first half, the nation’s economic growth has rebounded to 7.9 percent in the second quarter after dipping to 6.1 percent in the first three months of the year.

Just another anecdotal evidence that tension is building up worldwide on capital and stock markets. In China, where a slew of IPO’s took the Shanghai index to new highs, Chinese firms are still rushing to put out new IPO’s in the hope of raising enough capital to pay off their loans as they apparently expect a further contraction of the market… Especially due to the monetary contraction that is widely expected to take place in Q4 in China.

Dozens of Chinese companies are rushing to raise billions of dollars amid fears the recovery on global markets will fizzle and foreign lenders will start demanding their money back, analysts say.

China Metallurgical and Sinopharm Group lead a list of 15 firms hoping to raise nearly $18 billion in Hong Kong and Shanghai by Oct 31, and more than 80 initial public offerings (IPOs) are in the pipeline for next year, according to analysts and media reports.

“The pick up in the economy, pick up in stock markets and plenty of liquidity – all that makes for a good concoction,” said Andy Mantel, founder and chief executive of Pacific Sun Investment Management in Hong Kong.

Companies were forced to shelve their listing plans after the collapse of US investment bank Lehman Brothers in September last year sent global financial markets into freefall and prompted China’s securities regulator to suspend IPOs in Shanghai and Shenzhen for nine months.

In the first eight months of 2009, 10 firms raised $3.3 billion in IPOs in Hong Kong – about half the number and value for the same period last year, according to the Royal Bank of Scotland, citing data provider Dealogic.

Dealogic said 23 companies have made their debuts on the Shanghai and Shenzhen stock exchanges since the IPO suspension was lifted in June.

“It was virtually dead from the beginning of last year until the first half of this year,” said Kathleen Wong, an attorney specializing in finance and restructuring at the Shanghai offices of law firm Allen and Overy.

Wong said the strong rebound on stock markets this year – Hong Kong has surged 45 percent and Shanghai has piled on 60 percent – as well as fears the government could reinstate IPO restrictions has spurred companies into action.

“Everyone is rushing to be the first. You don’t want to be the last because you don’t know when this window will shut and you don’t know whether the appetite will last,” Wong said.

Some companies are racing to meet deadlines by which they must launch their IPOs to avoid defaulting on pre-IPO financing from foreign institutions, Wong added.

Foreign lenders often require companies to list within two years, or repay the money.

“As a consequence of not doing an IPO by the cut-off date… they could face debt repayments and they don’t necessarily have the money,” Wong said.

There are concerns that the flood of IPOs, combined with fears the government will eventually curb bank lending, could put pressure on share prices. Shanghai fell 22 percent in August on fears of tighter credit.

“I’m wary when you see so many companies trying to list at the same time,” Mantel said.

“We are cautious because of the… amount of money expected to be absorbed by this new stock.

“The biggest risk facing the market is liquidity and monetary policy – in the first half there was a lot of loans going into the share market but for the rest of this year, lending will be curtailed.”

As competition intensifies, companies that dominate their sectors are likely to draw the most support, particularly from foreign investors seeking exposure to the recovering Chinese economy, according to Kenneth Tseung, head of equity capital markets at the Royal Bank of Scotland in Hong Kong.

“If I were a fund manager, I would like to put money in this part of the world. That’s where the growth is,” Tseung said.

As we reported previously, about 20 % of the 7.4 trillion Yuan in stimulus lending during H1 2009 is considered to have gone to inflate the property and stock market bubble.

This was common knowledge, but apparently, despite the repeated assurances of the Chinese government that the money supply would be kept flowing as long as necessary to ensure a recovery of the economy, there are increasing signs that they are trying to deflate the stock bubble.

For starters, the suspicions of the auditors were awoken when they noticed that 23 % of the loans were given under the form of “discounted bills financing”, which is a loan given on receivable notes at a discount to their face value. This immediately available cash is thus theoretically not traceable anymore.

This news might explain some of the brutal pullbacks on the Shanghai these latter times, as the source quoted by Caijing says that “Some capital from unidentified sources fled the stock market as soon as word of the investigation spread”.

However, the companies that played in the stock market with their loans may have some worries ahead: the auditors announced that they wished to trace the larger accounts to find out who abused of these loans.

China’s National Audit Office is investigating recent lending by major commercial banks, in an effort to trace the flow of loans issued in support of the government’s economic stimulus funds, a senior executive at a major bank told Caijing.

The investigation focuses on loans that might have been diverted to stock markets.

In November, China unveiled a 4-trillion-yuan stimulus package to revive an economy badly shaken by the global downturn. The stimulus plan was facilitated by a moderately loose monetary policy, which resulted in the 7.4 trillion yuan record lending in the first half of 2009.

Concerns from regulators were aroused after about 23 percent of total first-half new lending was extended in discounted bills financing.

The authorities now suspect that much of the money was improperly diverted from the real economy to speculative investments in real estate and stocks.

Discounted bills financing is a short-term lending practice allowing companies to raise cash by surrendering receivables at a discount. But once the bills are cashed, banks can no longer monitor the capital flow, providing opportunities for the cash to be invested elsewhere.

“Some capital from unidentified sources fled the stock market as soon as word of the investigation spread,” a senior banker told Caijing.

Unlike loans issued for specific projects, capital from discounted bills is harder to trace. However, people familiar with the NAO investigation said the agency intended to trace large accounts with securities firms and track the funds back to their sources.

“The National Audit Office has the right to extend investigations to enterprises. They can possibly dig things out if they’re determined and make the effort,” said a banker from a large bank, adding that concern over the probe was one reason why capital has quickly fled the stock market.

1 yuan = 14 U.S. cents

The FDIC again publishes terrible news for the banking industry. The institutions insured by the FDIC lost about 3.7 Bn for Q2 alone. This comes as Meredith Whitney, the analyst reputed for predicting failure for Citigroup and success for GS, predicted that about 300 banks to fail by the end of 2009.

FOR IMMEDIATE RELEASE
August 27, 2009

Commercial banks and savings institutions insured by the Federal Deposit Insurance Corporation (FDIC) reported an aggregate net loss of $3.7 billion in the second quarter of 2009, a decline of $8.5 billion from the $4.8 billion in profits the industry reported in the second quarter of 2008. Insured institutions earned $424 million in net operating income during this latest quarter even after a special assessment of $5.5 billion to bolster the FDIC’s insurance fund. However, one-time losses and other items totaling $4.1 billion pulled the industry results into negative territory.

“While challenges remain, evidence is building that the U.S. economy is starting to grow again,” said FDIC Chairman Sheila Bair. “Banking industry performance is — as always — a lagging indicator. The banking industry, too, can look forward to better times ahead. But, for now, the difficult and necessary process of recognizing loan losses and cleaning up balance sheets continues to be reflected in the industry’s bottom line.”

Chairman Bair went on to say, “The FDIC was created specifically for times such as these. No matter how challenging the environment, the FDIC has ample resources to continue protecting depositors as we have for the last 75 years. No insured depositor has ever lost a penny of insured deposits…and no one ever will.”

Provisions for loan losses totaled $66.9 billion in the quarter, an increase of $16.5 billion (32.8 percent) over the second quarter of 2008. Extraordinary losses stemming from writedowns of asset-backed commercial paper totaled $3.6 billion, compared to extraordinary losses of $366 million a year earlier. Noninterest expenses were $1.7 billion (1.7 percent) higher, primarily due to increased FDIC deposit insurance premiums.

Indicators of asset quality continued to worsen during the second quarter. Both the quarterly net charge-off rate and the percentage of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) reached the highest levels registered in the 26 years that insured institutions have reported these data. Insured institutions charged off $48.9 billion in uncollectible loans during the quarter, up from $26.4 billion a year earlier, and noncurrent loans and leases increased by $40.4 billion during the second quarter. At the end of June, noncurrent loans and leases totaled $332 billion, or 4.35 percent of the industry’s total loans and leases.

“Deteriorating loan quality is having the greatest impact on industry earnings as insured institutions continue to set aside reserves to cover loan losses,” Chairman Bair noted. “Of all the major earnings components, the amount that insured institutions added to their reserves for loan losses was, by far, the largest drag on industry earnings compared to a year ago.”

All told, more than 28 percent of all insured institutions reported a net loss in the second quarter, compared with 18 percent a year earlier.

Financial results for the second quarter and first half of 2009 are contained in the FDIC’s latest Quarterly Banking Profile, which was released today. Also among the major findings:

Net interest margins improved in the quarter. The average margin (the difference between the average yield on interest-earning assets and the average interest expense of funding those assets) rose to 3.48 percent from 3.39 percent in the first quarter and 3.37 percent in the second quarter of 2008. More than half of all institutions reported higher margins than in the first quarter. Net interest income totaled $100 billion in the quarter, up from $96.6 billion a year earlier.

Net interest margins improved from the previous quarter at community banks and at larger institutions. “This is good news for community banks, since three-fourths of their revenues come from net interest income,” Chairman Bair said.

Total assets of insured institutions declined by $238 billion. A $125.5 billion decline in loan and lease balances accounted for more than half of the decline in total assets of insured institutions during the second quarter. The 1.8 percent decline in industry assets followed a $303.2 billion decline in the first quarter of 2009. Banks’ balances with Federal Reserve banks fell by $99.4 billion (20.4 percent) during the quarter, and assets in trading accounts declined by $65.5 billion (7.9 percent). The industry’s investment securities portfolio increased by $130.6 billion (5.9 percent).

The number of institutions on the FDIC’s “Problem List” rose. At the end of June, there were 416 insured institutions on the “Problem List,” up from 305 on March 31. This is the largest number of institutions on the list since June 30, 1994, when there were 434 institutions on the list. Total assets of “problem” institutions increased during the quarter from $220.0 billion to $299.8 billion, the highest level since December 31, 1993.

Total reserves of the Deposit Insurance Fund (DIF) stood at $42 billion. Just as insured institutions reserve for loan losses, the FDIC has to provide for a contingent loss reserve for future failures. To the extent that the FDIC has already reserved for an anticipated closing, the failure of an institution does not reduce the DIF balance. The contingent loss reserve, which totaled $28.5 billion on March 31, rose to $32.0 billion as of June 30, reflecting higher actual and anticipated losses from failed institutions. Additions to the contingent loss reserve during the second quarter caused the fund balance to decline from $13.0 billion to $10.4 billion. Combined, the total reserves of the DIF equaled $42.4 billion at the end of the quarter.

Chairman Bair distinguished the DIF’s reserves from the FDIC’s cash resources, which included $22 billion of cash and U.S. Treasury securities held as of June 30, as well as the ability to borrow up to $500 billion from the Treasury. “A decline in the fund balance does not diminish our ability to protect insured depositors,” Chairman Bair concluded.