Why a parallel with Lehman Brothers is not quite correct


The world’s most indebted real estate developer, China’s Evergrande, is in the throes of a massive $ 305 billion problem. Markets and analysts fear this could be a Lehman Brothers moment for China. But the parallel, if any, is superficial.

In 2008, the world was rocked by a gigantic financial crisis whose epicenter was the American real estate market, more precisely the bank called Lehman Brothers which had recklessly taken out massive sums of the bonds of the mortgage companies promoted by the American government, Fannie Mae and Freddie Mac. These bonds were presented as mortgage-backed securities, that is, bonds issued on the basis of receivables in the form of EMIs of real estate loans.

Home loans “perceived” as the safest

Home loans are viewed as the safest from a lender’s perspective.

Mortgage companies, of course, are sufficiently protected against payment defaults. But coincidentally, the US real estate market was on a downward trajectory.

Under US law, the hands of mortgage lenders were tied — no recourse to personal property; indeed, the inability of borrowers to pay EMIs could at worst only trigger the sale of mortgage property.

Borrowers scoffed at the liberal law in their favor, the law that was consequently opposed to lenders. The resulting mortgage lender losses weighed heavily on Lehman Brothers, with the US government refusing to bail it out.

What followed was the dreaded and nightmarish contagion effect that first rocked U.S. financial markets and quickly enveloped the world, thanks to the greenback’s international currency status.

The Evergrande case is not in default by mortgage takers

China, and indeed no other country, is giving itself over to mortgage borrowers. In addition, unlike the American crisis, the highlight of the Evergrande affair is not the default of mortgage takers but that of real estate developer Evergrande. And the putative default is on interest only, with the first tranche of bonds slated for 2024. That said, the markets cannot ignore the looming problems, as real estate accounts for around 25% of GDP and 80%. of Chinese household wealth. . It is also an important source of revenue for the government.

Debt-fueled real estate growth is one reason China’s credit-to-GDP ratio is above 300%. That’s why Evergrande’s shares fell (80% drop since July 21 on the Hong Kong Stock Exchange.)

Why Evergrande is not Lehman

At the same time, the differences are too marked to be ignored. Lehman dealt in cash, while Evergrande’s main asset is the land bank. The Chinese government, while opposed to a bailout, has rightly urged Evergrande to liquidate its unsold properties so that it can avoid defaulting on interest ($ 85 million) on its fall in US bonds, to next deadline. He has already paid interest on domestic loans but, as we know, bond issuers take liberties with distant offshore lenders by demanding time and getting it.

What should worry the Chinese government is the uninspiring name of junk bonds that Evergrande’s debt instrument has inevitably attracted. Evergrande’s dollar bond due 2025 is listed at 25.2 cents to the dollar after falling 10.9 cents last week – its biggest drop since late July, as Bloomberg– Compiled prices show. He is not alone.

Several bonds of Chinese real estate companies have been given junk status. Junk bonds are the delight of hedge funds. They revel in taking risk to increase returns for its investors.

The inverse relationship between the price of bonds and their return is something every star-eyed finance student will learn. Let’s say a Rs 100 bond is issued with an interest of 8% per annum. If it were listed at Rs 80, the annualized return on investment (ROI) would be 10%; whereas if it were listed at Rs 120, the annualized return on investment would drop to 6.67 percent. So, junk bonds are something risk-takers enjoy – buy low, win high. But it’s usually a double-edged sword — if you unintentionally buy high, the returns could be low.

Sovereign ratings matter

Sovereign ratings are important to a country and its pride. While no domestic company can score higher than the country’s rating, it is equally true that if there is a skyrocketing growth of low-quality companies from a given country, it will soon lead to a drop in price. the sovereign or national rating.

The Chinese government must view such a prospect, however distant, with disgust. Intuitively, therefore, he would do everything in his power to avoid such a shameful outcome, especially at a time when he lives under the charge of being the coronavirus super spreader.

China would certainly not like to join the ranks of its friend Pakistan, which is in the niche of international financiers. While the crisis may just be a storm in China’s teacup, the government needs to be keenly aware of what this issue portends.

China could follow India’s lead

In 1990, the Indian government airlifted huge amounts of gold for display in front of international financiers in order to redeem its credibility and ability to repay loans. The Chinese government can also be expected to show its determination to bring its real estate sector under control.

(The author is a senior columnist and tweets @smurlidharan)

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Posted: Saturday, September 25, 2021, 2:25 p.m. IST

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