Contagion, and I Don’t Mean Covid 🏢

Some are referring to this problem as the Chinese Lehman Brothers equivalent. Some people are not losing any sleep over it. This issue comes with opinions ranging from full-blown doomsdayers to complete optimists.

Let me explain.

Who is Evergrande?

They are a massive Chinese conglomerate whose portfolio ranges from an abandoned theme park called Fairy Land which was projected to surpass Disney Land in Chinese popularity by 2022 to the biggest soccer stadium ever built. But most importantly, they are one of the world’s largest and most powerful real estate holders and developers. They also happen to be the world’s most indebted real estate holder and developer. The company owns over 1,300 real estate projects across 280 cities in China and has racked up over $300 billion in liabilities.

What’s the problem?

Evergrande has notoriously carried massive debt with the intention of borrowing more and using down payments on new projects to fund the debt of their existing ones. This worked in China for a couple of reasons. One is that China has the highest homeownership rate in the world (around 90%) so they have heavily relied on turning over their residential units quickly. The second is that real estate is a big deal in China… like a really big deal. Remember, China is the biggest exporter in the world and real estate still makes up over 28% of their GDP.

As you can imagine, Evergrande’s $300 billion of debt comes with some pretty hefty interest payments. Payments they may have otherwise been able to make if China didn’t crack down on real estate leverage in 2020.

In August of 2020, China put into place “The Three Red Lines”. These are essentially 3 different debt and liquidity measurements that real estate companies must meet to take out more debt. They did this as a precaution in case the real estate market fell, their enormous amount of real estate debt would not tank the countries entire economy. As you can imagine, the worlds most indebted real estate company failed all three. So, their lines of credit were essentially frozen overnight.

Without their lines of credit, Evergrande will have a very hard time paying back their shareholders. Which is exactly what they said days before defaulting on an $83 billion bond payment. The company is now in the middle of a 30-day grace period where they can either find a way to make the payment or default.

The Grande Default Could be a Forever Problem

Let’s start with the opinions of the optimists. They believe that while Evergrande is a massive powerhouse indirectly employing millions of people, the fallout from their default will be contained. Evergrande is a relatively small portion of China’s overall GDP and despite the government repeatedly stating that they will not be bailing the company out, they will probably be forced to.

The doomsdayers opinion is the fall of Evergrande is the first domino in a worldwide financial contagion. Financial contagion is like a virus in that it spreads to anyone it contacts. Like the butterfly effect, the fall of one company causes the fall of another and another who have become dependent on them ranging in size from the massive lenders funding their projects to the independent carpenters who are furnishing them. In addition, the company has collected down payments on 1.5 million unfinished homes which could not be paid back if they were to collapse. This would create a ripple effect through China that could be devastating and is being compared the collapse of Lehman Brothers in 2008. And this devastation would not be contained to China. Evergrande has raised billions of dollars in foreign capital that would send shock waves through the global financial system. The scary thing is, Evergrande is not the only one. Since their default announcement in late September, other smaller companies have come forward saying they are in a similar situation. Only time will tell how big this problem could be.

What does this have to do with mortgage?

This is where we get a little conspiracy-ish…

As we know, the Chinese bond market is huge and is made up of investors from all over the world ranging from private investment firms to massive funds. If the real estate market is compromised, that money may start looking for a safer place. The typical 3 safe havens for cash are Switzerland, Germany, and the US. However, the benchmarks of the first two are currently negative (meaning it cost money to invest it) leaving one safe haven – the US.

If the US had the influx of bond investment that some people think is coming, mortgage rates would plummet.

Now, this is all completely speculatory… but the different opinions of what could happen is wild.