Who Should Pay for Trusts that Go Bust?
While preventing a systemic crisis in coping with failing trust products should be a priority, indiscriminate bailouts would merely delay the inevitable and leave a bigger blowup in a year. In resolving the current problems, the central government must deal with two evil forces that are poisoning China's financial system: moral hazard and adverse selection.
The banks that distributed the problematic trust products must be held responsible. Their sales commissions are too high to suggest that they are just neutral brokering agents. Indeed, investors bought such products mostly due to the reputation of the distributing banks. Trust companies, while less guilty than the banks, are complicit too because they often know how unreliable the borrowers are. The banks and the trust companies should be liable up to 5 to 10 times their commissions and not more than the principal.
Investors should know that high interest rates mean high risk. They blindly believe in the opinions of sales agents and their verbal guarantees. They should be liable for the remaining losses.
Such an arrangement would minimize the wholesale exit of investors from viable products. As commissions are often low in high-quality products, the exit may prompt more losses than waiting it out. A fair compensation scheme for bad trust products should prevent a systemic crisis.
The Bailout Expectation
High interest rates come with high risk. This common sense is the foundation of the credit market. However, bad money driving out good is a natural force in finance. Unless sound, prudent regulations and healthy financial intermediaries dominate the market, a race to the bottom is inevitable. China's financial system is very young. While the prudent regulations are all there, the enforcement capability is underdeveloped. This is why bad money driving out good has become such a big factor, especially in the shadow banking system, like the trust product industry.
While there are numerous trust companies, this industry could not have taken off without big banks entering the picture. In a few short years, the trust industry has risen from nothing to 10 trillion yuan in assets. The distribution power of big banks made this possible.
The banks became involved to increase income from fees. As their lending capacity became constrained by capital and sometimes government directive, they embraced trust products as the main off-balance-sheet vehicle to increase lending to their high-risk clients. These clients are usually willing to pay high fees. The banks could charge 4 to 8 percent commission on such products. When the products mature in, say, three years, they need to be rolled over. The banks could get 4 to 8 percent again.
Some trust companies are big and have distribution power. Most, I believe, are vehicles at the service of big banks. They charge a commission, too, though it is much smaller than the banks.
The adverse selection problem begins with who is willing to pay such high fees and high interest rates at the same time. Let's say the interest rate is 10 percent. The product is for three years. The commissions for banks and trust companies total 10 percent. The borrower gets 90 percent of the loan amount for a 30 percent interest payment over three years. Few businesses in China earn such a high return. The trust loan borrowers, mainly mining companies and property developers, often have greenfield projects. Their future depends greatly on the macro environment. The borrowers essentially gamble with other people's money.
When one is willing to gamble on a project with a high-cost trust loan, it is usually not a great project. Otherwise, it would have gotten cheap funding. Marginal projects are more likely to go to the trust market. The trust industry essentially attracts people who are likely to go bankrupt.
Why would the banks develop this market? Short-term profit is the motivation. The incentive structure within China's financial system has a significant bonus component. It is linked to one's short-term performance. The same force led to the United States' financial crisis in 2008. What I have heard over the past few years is that there was widespread consensus that the trust industry would eventually become a big mess. However, it kept going because it was in everyone's interest.
The people who should be most concerned are investors who, in theory, are on the hook. This is where China's unique financial system comes to play. Almost all significant financial institutions are government-owned, even the trust companies. They carry the aura of government support. People's faith in the financial system is a major stabilizing force. But, when manipulated by certain players, it could lead to a huge mess, like the trust market.
There is little doubt that the sales people at most state-owned banks misrepresent the facts to potential clients. These people essentially use government credibility to drum up sales to maximize their bonuses. Not all investors are fooled. But they still go in, believing that (1) the banks could not afford not paying because of the social consequences, and (2) that the government would not let the banks fail because of the macroeconomic consequences. The investor market essentially functions on moral hazard.
The trust market has prospered on adverse selection in the borrowers market and moral hazard in the investor market. It is a recipe for rapid growth and a huge disaster down the road. It appears that the tipping point is here, as the mining industry and property market falter.
Moral hazard works because the government is often checkmated into bailing out financial institutions or products for fear of a broad collapse. Hence, the bigger the problem, the better the risk-takers fare. China's trust industry, with assets at 18 percent of GDP, could be considered too big to fail. Because most trust products are short term, if investor confidence collapses, the whole industry could unravel. The underlying real economic activities would all cease. And, the investors who suffer the losses may shrink their activities too. The economy could suffer greatly in the short term.
A systemic crisis could be prevented without bailing out everyone. In 2008, the U.S. government could have just taken over all the banks and let shareholders and bondholders lose everything. The financial system could still function and, after recapitalizing, the government could have floated the banks to raise the maximum amount of money to minimize taxpayer losses. It chose a different path: protecting bondholders entirely and shareholders partially.
China has the same option. If the project behind a trust product is important, the government could take it over and keep it going through a different funding channel. Hence, the financial mess would not spill over into the real economy.
If one trust product fails, could investors bail out on all trust products? If the failure is not handled well, the domino theory may pan out. Citing such a possibility to bail out everyone would be a worse result. On the surface, the problem is solved. Of course moral hazard behavior is rewarded. More people would join in. The industry would not have a liquidity problem for the time being. It would create a bigger mess later. Such high-cost financing on a large scale must be a Ponzi scheme. Few businesses in China earn returns of over 10 percent. The cost of trust financing is higher than that. When the real economy cannot support the required returns, the only solution is to borrow anew and retire the old, i.e., as in a Ponzi scheme. No Ponzi scheme can continue forever. The economy would not have enough money to support it at some point. The bailout strategy would bankrupt China's financial system.
A Fair, Effective Solution
Hong Kong had a Lehman Brothers mini bond disaster. Some banks sliced Lehman's corporate bonds into small denominations for sale to retail investors in the city. When Lehman went bust, these small investors claimed that they were misled and held the banks responsible. The disputes involved in this case are similar to that in China's trust failures.
First, the banks are guilty. They sold these products for high fees and must have known that the issuers were troubled. When Lehman's mini bonds were sold to retail investors, it was already a troubled company, even though its rating had not been downgraded yet. China's trust products are marked as high-risk assets, but are often sold with a different tone. How guilty the banks are can be reflected in the sales commission. The unusually high commission should reflect how desperate the borrower must be. The banks should be penalized proportionate to their commission. For example, a penalty of 5 to 10 times the commission income could be considered. If the commission is 4 percent, the banks could be liable for 20 to 40 percent of the principal.
Second, the trust companies should be treated like banks and be closed for having multiple bad products. China's trust companies are really sellers of junk bonds. They should fall into the same category as stock and bond brokers. Calling them trust companies is just misleading.
Third, investors must pay a price to stop the moral hazard problem from escalating. Interest income, both from the past and future, should be forfeited, i.e., investors should receive their principal minus the past interest income, at a maximum. When banks and trust companies cannot cover this amount, investors should suffer absolute losses.
Solutions along the above lines should not lead to a systemic crisis. A bad product usually involves high commissions for the issuing trust company and the selling bank. Its investors should be able to get most of their money back. When investors run away from a good product, if it fails, the compensation would be small. Hence, there is incentive to stay in such products.
There is nothing that a government could do to stop adverse selection directly. It can only motivate financial institutions to stop it. If the banks and trust companies are not penalized in this debacle, the future of China's financial industry is dim. When bad behavior is rewarded, no one wants to do good work anymore.
Investors must be penalized too. Otherwise, China's credit bubble would expand event faster. The shadow banking system functions on the expectation that the central government will ultimately bail out all significant players. If this expectation is met in the trust debacle, the shadow banking system will expand faster. Of course, the resulting high interest rate squeezes out real businesses. Could the financial system and the economy function on a giant asset bubble funded by the shadow banking system?
The Local Gov't Debt Challenge
The current troubles in the trust industry are driven by private mining companies. They are not so big. The property industry is a bigger factor. Local governments sometimes borrow directly from the trust market and, indirectly, depend on high land prices, supported by property developers, to borrow from banks with land as collateral. When the land price falls below some level, tons of trust products will suddenly become insolvent.
China's property bubble is unprecedented in modern economic history. Its land is all controlled by local governments. They use it as a currency to finance their activities. They are totally incentivized to suck as much money as possible into the land market. When developers borrow and buy land in a city, its money supply rises sharply. The echo effect is to boost the land price, which attracts more into it. The high money stock filters down into the local economy, creating purchasing power for expensive properties. It seems like a beautiful story for a while. Its fatal flaw is that its monetary growth begins with debt for land purchases, not competitive businesses that sell products or services. It is really a Ponzi scheme.
Crunch time is already here for many, if not, most cities. As all the land
gets developed, the supply is huge. When a city does not have competitive
industries to earn money and pump it back into the economy, the income base for
borrowing money maxes out at some point. When banks lower lending standards, it
keeps going a bit longer. At some point, banks cannot just give away money.
That's when the music stops.
The handling of the problems in the trust industry is a good exercise for a bigger challenge to come. If the decision is to bail out everyone for now, when the big one happens, the central government will have to pick up the whole tab. That would not be what Chinese leaders want.
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