Debt guarantee chains in China, where companies guarantee loans to other unrelated companies, are not as strong as they are meant to be.  Everything appears rosy in good times, when such arrangements are made.  The real risk is the same economic headwinds driving the original debtor into default, often also negatively affects the debt guarantor's ability to pay.  This is especially true for small or mid-sized companies in a concentrated geographic area.  Given most banking relationships are local, this risk is always present.

This risk is magnified in China because such guarantee chains have played large role in driving it's rapid massive debt expansion since the 2008 financial crisis.   About 25% of US$13trn in total outstanding loans as of end of October 2014 was backed by promises from other companies and individuals to pay up if borrower defaults. 

Lenders outside traditional banking system, aka shadow bankers, have also relied heavily on guarantees to assure investors their funds were secure and to circumvent government restrictions on lending to certain types of businesses.

As typically happens when things start to slow down or go bad, what was once considered isolated, separate, and secure, turns out to really be closely linked and threatens broader/deeper risk.

Guarantees were traditionally used by state firms to back loans to undercapitalized units, Recently, they have been directed to unrelated companies.  US$20.6bn of guarantees have been extended by companies listed in Shenzhen and Shanghai to firms other than their own units over the last 2 years (+76% increase),  according to data provider Wind Information.

Guarantees play a key role in many countries where governments leverage their own balance sheets to encourage lending to small firms or to support home ownership. In US, Fannie Mae andFreddie Mac guarantee trillions of dollars’ worth of mortgages. Credit default swaps are used by private-sector lenders to insure themselves against risk of borrower defaulting.

China is, as always, different.  In China, individual companies are the guarantor.

Such guarantees gave banks false sense of security and they did not scrutinize borrowers’ ability to pay, some analysts and banking executives say.

Customers of companies forced into liquidation can also have their business negatively impacted as the debtor's assets, including machines and inventory are locked up awaiting liquidation.  Production scheduled, becomes unscheduled.

Source: http://online.wsj.com/articles/loan-guarantee-chains-in-china-prove-flimsy-1416775097

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

Background

• Suntech Power Holdings was forced to put its Chinese solar unit into bankruptcy in March 2013
• The slide into insolvency began in 2009 when customers linked to the company's founder were not paying their bills and yet the company booked the sales as revenue anyway
• Suntech suffered a €60m (US$720m) fraud resulting in a US$541m bond default

Missed Red Flags

• Suntech was booking revenue from sales to related companies with unbuilt projects in a fledgling industry - solar.
• Suntech guaranteed loans to those related companies. 
• Suntech relied on a former sales agent to secure one guarantee with bonds it never saw or verified actually existed.
  
• Suntech had uncollected bills from related-company projects exceeding sales from those companies by a widening margin. Receivables were US$44.7m in Q1 2011, against US$33.6m in revenue booked from the companies. Sales dried up in later quarters and uncollected bills remained.
  
• Suntech’s vehicle for investing in new solar projects in the credit crisis was Luxembourg-registered Global Solar Fund, run by Javier Romero, who was once Suntech’s external sales agent in Spain. Romero persuaded Shi to commit 258 million euros to Global Solar Fund beginning in 2008, eventually giving Suntech an 86% equity stake.  Shi himself committed €32m for almost 11% of the fund. Suntech wound up with 79% of the fund after giving part of its stake to Romero as an incentive payment.  Global Solar Fund invested in 7 solar projects, mostly in southern Italy. They became the Suntech customers that had difficulty paying their bills. One of them, Solar Puglia II S.ar.L, required the guarantee of a €554.2m bank loan from China Development Bank.  Suntech told the SEC that Global Solar Fund backstopped the guarantee with €560m of German government bonds.  Romero assured Suntech that the bonds could be sold at any time to pay China Development Bank if the project defaulted on its debt, Suntech wrote to the regulator. Trouble was: The German bonds Romero promised as a backstop never existed, Suntech said in December after looking for them for four months.
  
  

How did people miss this?  They did not check the SEC files and correspondences available online.  

The SEC’s first letter to Suntech was in November 2005, and its latest was April 2011. All of its letters were available to the public by mid-June 2011. There were about 38 equity analysts covering Suntech as of July 1, 2011, of whom 31 recommended either holding or buying the stock, data compiled by Bloomberg show.

Source:
"Suntech Unit Bankruptcy Had Roots in Deadbeat Customers", Bloomberg, April 4, 2013
http://www.bloomberg.com/news/2013-04-02/suntech-unit-bankruptcy-had-roots-in-deadbeat-customers.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

S&P estimates China will need more than $8 trillion for refinancing during the five years ending 2017, accounting for half of such needs in the Asia-Pacific region.  

Bloomberg data shows borrowers from Hong Kong and China have sold 7x more bonds to repay existing debt this year than in the first five months of 2012. 

Bright Food Group Co., which has operations from dairy to wine, issued US$500 million of securities maturing May 2018, according to data compiled by Bloomberg. The company will use the funds to repay financing for its acquisition of British cereal maker Weetabix Ltd., Moody’s Investors Service said in a report on May 7.

This is how the beginning of the end begins.  Companies and governments issue new debt to pay off old debt as the cash flows of the underlying asset/investment do not generate sufficient returns to pay off the original debt.  And they never will.  Kicking the can down the road works for a time, that is until the road ends either because runaway inflation prevents governments from continuing to print money or investors balk at rolling over the debt again forcing a bankruptcy restructuring.

Source:
"China Corporate Debt to Overtake U.S. Within Two Years, S&P Says", Bloomberg, May 15m 2013
http://www.bloomberg.com/news/2013-05-15/china-corporate-debt-to-overtake-u-s-within-two-years-s-p-says.html

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.

A recent settlement between the U.S. SEC and a husband-and-wife team that ran a Chinese maker of pollution control equipment provides another shining example of how due diligence was not "do" diligence.

In this case, CEO Zou Dejun and his wife, the chairwoman, Qiu Jianping, ran Rino International, at one time worth about US$500 million on Nasdaq.  It collapsed after short seller Muddy Waters accused it of claiming revenue from nonexistent contracts. More than three years ago, the company raised $100 million from American investors in a stock offering.

The S.E.C. complaint said the company kept two sets of books. The Chinese books, which the S.E.C. said were correct, showed total revenue of $31 million from the first quarter of 2008 through the third quarter of 2010. The United States books, which were used in financial statements, showed revenue of $491 million, or about 15 times as much.

Shocking!  A Chinese company with more than one set of books?  This surely has never happened before in China or anywhere else.  Nod, nod, wink, wink.

The S.E.C. said that days after the 2009 public offering, the couple, who together controlled 65 percent of the company’s stock, used $3.5 million of the money raised to buy a home for their use in Orange County, Calif., then gave conflicting accounts to auditors regarding how the money was used. They eventually signed notes indicating that they had borrowed the money from the company.  So they got caught with their hand in the company cookie jar, and the auditors did not think maybe something else is going on and just took everything else at face value?  Well done to the due diligence team.

The fraud fell apart in November 2010 after the Muddy Waters research Web site, which seeks out stocks to sell short and has exposed a number of Chinese frauds, released a report saying some of the company’s reported revenue came from fraudulent contracts with purchasers.   A few days later the company’s auditors, Frazer Frost, reported that Mr. Zou had admitted that some of the contracts did not exist. The auditors withdrew their previous certifications of the financial results.

Again, well done to the Frazer Frost auditors for the level of rigorousness on this one.  They were clearly more concerned with getting paid than fulfilling their responsibility for investors.

On Nov. 30, the company sent a letter to the S.E.C. saying it intended “to file restated audited financial statements” for 2008 and 2009 “as soon as practicable.” It has made no such filings since, and the company’s Web site is no longer available.

Source:
"Couple Settle Fraud Case Involving Chinese Company", New York Times, May 15, 2013
http://dealbook.nytimes.com/2013/05/15/chinese-couple-settle-s-e-c-fraud-case/

CKB Solutions is all about real solutions for the real world.  To learn how we can help your business, contact Greg Kovacic in Hong Kong.