China is getting closer to its Lehman moment

By Anjani Trivedi and Shuli Ren

WALL STREET’s movers and shakers are largely seen as part of the solution to the coronavirus-ravaged US economy. Chastened by the collapse of Lehman Brothers and the great recession over a decade ago, they were forced to scale back businesses considered risky and clean up their balance sheets. In this crisis, they’re no longer the problem.

The same can’t be said of China. Beijing has made martyrs of its banks and insurers, asking them to lend to the needy, forgo profits and support the animal spirits of its trillion-dollar capital markets. But, along with brokers, they’re still a troubled bunch, far from being sturdy pillars of the financial system. If anything, COVID-19 has exacerbated credit risks. China’s Lehman moment, when isolated events cross the line into systemic effects, is just lurking around the corner.

Last Friday, regulators took control of nine troubled firms, controlled by fallen billionaire Xiao Jianhua’s empire under Tomorrow Holding Co., totaling more than 1.2 trillion yuan ($171.5 billion) in total assets. It’s one of the largest seizures in China’s recent history. Xiao was taken from Hong Kong’s Four Seasons hotel by Chinese authorities three years ago and has disappeared from the public eye since.

That is unsurprising: Insurers have been problematic since at least 2017. A review then found that their corporate governance scores were deteriorating. Companies like Huaxia Life Insurance Co., one of the seized firms, were selling policies that flouted rules and improperly disclosed policyholders’ information. The insurance regulator said it was “determined to weed out illegal and improper practices.” It also found that companies were falsifying funding sources and leveraging the same assets for multiple loans.

The takeovers come a year after the seizure of Baoshang Bank Co., when we wrote that counterparty and solvency risks had arrived — together. Regulators tried to say then that it was a one-time solution. Yet, the most recent events point to these issues becoming acute, and spreading. At some point, the chain of lending and liquidity will be disrupted.

Beijing has once again shied away from letting the market price such likelihoods. “The dilemma is fundamental,” as analysts at Rhodium Group wrote after the Baoshang incident. Authorities can allow the market to digest failures, or try to maintain “stable” production of ever-riskier forms of credit. They can’t have both. By effectively assuming counterparty risk, regulators are hurting market credibility at a time of rising jitters as financing channels are squeezed.

To be fair, they didn’t have much choice. Heavily leveraged, a single-digit percentage drop in asset value induced by COVID-19 could wipe out these firms’ equity book value. Take Huaxia Life. Over the last decade, via aggressive selling of high-yield savings products, it has become the fourth-largest insurer in China, with close to 600 billion yuan in total assets at the end of 2019. Its assets-to-equity ratio stood at a whopping 26 times.

It’s not hard to imagine large asset write downs behind closed doors. As the impacts of COVID-19 distressed businesses in the second quarter, the worst bond rout in a decade caused investors to nurse losses on even relatively safe wealth management products, not to mention riskier non-credit investments. In the first three months of the year, data provided by CLSA Ltd. show that Huaxia Life’s book value shrank by 23% quarter on quarter, due to mark-to-market losses of its investments. It’s no wonder that the insurer is on regulators’ radar, or that they’re trying to send a message.

Still, China’s financial woes extend beyond a fugitive businessman’s overly extended balance sheet. Since 1995, only 12 firms have been seized by the central bank or other agencies — half of them over the last year, excluding the ones last week. Some large trust companies have fallen afoul of authorities, unable to pay back investors’ principal and interest in recent months.

Under the latest takeovers, regulators will send teams to take the roles of shareholders, directors and management. Other financial firms, including some of China’s largest insurers and securities houses, will end up as trustees. In theory, they’ll push to shrink the troubled businesses and monetize assets.

Call it what you want, but this is China’s version of financial contagion. Just plugging holes will no longer cut it. How many firms can regulators try to salvage? How much capital will be injected? Can they find willing shareholders and white knights?

The answers to such questions won’t come without pain. According to CLSA, 11 insurers with about 15% of the market and 2.4 trillion yuan in total assets would be “walking a tightrope” with regulators. On average, if their asset value was 2% to 5% less than what they showed in 2019, their surplus capital — the capital over the minimum regulatory red line — would have been wiped out. If Beijing ever needs to rescue them all, the costs would be enormous. If not, the insurers would have no choice but to dump assets, which could threaten the broader market.

So far, Beijing hasn’t successfully unwound troublesome financial empires. In the two years since the overextended buyer of New York’s Waldorf Astoria, Anbang Insurance Group Co., was seized, attempts to dispose of its assets and find strategic investors have turned into a prolonged and painful process.

It may be time for Beijing to face its fears and let some companies fall off the cliff. In doing so, it may finally be able to save the ones that really matter.

BLOOMBERG OPINION