I have spent my career in the financial markets, focusing on risk analysis and trading with a sharp point of view through the lens of credit. I think the credit markets are the most important, the most informed and unfortunately the most misunderstood of the different silos of risky assets.
Credit analysts are inherently pessimistic. They always ask, “How much can I lose? Unlike stock analysts, who seem to believe trees grow to the moon and growth can accelerate forever. Credit analysts prefer math, downside sensitivity analysis, prioritizing claims certainty, and can calculate bond price movements – on the fly – from changes in credit spreads.
I, too, prefer statistics to subjective analysis. Math is the basic layer of language, but many investors are illiterate in this regard. While this leads to huge capital structure arbitrage opportunities for credit-oriented hedge funds (my past life) that trade credit against stocks and equity derivatives of a given company, it is is often the retail shareholder who is used as cannon fodder.
That’s life. Play silly games, win silly prizes. If the ill-informed investor does not understand credit and bonds / price but invests in the equity (subordinated claims) of a leveraged firm, he or she exposes himself to a potential world of harm.
With this warning out of the way, I would like to focus on the current situation of Evergrande in China and what it means for global risk assets. I will examine the potential effects of contagion on China’s domestic credit markets, the contagion of risk assets globally, as well as some potential macroeconomic concerns. I also conclude that the implications of credit contagion for sovereign credits are increasing and that BTC is the perfect insurance against declining fiat credit quality.
Don’t overthink it. BTC is sovereign credit insurance (long volatility) with no counterparty risk.
Potential defect size
In the context of recent significant global defaults, Evergrande’s debt is not too much of a concern. Evergrande’s total liability is $ 300 billion, of which $ 200 billion is prepayments for housing for Chinese citizens. The balance of the exposure is made up of debt, both onshore and public banking, as well as offshore debt to international investors. Compare that to Lehman Brothers’ $ 600 billion default of on-balance sheet exposure, as well as multiples of off-balance sheet derivatives and credit default swaps (CDS). Goldman recently calculated Evergrande’s potential off-balance sheet liability at $ 155 billion (one trillion yuan) in “shadow bank” exposure. This is worrying because it looks more like a Lehman moment but again, it is not catastrophic in the global context.
The risk of contagion at Lehman was easy to understand, as the whole system was on the brink of collapse due to counterparties whose insurance contracts (CDS contracts) could not be claimed. Remember, the rumor was that if AIG was allowed to go bankrupt, Goldman would also fail since it had bought so much insurance from AIG in order to license its exhibits (both the client exhibits and the main exhibit) .
Another global default that had macroeconomic implications was the restructuring of Greece in 2012. This involved approximately $ 200 billion in debt, and although there were trade and other debts not Debt-related issues, overall restructuring was weak compared to Lehman, but still twice as large as Evergrande (before adjustment for economic growth).
Therefore, given the scale of a default, I think it should be largely limited to the Chinese High Yield Bond (HY) market and other related credit markets. The total world debt is $ 400 trillion. I know I’m old enough to remember when a $ 100 billion public debt default was significant (as with the ‘LDC debt crisis’ in 1988, for example) but with all the growth in debt. , the truth of the inevitable spiraling global debt, and the liquidity that global central banks are flooding the market, I think the risks of contagion are low. Not zero, but certainly nothing like a Lehman moment. Shadow banking concerns should be contained in China and banks exposed to Asian credit, so watch bank certificates of deposit for names like Standard Chartered and HSBC for indications it’s spreading.
Reaction on the Chinese HY and IG markets
Looking only at the Chinese HY market, one can feel the pain felt in the bond price action. It would be more precisely defined as the Chinese “troubled debt index”, because the market is largely made up of real estate developers and, among these developers, Evergrande represents around 15% of the weight of the index. The index returns over 14% (compared to the US HY index at around 4%).
However, there are a few significant considerations, including some bond math. First, the US HY market is much more diverse by industry, has much more diverse and experienced players, and has a genuine group of struggling debt buyers who live under the HY market. In the event that a credit becomes stressed or struggling, distressed US debt buyers rush to fill the shortage of buyers compared to traditional “going concern” HY buyers. The Chinese HY market is younger, much less diverse and much less experienced in terms of learning history.
The mathematical consideration of bonds is also important. When debt is trading at less than 50 cents on the dollar (Evergrande’s debt is at 25 cents on the dollar), a yield to maturity (YTM) calculation doesn’t make sense and provides a garbage comparison. Debt is no longer traded to maturity (100 cents to the dollar) but rather up to a salvage value. In other words, in the case of Evergrande’s debt trading at 25% of the receivable, buyers calculate a return on collection value, rather than the internal rate of return (IRR) or YTM on the cash flows. cash flow, including a 100% return of capital. . So looking at the 14% YTM of the Chinese HY market sends the wrong comparison.
In contrast, the investment grade (IG) corporate debt market in China held up fairly well. Credit spreads actually tightened, not reflecting any contagion issues. It could be argued that the IG market views systemic risks as reduced. I wouldn’t draw that conclusion immediately, but suffice it to say that the GI market would expand significantly if there were genuine systemic concerns.
Longer-term risk of contagion
The real risks of contagion in China are perhaps more psychological. Confidence in the land as a store of value can be affected. Real estate has always been a big investment in a portfolio in China, and more than one million Chinese consumers can lose a large portion of their prepayments. The fallout includes a slowdown in the national economy (land sales accounted for 8% of GDP) as well as lower consumer confidence. A drop in consumer consumption would be a natural impact.
There has also been a notable expansion of default insurance on Chinese five-year CDS. In the eyes of default insurance markets, China’s default risk now reflects more of a BBB-rated credit rather than the unique A S&P rating. This is important, as the world’s second-largest economy is trending toward undesirable rated credit. Another downgrade (in the eyes of the market, to BB) and he is now a HY borrower. Wow!
Finally, it will be very interesting to see how China deals with domestic claims versus international lenders. I know how a capitalist court would deal with this situation. There is precedent in the West and it gives troubled debt investors a well-honed track record. CCP is a different animal, and its “bother” with the debt priority model that is the law in the West can dramatically increase its borrowing costs when international investors decide to avoid Chinese exposure.
Also think about China banning Bitcoin mining and how it is in fact a gift to the West and the true global capital flows. These two events could lay the groundwork for centralization (and control / abuse of capital) by the CCP over the decentralized model that was once adopted by freedom-loving Western countries. Markets are generally smart in the long run. In my opinion, there will certainly be long-term consequences.
How does Bitcoin fit in?
I have long argued that Bitcoin should be viewed as default protection on a basket of fiat currencies. If the second economy trades as an unwanted borrower in the eyes of the market, then the value of the insurance provided by bitcoin is expected to rise as other countries and smaller credits are also dragged into the vortex of declining quality of the market. sovereign credit.
This is the much bigger problem in my mind. As stated in my article (published by Bitcoin Magazine in April and linked here), the intrinsic value of CDS-based BTC of a basket of sovereign credits was over $ 150,000 per coin before the recent widening of CDS spreads. Since the intrinsic value of BTC increases as spreads widen, this intrinsic the value now has increase.
Some readers will say, “Well Foss, then your thesis doesn’t hold water. BTC acts as a risk free asset.
To which I reply: “The BTC market still has its training wheels. The market does not understand that BTC is a long volatility position. When you are credit short, you are volatile long. And BTC is a short credit position on a basket of sovereigns. “
Proceed accordingly. BTC is the best asymmetric (and hedging) investment opportunity I’ve seen in my 32 years of risk management. Fiat is the ponzi scheme.
“But Foss, they can print money to pay off the debt!” ”
This is true, but in a spiral of debt, debt never matures, it must be renewed. And when an auction fails and the debt doesn’t roll, the ebb tide will show who swam naked.
All fixed income investors should hold BTC as insurance against the inevitable fiduciary depreciation (bonds are only a fiduciary contract), as well as declining sovereign credit quality.
This is a guest article by Greg Foss. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.