The third down week in a row had the SSE Composite finishing with a 1.1% loss Thursday and a 1.9% loss Friday, to close at 1840. Checking the historical data provided by Bloomberg indicates that we have to go back nearly two years, to November 2006, right around the beginning of the ferocious Chinese bull market, to find the SSE Composite closing lower. The wild bull market started at roughly 1500 in July 2006 and reached a high of around 6100, if I remember correctly, just over a year ago. Given the growth of China’s GDP during this time, and assuming that earnings growth is more or less in line with GDP growth, I would say that we are already more or less back to where we were at the beginning of the bull market.
Recent declines were led by financials. Part of the reason for the weakness in financials is all the further noise coming out about more derivatives losses among Chinese companies, which seems to have awakened widespread worries about risk mismanagement. Shanghai Securities News reported Friday that unspecified sources claimed that there were apparently more “huge” losses and that policy-makers suspect losses were being hidden by companies, although without specifying which companies. Right on cue South China Morning Post reported that Nanjing-based China High Speed saw its share price plunge 30% Friday on news of a very large hedge it had taken on.
As I understand it, the hedge works so that CHS makes money if its share price goes up and loses if it declines – but this sounds like nothing more than a complicated name for a long forward position to me. The company explained that this derivative position was to hedge a convertible they had earlier issued.
Now let’s see if I can figure this out, and sorry to my uninterested readers for my indulging in the financial geek side of me. Selling a convertible is like selling a call option on your stock. This is already a hedge, as I see it, because you benefit upfront (lower borrowing cost) and only “lose” (sell your stock below its current market value) if your underlying conditions improve – i.e. your cost of capital declines. That is how I define a hedge – the hedge wins when your underlying position deteriorates, and loses when it improves, thus bringing stability to your position.
But CHS decided to “hedge” this hedge. In principle it seems to me that if you want to hedge this position you would buy a call option that matches the terms of the call implied in the convertible you sold, or something whose delta is reasonably close to such a position. But CHS decided to go one better. They seem to have entered into what looks suspiciously like a pretty plain-vanilla forward – which of course implies a much higher delta – perhaps disguised with some fancy bells and whistles. The problem is, as most finance geeks know, you don’t hedge a short call option with a nominally-equivalent long forward. If you do, you end up with nothing but a short put position. CHS, in other words, by selling a convertible and buying a forward have effectively sold both debt and a put option on their own shares.
This is most certainly not a hedge. On the contrary, it is a doubling up of your own bet – you make money if things go well, but if things go badly you double your losses. I am only guessing about all this because the information in the various newspaper accounts is not terribly complete, but if my sketch is anywhere close to the truth, it is not a surprise to me that the market sold CHS down 30%.
The aim here is not to make a big deal of CHS’s exposure, but rather to point out that nearly every derivatives “hedge” I have seen recently has turned out to be little more than a speculative bet that had nothing to do with the company’s underlying business. Six months ago I was talking about the losses associated with the euro-inversion option many Chinese companies purchased, and now a company has been implicitly selling put options on its own stock – these range from useless to actually negative as far as hedging strategies go.
I am sure there is a lot more of this stuff hidden under various rugs. In my experience, whenever we suddenly start seeing a spate of unexpected financial losses like this, it suggests that a lot of companies in one way or another were making the same liquidity bet – go long stuff that tends to outperform in a rising market flush with liquidity – and unfortunately these bets all tend to go wrong at the worst possible time. They also indicate more serious underlying problems in the various corporate and banking portfolios.
After all, if lots of managers thought this was a good bet to make with derivatives, why should we doubt that a lot of loan officers also liked similar implicit bets? Remember that in 1989-91 when the Japanese banking system was crashing with bad loans, Japanese corporates were getting smacked by all the bad zaitechu losses. This was not an isolated incidence of bad luck. These almost always go together.
Of course the stock market drop was not just all about hidden liquidity bets. Part of the weakness in financial stocks also comes from more expected cuts in mainland interest rates, especially on mortgages. The government is in a frenzy to stop the decline in real estate prices. They have encouraged officials at the provincial level to engage in a whole lot of measures to prop up property prices, and at a more macro level they are planning to cut mortgage rates and lower the minimum deposit required to buy first homes.
Lowering the minimum deposit for house purchases, my astute readers will realize, is similar to the stock-market measures announced three weeks ago allowing companies to issue bonds to purchase shares, and allowing margin purchases of stock. All of these involve trying to support prices by allowing riskier buying strategies – i.e. more leverage. The rest of the world seems to think that the best solution to their problems is to deleverage, but here we are leveraging up buying power. If the problem here turns out to be small and manageable, this strategy will look very smart. If it is worse than we expected, thise strategy will force greater adjustment and more deleveraging.
Xinxin Li at the New-York-based Observatory Group released an interesting report yesterday on Beijing’s moves to boost the property market. He lists and extends the following three:
¨ Housing transaction taxes and fees were cut at the margin. The real estate contract tax was reduced by 0.5 percentage point to 1%.
