Valuentum Exclusive Analysis for the Discerning Investor

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One thing will always be the case – banks never hold enough capital to cover asset losses in excess of the inverse of their leverage. Said differently, if a bank is leveraged 10 to 1--meaning its assets are 10 times as much as its equity--it would only take a 10% decline in the unhedged market-value of asset prices to wipe a bank’s equity capital position clean, all else equal, and provided capital infusions aren’t available.

The US lived through this dynamic during the Financial Crisis, and to the credit of the Fed, Treasury, and related participants, they did a fantastic job, all things considered--being that we’re not currently in the midst of a modern-day Great Depression. It is clear to us, however, that China, if challenged, will not be as proficient in handling their version of a financial crisis as the US was. The (lack of) effectiveness of the Chinese government’s recent market-intervening initiatives speaks to a very real global concern.

In early June, investors in Chinese stocks thought they were 60% wealthier than they are today. While such wealth has been obliterated, the obligations of businesses and consumers have not. For those already on the margin in meeting creditor demands, the vast losses in discretionary income will likely reverberate throughout China’s banking system. According to Bloomberg, we’re already witnessing serious repercussions. Two of the Big Four Chinese banks reported earnings this week that showed a 31% increase and a 28% increase in bad loans, at the Industrial & Commercial Bank of China (ICBC) and the Agricultural Bank of China, respectively. Bloomberg noted that ICBC is experiencing “severe conditions.”

With commodity-levered businesses in the construction and mining industries facing difficulties, a situation exacerbated by the evaporation of consumer wealth, the Chinese banking system is on extremely shaky ground, in our view. How long before the commercial and residential property markets begin to seriously roll over as consumer default rates begin to increase? A study completed by the Stern School of Business calculated that, in the event stocks fell by at least 40% in six months, the cost of “propping up China’s banks…has nearly quadrupled in the past three years, to $526.2 billion.”

Of course Chinese stocks are down 60% in two months, but that may not be the very worst of it. As recently as last month, property in China had become an acceptable form of collateral for stock trading on margin. Fitch noted in May that “property exposure had become the biggest threat to the viability of Chinese banks because of the banking system’s reliance on real estate collateral and the strong linkages between property and other parts of the economy.” For weeks now, Chinese speculators have been selling properties for 90 cents on the dollar or worse to cover vast losses in the stock market. Forced property selling could make for some steeper asset write-downs on the banks, and many may be holding on…waiting for a stock-market bounce in China that may never come.

“Experts” keep saying not to worry, but we remember all-too-well when “experts” said subprime mortgage lending was “okay” because housing prices always go up. The pace of property value declines are likely accelerating, even as we speak, and Fitch has it right, in our view:

Fitch views a protracted downturn in property markets as a low probability, but high impact, scenario that could result in a credit crunch and force a chaotic deleveraging process for corporate borrowers. A steep fall in property prices would diminish the value of collateral, weaken banks' lending capacity and increase borrowers' default probabilities. A protracted downturn in property markets could therefore threaten the solvency of Chinese banks, given their modest loss-absorption capacity.

According to a tweet by CNBC’s Kayla Tauche, Citigroup (C), JP Morgan (JPM) Bank of America (BAC), and Morgan Stanley (MS) have relatively minor direct exposure to China at ~$21.1 billion, ~$17.7 billion, ~$11.3 billion and ~$4.5 billion, respectively. However, it appears that it may be the British banks that are truly on the hook for the eventual contagion this time around. According to the Wall Street Journal, HSBC (HSBC) at ~$36.2 billion and Standard Chartered at ~$58.3 billion may have the greatest risk, and “British banks acting as foreign lenders” have a total of ~$220 billion outstanding loans to China. If China falters and the British banks teeter, the US won’t be spared pain either, even if again, the US may be best prepared for another global calamity.

The pace of sales of Apple’s (AAPL) new iPhone in China may be the least of our worries.