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China Debt Bomb to Trigger US Stock Meltdown? Maybe, but Not Yet


A counter-argument to Larry McDonald's Forbes piece on an impending China credit implosion. Do investors need to worry about US stocks?

About 16% of S&P 500 earnings come from the emerging markets vs only 4% twenty years ago, much of this is from China.
According to Newedge, global dividends in 2013 reached $1 trillion, up from $715 billion in 2009. Led by China, dividend growth from emerging markets surged 106%, while Europe's contribution in 2013 was 21% vs 30% in 2009.  This is not your father's stock market, developed markets are 5x more exposed to emerging markets than they were in years past.  Ignore China at your peril.

-- Larry McDonald, "Can China Diffuse Its Debt Bomb?"

On Wednesday night I had a long Twitter conversation with Larry McDonald over his latest article concerning China. You can read his piece here, but the gist of it is that

  1. based on the spreads of their respective credit default swaps (CDSs), the credit risk of several Chinese / China-sensitive financial institutions is now higher than the credit risk of US financials;
  2. The underperformance of Chinese credit risk is a telltale sign of credit problems that will transmit to equities; and
  3. He concludes with the following paragraph: "We think the situation becomes disorderly and leads to a massive contraction of available credit in what was the fastest-growing economy in the world. Sell US stocks."  
I won't dare to suggest that China's credit issues won't become disorderly and the world won't suffer from it. There is little doubt that China has wasted trillions of dollars to build empty cities, and that its shadow financial system (and even the non-shadow one) is about as transparent as mud. On the other hand, one must also consider that China sits on almost $4 trillion of foreign reserves. That's as much as the Fed has printed to intervene in the $17 trillion US economy, and the Chinese economy is half that. So he "may be right, I may be crazy," and only time will tell.

My main disagreement with Larry is not on China's financial health (or lack thereof), but rather on how one should interpret the pricing of credit default swaps as a tell of imminent, widespread credit upheaval.

For those not too familiar with credit default swaps, you can think of them as insurance on the risk that a bond will default. The higher the premium (a.k.a "the spread") commanded by the market, the higher the perception of the risk of default. Just like insurance policies, CDSs are offered with various durations, based on when bond holders see a catalyst for potential credit problems.

Larry argues that the simple fact that the CDS contracts on Chinese bonds, and on bonds of financial institutions highly sensitive to Chinese finances, are more expensive than CDS contracts on US financials, or on Irish sovereign CDSs (highlighting a country with recent sovereign risk problems), is basically all the evidence we need to show that a crisis is approaching. I would suggest that there's quite a bit more to reading those tea leaves.

First of all, in my humble opinion, the most important consideration when evaluating credit risk through the lenses of CDS pricing, is the absolute spread on the CDSs.  The "spread" price represents the percentage of the amount of the bonds to be insured that a CDS buyer must pay.  For example, if I own $10 million of bond B1, I want to insure against default for five years with a five-year CDS, and if the spread on that CDS is 100 bps, it means that I will have to pay an annual premium of $100,000/year for five years. The fact that the CDS of bond B2 trades at 200bps suggests that B2 is riskier than B1, but the buyer would still be paying only 2% of the face value of the bonds to insure them -- hardly a sign that the buyer thinks default is imminent. Just as a teenager is charged higher auto premiums than an adult because the former is clearly "riskier" than the latter, the higher premium doesn't suggest the teen is about to mow down a bunch of pedestrians on the sidewalk. 

So when is a spread high enough to conclude that a default is in the offing? Aside from the "risk in the eye of the beholder" approach, we can look at past pricing of those same CDSs. Using Goldman Sachs (NYSE:GS) as an example, well before the financial crisis hit its five-year CDS contracts traded in the 25-35bps range; when Bear was failing, the CDSs jumped to 250bps, only to return to 80bps a few weeks later.
By the time Lehman failed the spread skyrocketed to 500-600bps, before working its way back to 100bps.  And when the Greece/EU crisis unfolded, the CDSs once again widened to 400bps.  Today they are trading back down around 100bps, which is probably the "new normal" for a company like Goldman Sachs, post-financial crisis. Knowing the guideposts for a specific name relative to the existing noise of systemic credit risks lets us gauge how real that noise is. Just because the CDSs today trade for the same price as they did when the crisis began to unfold it does not mean that another crisis is around the corner -- we know how wide these CDSs tend to trade when a real systemic risk is looming. (All that said, if a company's five-year CDS trades above 1,000 bps, the prospects for those bonds look pretty dim.)

A second, more wonky type of analysis involves comparing the total price of a credit default swap (i.e. spread x however many years the CDS remains in force) to the total potential return from the bond over the same period. A bondholder would generally not want to pay more in insurance premiums than what it can earn on the bond. Careful not to use this approach as gospel however, because CDS prices are influenced by speculators who buy CDSs naked (i.e. without owning the underlying bond) and on the opposite end, by bondholders who do not necessarily insure the entire amount of their bonds, thus leaving more risk but also more returns.

The third approach, and one I prefer by far, involves looking not just at the CDS prices, but at the shape of the "CDS curve." I have posted often on Minyanville's Buzz & Banter (subscription required) about the curve of the Volatility Index (INDEXCBOE:VIX), and how the shape of the curve is more important than the level of the VIX in trying to decide when real fear has entered the equity marketsThe same analysis applies to CDSs: If market participants truly believe that the risk of default is at hand, they will pay more (but for a shorter period of time) for near-dated insurance, rather than a little less but for an extended period.  It's just common sense. Why pay premiums for five years if you are confident the accident will happen tomorrow? This dynamic will cause the shape of the curve to invert, meaning that one-year/two-year CDSs will trade for a higher price than five-year CDSs. If/when you see an inverted CDS curve, it is truly the time to worry.

Here are two classic examples: While the financial crisis culminated in late 2008 - early 2009, it began in earnest in mid to late 2007, when Bear Stern began unraveling, the corporate bond market stopped buying new issues, and the municipal auction rate securities began collapsing. Here is a chart of Bear Sterns CDS curves on November 1, 2007 (dotted green line), December 1, 2008 (yellow line), and today (green line).  

In Nov. '07 the price of a six-month CDS was double the price of a seven-year CDS. Traders were absolutely certain Bear would not survive past six months, and indeed, but for JPMorgan (NYSE:JPM) doing the government's dirty work, Bear would have been another Lehman. The curve was deeply inverted. In Dec. '08 (with Bear bonds having been absorbed by JPMorgan) you can see that despite the financial chaos of the time, JPMorgan was viewed on firm footing and its curve was "normal," i.e. it had lower CDS prices for nearer-dated CDSs. Today the curve is even steeper. Interestingly, focusing just on the five-year spreads would lead one to conclude that Bear bonds were a better credit risk in '07 than they were in '08.

A similar pattern shows up on Morgan Stanley's (NYSE:MS) CDS curve. Morgan Stanley was not in the headlines in late '07, but as credit participants were already sniffing problems, the curve was slightly inverted. It became deeply inverted in late '08 as Morgan Stanley was on the verge of imploding. Today the curve is normal, and coincidentally, the five-year CDS trades at the same spread as it did back in '07.  I suspect no one would argue that the risk profile today is the same as it was in '07.

So what does China's current credit risk profile look like? Is it on the verge on imploding?

The CDS curve of Chinese sovereign debt is as steep now as it was in November of last year, while in absolute terms the five-year CDSs have widened from 80 to about 100 bps.  The spread is about 80bps lower than at the peak of the '08 crisis.

And in the case of financial names that could feel the brunt of Chinese credit problems, such as HSBC Bank (NYSE:HSBC), Standard Chartered (OTCMKTS:SCBFF), and China Development Bank, the charts look about the same, with steep curves, absolute levels sub-200 bps, and changes in spreads from November of last year that vary from slightly tighter (HSBC minus 5bps), to a bit wider (China Development plus 55bps).     

In sum, I am not discounting the latent risks in China's debt markets, and Larry  is correct in arguing that they need careful monitoring. I am also certain that there is a ton of bad debt that will eventually be purged, and the process will make for some scary headlines. But, unlike Larry's conclusion, through the lenses I discussed above, it is difficult to see an impending meltdown.

Twitter: @FZucchi
Position in GS
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