From my former Tsinghua student and investment banker Henry Zhang I got the following phone message today:
I am in the bank now and I am shocked by how many crazy people there are buying funds, stocks, etc. Most of them are old people, and how they decide on what to buy is based on their discussions with each other, which is totally clueless.
Coincidentally Kobain Wang, another one of my former Tsinghua students, who trades for a foreign investment bank, wrote me an email today under the heading "This is going NUTS":
A study by the Shanghai Securities News and Shenyin & Wanguo Securities found that investor deposits for trading local currency A shares reached RMB 1.3 trillion by the end of August, up by RMB220 billion from the end of July.
Brad Setser in his latest posting (http://www.rgemonitor.com/blog/setser) wonders about the real exposure Chinese institutions might have to subprime mortgages. Chinese institutions -- largely the PBoC and the largest banks -- have had to invest over $800 billion abroad just in the past two years and it would be surprising if very little of this was exposed to assets adversely affected by the crisis. He is a little skeptical that we have heard the end of the story, and I can't help but agree.
The official numbers suggest, as best I can remember, that total subprime exposure is under $15 billion. That is not a lot, but I want to suggest two reasons for caution.
The first and most obvious is that in a very complex financial market it is not always clear where the exposure lies. I remember in 1995 that one of the US investment banks most severely hit by the Mexican crisis was caught completely by surprise over the extent of its exposure. It had assumed that the bulk of its exposure to Mexico would be on the Latin American trading desk, and an examination of the books indicated that its losses there were manageable.
It turned out however that the repo desk, an area of the firm that had almost no expertise in or knowledge of the risks of trading Latin America, had been doing a roaring business in Latin debt and had been earning very high spreads largely, I suspect, because they had unwittingly underpriced risk. They had no idea that their "good" collateral could turn bad so quickly. When the bank's managers finally realized the extent of the losses on the repo desk, the bank came close to failure.
This story is all based on market gossip and rumors because very little of this was made public, but any experienced trader recognizes the story. While managers were diligently monitoring risk in the area where it most obviously belonged, they hadn't noticed that a completely separate business had taken on the same risk, and that this businessdid not fully realize its extent. I don't know for a fact that this has occurred in the case of China, but I assume and hope that financial authorites and bank risk managers are looking not just at the desks that are formally permitted to take subprime exposure, but also any desk that may have indirectly assumed such exposure.
The second reason for caution is that I suspect there have been a lot of subprime-related losses in other non subprime areas that have not been recorded or explained. For example based on anecdotal evidence I believe Chinese institutions have been big buyers of structured notes. Many of my former students from Peking University and Tsinghua University have joined trading or capital markets desks at major foreign and Chinese investment banks, and from what they tell me the structured products groups have been among the most profitable and active groups in each of their banks. In fact there is one French bank for which, I understand, most of their revenues comes from the sale of derivatives and structured products.
Without knowing exactly what these products are, I have no way of knowing whether or not there have been big losses, but I do know that at least one European bank (I spoke to one of my students there) has booked huge profits in the last few weeks from being on the sell side of the product, and unless the buyers were hedged (almost inconceivable, for many reasons) they must have equivalent or greater losses.
What would explain this? Most investors buy structured notes for their high coupons, especially in a market in which interest rates are low and investors eager for a spread. It is very easy to structure a note with a high coupon. All you have to do is imbed options into the structure such that the buyer of the note is effectively selling the note-seller one or more options. The higher coupon is, in effect, the price of the option amortized in the coupon.
That means buyers of most structured notes are effectively short options -- or short volatility, in the lingo. If there is little volatility in the market, the buyer keeps his higher coupon and gives up nothing in return. Therein lies happiness. If volatility spikes upward, however, or the underlying asset moves in the wrong direction, the value of the option immediately rises and, since the buyer of the structured note is "short" the option, the value of his note drops.
Without knowing exactly what Chinese institutions have purchased, it is tough to say whether or not the fair market values of their structured notes have dropped, but I would be very, very surprised if there wouldn't be some pretty substantial losses on a mark-to-market basis. I don't think most of the buyers mark to market and in fact there really is no market for most of these notes. I suspect that the buyers also don't have the pricing formulae needed for figuring fair market value (no selling bank would give away the pricing formulae because these are usually proprietary and very valuable), but I would bet heavily that if they asked the selling banks to buy them out of their positions, they would book very large losses.
It is the impact of the subprime crisis on underlying volatility that probably will account for the biggest losses Chinese institutions (and non-Chinese institutions too, for that matter) will take from the events of this summer. Unfortunately we don't really know how much that is.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
Subscribe to this Site
) wonders about the real exposure Chinese institutions might have to subprime mortgages. Chinese institutions -- largely the PBoC and the largest banks -- have had to invest over $800 billion abroad just in the past two years and it would be surprising if very little of this was exposed to assets adversely affected by the crisis. He is a little skeptical that we have heard the end of the story, and I can't help but agree. 
January, 2008