My Blog

October 5, 2007

FRI 5 OCT 2007

Responses to "Should Chinese Banks...?" By Michael Pettis

I still can’t respond directly to comments because Sampasite is blocked in China, and the proxy I use doesn’t allow me to see and post the required access codes, so I have to post responses in the form of new entries.

 

JKH, you ask if the way a purchase were funded might change my conclusion that a Chinese purchase of a foreign bank would, if large enough, actually destroy market value.  You agree that this is the case for an equity-funded purchase but wonder what would happen if the purchase were funded by issuing debt.

 

The way I see it is that it would still cause a reduction in market value, probably even greater.  Let us assume that Bank A (a Chinese bank) buys Bank B (a foreign bank) and pays for it by issuing $100 of stocks.  We both agree that in this case there would be a reduction in total market value.

 

Now let us assume that the new (larger) Bank A issues $100 of debt and uses the proceeds to repurchase stock.  I think you would agree that the resulting capital structure would be the same as if Bank A had funded the purchase of Bank B by issuing debt.  The question is will this second transaction create or destroy value.

 

As I see it, since the new Bank A is almost certainly going to have more debt than is optimal, the “old fashioned” M&M framework makes it clear that the marginal cost (financial distress costs) of new debt will be much greater than the marginal benefit, so enterprise value will fall.  That should reduce the total value of the combined venture even further.  I realize that I am not answering your question directly but rather am backing into an answer, but my first reaction tells me that financing the purchase with debt would be even worse for total market value than financing it with equity because we are presumably on the wrong side of the marginal-value-of-new-debt curve.  Would you agree?

 

As for your second point, I think you are saying that the more ownership the government sells, the more it is willing to force the bank to enter into transactions that protect the creditors (which encompasses the interests of regulators) and harm shareholders.  I hadn’t really thought of that but if I am interpreting you correctly, then I agree fully.

 

Twofish, the idea that a share price is some sort of barometer of the health of a company is very widespread but, as you point out, wrong.  To be technical, this is only the case if the share price has a great deal of intrinsic value and little time value (the case for a very solvent, healthy company).  If it is all time value, then it reflects changes in volatility more than changes in “health”.  This, in a way, is the main point of my Far Eastern Economic Review article – Chinese bankers and their regulators should not misinterpret what the market is saying about Chinese banks.

 

I think the option framework does support your conclusion that banks need to be heavily regulated because the temptation (especially with deposit insurance) to speculate wildly is too great.  In a nutshell I believe that this is the story of the US S&L crisis of the 1970s-80s.  Once the banks were made insolvent by DIDMCA, they asked for significant relaxation in their lending restrictions.  Congress, unwilling to foot the bill for cleaning up the S&Ls, bought the argument that with more freedom the S&Ls could “earn” their way out of bankruptcy, but of course they were wrong.  The incentive for the insolvent S&Ls was to borrow more (deposit-insured) money and speculate wildly in the hopes of success.  Heads, I win; tails, the government loses.  Who wouldn’t speculate under such conditions? 

 

Not at all surprisingly, the S&Ls were the chief piggy banks for the then-exploding junk bond market and when heads turned up on the flipped coin, their investors made fortunes.  When tails turned up, however, which it did more often than not, the government took it on the nose.  As we all know, in the end the S&L clean-up turned out to be far more expensive for the US government than it originally would have been.  This becomes breathtakingly obvious when you use the option framework to analyze the incentive structure and predict the banks’ behavior.  In fact the option framework does an extremely good job of predicting a lot of otherwise inexplicable behavior.

 

Twofish, this is probably why I am so much more pessimistic than you are about the Chinese banking system.  The way I see it, the incentive structure for excessive risk-taking is too great.

 

By the way, if you don’t have an FEER subscription (get one – it has become a very interesting read again) you can read the original FEER article here: http://www.iea.usp.br/iea/english/articles/pettischinasvolatility.pdf

FRI 5 OCT 2007

Difficult decisions postponed? By Michael Pettis

From talking to friends much more knowledgeable that I am it seems that the 17th CPC Plenum, which will be opened next week, is turning out to be much more fractious than expected, and it is not clear that it will lead to a resolution of factional infighting.  There will be no clear victory, apparently, for either of the major factions.

 

I can't comment on other aspects of what a divided leadership will mean, but I do worry that without clear lines of responsibility and control it may take longer than ever to resolve the large and growing imbalances in China's monetary condition.  There seems to be a fight between those on the one hand who worry most about the consequences of excess financial expansion and those, on the other hand, who don't want anything done that might slow down employment growth in the near term.

 

As I see it, to take the bull by the horns and start applying the brakes is a no-win solution.  If you are unsuccessful and overdo it, thereby precipitating a crisis, you will be blamed for it.  If you are successful and save the country from a financial disaster, but do so at the cost of a short-term rise in unemployment, you are still vulnerable to criticism.  You can't prove that you averted a crisis but you certainly can be blamed for the misery you caused.

 

In that case, there is less reason to take the risk of addressing the problems directly.  Instead of simply convincing your boss that something must be down, and that there will be a cost to doing it, but that the cost is much less than the consequence of not doing it, you have to avoid getting blamed for any downturn.  Even if what you do is right, if it allows your factional enemies to undermine you it is better not to do it.  This cannot be a good thing if you believe, as I do, that some very difficult decisions need to be made as quickly as possible and then implemented without hesitation.