How Can Evergrande’s Contagion Occur? 2
As the Evergrande induced contagion spreads, banks and other financial institutions will be forced to write down the value of their investments across the Chinese real estate sector; encompassing loans, bonds, exotic financing products (a la the infamous wealth management products), and even shareholdings.
The net result of which is not just financial investors losing a lot of money, but the possible impairment of a segment of the Chinese banking system. Banks that were too exposed to the housing market will find themselves nursing very large losses on mortgages and loans that will not be repaid. If these banks also happen to be overleveraged, then the hit to their balance sheets could send them spiraling into default as well.
As this point, the contagion ceases to just be about real estate, and has snowballed into a domestic financial crisis. As banks begin to default, capital markets will shun them in the same way they shunned real estate developers; refusing to lend them anymore cash, or to infuse capital through other means of fundraising.
Consequently, the entire banking sector goes into crisis mode, which entails not taking any kind of meaningful risk with their available capital in order to ensure their survival. While this works for them, the economy suffers as banks stop making loans, and makes credit available only to the most creditworthy clients, which is how the contagion spreads to the entire domestic economy.
This sudden and sharp cutback in bank lending and credit provision creates liquidity problems for every other sector in the economy. Companies which are overleveraged, regardless of how related they are to the real estate sector, now find themselves struggling to raise cash to meet their interest payments. Those which cannot find, or generate, the cash they need will end up defaulting. The end result of which is another wave of bankruptcies, and a significant spike in unemployment, as what started in real estate sweeps through the banks and engulfs the rest of the economy.
Of course, while all of this is happening, Chinese homeowners, investors, and speculators are facing their own kind of hell. More defaults lead to lower property prices as developers desperately slash their asking prices in order to reduce inventory and raise cash to meet debt obligations. Unfortunately for everybody involved, developers as well as homeowners, such fire sales more often than not lead to more fire sales.
As house prices fall, folks who took on too much leverage to purchase real estate find themselves sweating as they can no longer sell their investment at a price that enables them to fully pay off their mortgage. The flood of supply into the market could also lead to lower rents, further affecting those who were looking to generate rental income from their investment in order to service the interest payments on their mortgage.
All of this further compounds the economic pain of high unemployment and lack of credit availability, ultimately contributing to a spike in personal bankruptcies to go along with those seen in corporates.
To be continued…
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