Evergrande's Real Estate Crisis

On August 17 2023, the China Evergrande Group filed for Chapter 15 bankruptcy (a set of procedures designed for insolvency cases involving multiple countries) in New York. This will basically allow American bankruptcy courts to step in and help protect the assets such that they can be fairly distributed among Evergrande’s creditors. While this development is certainly relevant in China’s ongoing real estate crunch, it surprised few. In fact, this was simply 2 years in the making as Evergrande has been in default since late 2021.?

The background

The Chinese real estate market was notably shielded from the Global Financial Crisis, with property prices experiencing a substantial boom between 2005 and 2010. Some analysts were already pointing to various markers, such as the high price-to-income ratios, that would indicate a bubble. Regardless, the Chinese government addressed the 2008 crisis by continuously investing in infrastructure via local government financing vehicles (investment companies set up by a local government in China to fund real estate and infrastructure projects. Since local governments don’t issue municipal bonds, LGFVs will borrow from banks on behalf of the municipalities). This may have kept prices up, but it also built a reliance on increasing land value, not to mention the accumulation of larger debts.

The debt in particular became so problematic that in August 2020, the Chinese government introduced the “three red lines,” a series of guidelines for property:?

• Liability-to-Asset Ratio (LAR): the proportion of a company’s total liabilities shouldn’t be greater than 70% of its total assets?

• Net Debt-to-Equity Ratio (NDER): the proportion of a company's net debt shouldn’t be greater than 100% of its equity?
• Cash-to-Short-Term Debt Ratio (CSDR): a company should be able to cover its short-term debt with its available cash reserves (in other words, a CSDR of 1)

Other government regulations were also enacted in an attempt to control housing prices. These included mortgage lending limits, rent caps, and outright canceling land auctions.?

From financial high to fiscal hopelessness

Evergrande Group was a highly leveraged real estate development company, aggressively expanding their operations and investments prior to the three red lines. Whether it’s a 100 billion RMB ($15.5 billion USD) artificial island project or spending 727.42 billion RMB ($100 billion USD) on a series of theme parks dubbed “Fairyland,” Evergrande certainly wasn’t shy to diversify their holdings. They even bought China’s richest soccer club, Guangzhou F.C, in 2010 for 100 million RMB ($13.75 million USD).?

All these activities meant two things. First, Western markets (especially financial firms) were exposed to Evergrande either through their projects or corporate bonds. UBS, BlackRock, and HSBC, for example, each owned $300 million, $400 million, and $31 million in bonds, respectively. Secondly, Evergrande had to substantially adjust their borrowing practices. So in March 2021, they said they were looking to cut their debt by 150 billion RMB ($23.3 billion USD). Usually when a business discloses something like this, it’s generally seen as a good thing by credit rating agencies. Not for Evergrande. A month after the announcement, Fitch downgraded them from B+ to B, stating:?

The downgrade reflects ongoing pressure for Evergrande to downsize its business and reduce total debt. We believe the company's debt reduction plan is achievable, but it is subject to meaningful execution risk and may also negatively affect the company's business profile in the medium term.

As if their credibility couldn’t weaken any further, Evergrande had to deal with even more gossip in the months following Fitch’s downgrade. In late August 2021, a letter from Evergrande informing the Guangdong provincial government of their liquidity problems began circulating online. After trying and failing to dismiss the memo as fake, they came clean in their H1 2021 earnings report; Evergrande was going to default on their incoming bond payments unless they quickly acquired sufficient funds.?

Moody’s and S&P then lowered Evergrande's rating from B2 to Caa1 and from B? to CCC, respectively. Soon after, the Zhuhai and Nanshan District (in Shenzhen) municipal governments took over Evergrande’s sales revenue and moved it to a government-controlled account for safekeeping. However, this wasn’t enough to prevent things from going from bad to worse. On September 24th, Evergrande missed $83.5 million USD in bond payments. And while they managed to pay off the debt within the 30-day grace period (thereby avoiding a default on those bonds), they also missed an additional $148 million USD in coupon fees, which they also fulfilled later. Regardless, missing 2 consecutive grace periods is never a good sign.

At this point, the Chinese government focused on selling Evergrande’s assets and preventing financial contagion over the next several months. They sold a 20% stake in Shengjing Bank for 10 billion RMB ($1.5 billion USD), an 11% stake in HengTen Networks Group for 3.06 billion RMB ($420 million USD), and a series of residential development projects in Chongqing, Dongguan, Foshan, and Guangzhou for 2.13 billion yuan ($337.35 million USD), to name a few.

Unfortunately, it sort of just stopped there. In early October, Hopson Development said it was in talks to buy a 51% in Evergrande Real Estate (a subsidiary of Evergrande Group) for 36.42 billion RMB ($5 billion USD). This deal would’ve been a major lifesaver had it gone through, but Hopson retracted the offer a couple of weeks later. Evergrande announced that it made little progress in the asset-selling program, causing shares to plunge over 13%.?

Things weren’t looking too good on the financial quarantine side either. Other Chinese real estate firms began either missing or outright defaulting on their own bond payments, which not only sent bond yields sky-high (lower demand for Chinese bonds = lower bond price = higher bond yield) but also shook the market: in the days after Sinic Holdings Group Co defaulted on US$246 million worth of bonds, official figures painted a deeply bearish Chinese real estate market.

Default and Aftermath

On 19 November 2021, Hong Kong's Hang Seng China Enterprises Index said it intended to delist Evergrande Group, likely due to the company’s poor performance (as is usually the case with any index delisting). After failing to fulfill several additional bond payments, Fitch further downgraded Evergrande from “C” to “RD,” meaning literally “restricted default.” S&P followed suit almost 2 weeks later on December 17, 2021.?

Evergrande more or less hit rock bottom by now. The only question was just how deep the hole is. Here are some figures to give an idea of where things were:

• Their share price hit an all time low of $0.15 USD from an all time high of $3.95 USD
• 2021 sales tanked 39%, or $70 billion USD, from the previous year
• The loss attributable to shareholders in 2021 totalled $14.7 billion USD, with its total liabilities as of the end of 2022 reaching $340 billion USD

Evergrande was 2022’s most indebted company. As for China’s broader economy, property sales in 2023 so far aren’t looking up, partly because of a government-imposed price floor to prevent further price cuts. According to the China Real Estate Information Corp (CRIC), sales from the top 100 Chinese property developers fell a third in 2023, furthering the hard reality that the country’s not out of the woods yet.

Econ IRL

If your house is flooded, you'd call your insurance company. If your entire neighbourhood is flooded, your insurance company probably needs to call their insurance company – reinsurance. Reinsurance plays a vital role in this industry by allowing smaller firms to take on a large number of clients while passing on large risks, such as natural disasters, to reinsurance companies. The authors of this week's paper studied the optimal pricing and risk management of reinsurance companies and first-line insurers.?

The researchers studied the interactions between these two parties as a continuous Stackelberg game, a game theory model involving two players: the leader and the follower. The leader makes the first move, then the follower responds based on the leader's actions. This sequential order gives the leader an advantage; they can anticipate the follower's response and adjust their own actions accordingly. Like other game theory scenarios, both parties strive to reach an equilibrium that maximizes their payoff while considering the other player's best response. In the context of reinsurance, first-line insurers maximize their reward from this interaction by choosing to reinsure the portion of their losses that optimizes utility (a satisfaction score), and the reinsurance company aims to maximize the price of their services. At the Stackelberg equilibrium, where both parties maximize their gains, the reinsurance company's pricing model is closely related to the barycentre (the point around which the data points tend to cluster around) of the initial insurers' loss models.?

‘Till next time,?

SoBasically