Analysis: Too big to fail? China's wealth management products stir debate

The default of a Chinese investment plan has handed Beijing a tough choice: bail out investors and endorse moral hazard or let it fail and risk unnerving those who hold at least $1 trillion in so-called wealth management products.

China's bank regulators are debating what to do about the investment sold at a Hua Xia Bank <600015.SS> branch near Shanghai, which failed to pay out on maturity late last month. The bank, a mid-sized lender partly owned by Deutsche Bank , says a Jiading district branch employee sold the product without authorization.

Angry investors protested outside the branch for a week. That marked the first time - since warnings earlier this year from regulators and even one top bank executive who said some Chinese wealth management products were akin to a Ponzi scheme - that a failed product grabbed national media attention.

It's not yet clear how many, and to what extent, others have defaulted. But analysts say that if more flop and generate headlines like the Hua Xia case, a crisis in confidence could ensue, sparking a run on the wealth product market.

"Some of these products won't be able to generate enough money to pay back investors," said BofA-Merrill Lynch China strategist David Cui. "The issue is, at a certain point, if it gets to a certain scale, you can no longer cover up the losses. Then we may have a systematic risk on our hands."

Wealth management products have taken off in the past five years, with Chinese looking for investment choices other than real estate, betting on the country's roller-coaster stock markets or parking money in bank accounts that offer state-set deposit rates.

The majority of the products are short-term savings vehicles often created by third parties and issued through banks. The products mostly invest in stocks and money market instruments, promising returns of 4-5 percent.

But a sizeable amount have funneled money into riskier investments, offering double-digit gains by financing anything from property and infrastructure projects, to car dealerships, pop concerts and even the sale of ham.

The products are part of China's "shadow banking" system - or credit given to borrowers outside formal lending channels. Barclays estimates the shadow banking industry has nearly doubled in the past two years to 25.6 trillion yuan ($4.11 trillion), or more than a third of total lending.

Beijing has not forced Hua Xia Bank to pay back the estimated 500 investors hit by the default.

China International Capital Corp (CICC), a prominent Chinese investment bank, urged regulators in a December 4 note to allow such products to fail. Most are not guaranteed by banks, analysts say.

"If we don't take this opportunity to let a relatively small-scale contract be broken, it will only reinforce the attitude that these products have a rigid return and a limitless guarantee," CICC said. Forcing Hua Xia to stand behind these products would cause "no end of trouble", it added.

In a sign of how sensitive the issue has become, the China Banking Regulatory Commission (CBRC) recently told reporters not to ask about Hua Xia. Reports by some Chinese media have been taken off their websites.

The CBRC confirmed a report on Wednesday in the Southern Metropolis Daily which said the regulator had sent an "urgent" notice to banks ordering them to check third-party financial products sold through their branches, mainly trusts, insurance and investment funds.

At the same time, state media have stepped up efforts to warn of the risks associated with certain wealth products.

The official China Securities Journal on Saturday warned investors about a product called "Good Voice", an 800 million yuan investment offering double-digit returns from music concerts. The same article mentioned one that invested in hams, launched last month by Jinzi Ham Co Ltd <002515.SZ>, offering returns above 10 percent.

CHINA'S VERSION OF THE CDO

Wealth management products shot to prominence after China's stock markets sank during the 2008 global financial crisis. As China pumped up its economy and inflation surged past official interest rates, investors sought higher returns elsewhere rather than effectively lose money in bank deposits.

Since then, the number of products in circulation has jumped from a few hundred to around 29,000, according to one estimate.

China's wealth products have been likened to the U.S.-invented collateralized debt obligation (CDO). That product pooled together loans, mostly American mortgages, and sold them to hedge funds. When home owners defaulted, and hedge funds stopped buying CDOs, banks were left with packaged loans they couldn't sell. That helped cause the 2008 financial crisis.

Beijing has tolerated wealth products because they offered alternative investment opportunities and channeled credit to industries in need.

The CBRC put the total outstanding at 6.7 trillion yuan ($1.08 trillion) as of September, nearly double the year before. Fitch Ratings predicts total sales will hit 13 trillion yuan by the year-end, or more than 16 percent of total bank deposits.

THE HUA XIA CASE

The advertised yield on the product issued by Hua Xia Bank was 11-13 percent over one year, more than triple the one year, state mandated 3 percent deposit rate.

Created on November 25, 2011, by a firm called the Zhongding Wealth Investment Center, the product planned to invest 200 million yuan in a pawn shop, two car dealerships and a TV production company, according to the prospectus.

The product required a minimum 500,000 yuan individual investment, although sources with knowledge of the investment vehicle said money was pooled among various groups. According to CICC, 160 million yuan was raised.

The protests began when the product failed to pay out its annualized return on the given date. It was unclear if investors had permanently lost their principal payment and interest.

INVESTOR PSYCHOLOGY

Sanford Bernstein analyst Mike Werner said less than 10 percent of products promised a yield of more than 5 percent, meaning most are fairly low risk.

Working out how many need to default before they threaten China's financial system is impossible to tell because the real threat is investor psychology, he said.

If Chinese investors stop buying wealth products en masse, that would likely cause a liquidity crunch, and force Beijing to react, according to Werner.

"The government will step in if social stability is at risk," Werner said.

Cui from BofA-Merrill Lynch said any loss of confidence in wealth management products would have wider consequences.

"This can be self-reinforcing. Once people stop buying (them) for fear of potential defaults, in addition to the solvency risk, the market will face liquidity risk as well," he said.

Analysts suspect a lot of lenders are using new money to pay old customers that have invested in wealth products.

Banking analysts use the term "asset-liability mismatch" to describe the practice, which they have seen increase over the last year as China's economy has slowed, and its stock market has slumped.

A "Ponzi scheme" is what Xiao Gang, chairman of Bank of China <3988.HK> <601988.SS>, the country's number 4 lender, called certain wealth products in a newspaper editorial in October. A Ponzi scheme collapses when new money no longer comes in, and old investors cannot be paid.

"CALL IN THE CHIPS"

Around 70 percent of wealth products are tied to bond and money markets. Where the rest goes is less clear. The government has said principal guaranteed products offered by banks must be counted on a lender's balance sheet.

That means banks are on the hook for the roughly 15 percent of products in circulation they have guaranteed.

Analysts agree that if a host of wealth products went bust, it would cause a liquidity crunch. At the very least, banks would be expected to cover losses and pay investors principal plus interest on products that had been guaranteed.

They said that banks, particularly large ones, probably had enough cash on hand to cover any losses.

Fitch analyst Charlene Chu said smaller banks were now major sellers of the products, and that shorter maturity dates were rising. That means in some cases, products with a 3-month maturity were being used to fund real estate and infrastructure projects that would take far longer to finish.

The ability of a smaller bank to handle a run on wealth products was a concern, she said.

"With more products at these entities, the sector is more susceptible to repayment issues," Chu wrote in a recent report.

One analyst who covers Chinese banks said the most drastic government action would be if it "called in all the chips", and forced banks, trust companies and other providers of wealth products to mark the plans to market, which would reveal the actual value of the product compared to what was promised. He was not authorized to speak publicly on the matter.

May Yan, head of Asia bank research at Barclays, said the market needed failure to educate domestic investors about taking excessive financial risks. At the same time, the government needed to be aware of the pressure that would fall on banks should customers demand repayment.

She predicted the banking regulator and the central bank would tighten up on wealth products and shadow banking in 2013.

"If the product fails, it is a big step forward for risk awareness in China," Yan said. "If banks need to bail everyone out, the implications would be very negative."

($1 = 6.2415 Chinese yuan)

(Additional reporting by Lucy Hornby and Kevin Yao in BEIJING, Pete Sweeney in SHANGHAI; Editing by Ian Geoghegan and Dean Yates)