The Chinese inflated a real estate bubble more than ten times larger than the United States. Bursting this bubble could destabilize the world economy.

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I recently asked what would happen if the Chinese housing bubble burst. The implications for Coastal California’s real estate market is enormous as a crash in Chinese real estate would not just remove a component of local demand, it could turn Chinese buyers into desperate sellers. My sanguine attitude about the ability of lenders to maintain pricing through inventory restriction would change if desperate Chinese sellers began putting must-sell inventory on the market.

The problems in China go beyond our little niche in the real estate world. A deflating housing bubble in China could destabilize their entire financial system and disrupt the world economy.

Some in China want to see the return of market forces and a movement away from central economic planning.

Let housing prices in China be determined by market forces

Yi Xianrong, 2014-06-13

If the government weighs in to reverse the downward trend in real estate prices, the market might not plunge temporarily, but it is sure to lead the market down a more dangerous path, force the property bubble to burst and jeopardize the country’s economy. …

Chinese investors, who have invested their funds in the housing market during the last decade when the market was booming, are eager to lock their gains by cashing in their chips.

The investors’ withdrawal from the market is set to trigger a decline in prices which could hardly be reversed despite the government’s interference. Knowing that market forces will lead to the most effective use of economic resources, the 18th National People’s Congress decided that the government should refrain from interfering with the market, which means that the government should try not to control housing prices.

The business circle that has prompted the decline of real estate prices may be hindered for a moment by the government’s meddling but it will have its own way in the long run.

The reason the Chinese government will likely continue to prop up its real estate market is because the bubble is so large, that allowing prices to find a natural equilibrium will lead to a 90% to 95% reduction in home prices — and that’s not an exaggeration.

We built $500,000 houses for a local population making about $40,000 a year in Riverside County, CA. Prices cut in half there despite aggressive government stimulus before an equilibrium was restored. In China, they built $500,000 houses in areas where the local population lives in shanties on $3,180 a year, so take our bubble and multiply the problem by 12. A 90% reduction in prices is necessary just to bring priced down to where they were as inflated as our bubble was during 2006. Cut that in half again, and a 95% decline in Chinese house prices is a very realistic scenario.

There is more evidence of the 10-fold imbalance. The United States averaged a home vacancy rate of about 1.6% since the mid 1950s. During the housing bubble, due to property speculation, investors began trading empty stucco boxes, and the US home vacancy rate increased to 2.7%, a dangerously high level indicative of a housing bubble.

If 2.7% vacancy is dangerous, what do we make of China’s vacancy rate of 20%?

More Than 1 in 5 Homes in Chinese Cities Are Empty, Survey Says

By Esther Fung, June 11, 2014 7:01 a.m. ET

SHANGHAI—More than one in five homes in China’s urban areas is vacant, and a current housing-price correction is putting additional pressure on the owners of such empty properties, according to a nationwide survey by researchers from China’s Southwestern University of Finance and Economics.

The vacancy rate of sold residential homes in urban areas reached 22.4% in 2013, or 49 million homes, up from 20.6% in 2011, according to the Survey and Research Center for China Household Finance, which conducted the analysis.

Again, China’s problems are 10 times larger than ours were at the peak of our disastrous housing bubble.

So why does this matter?

Dear Investors: China’s Problems Are Your Problems

By A. Gary Shilling, 31 May 26, 2014 6:03 PM EDT

… a financial crisis in China could well be the trigger that persuades investors to pull in their horns.

China is the world’s second-largest economy, even if it remains an economic pygmy, with $6,091 in per-person gross domestic product in 2012, compared with the U.S.’s $51,749. Its global importance was magnified when North America and Europe shifted their manufacturing to the Middle Kingdom. That shift made China the primary importer of raw materials and exporter of manufactured goods. …

China’s size and impact on the global economy mean that China’s problems … are now the world’s problems….

Disruptions on the flow of capital and goods and services will have global implications.

Chinese leaders want to shift from export-driven to domestic-led growth. But in promoting a consumer-led economy, China is way behind the goal post. The latest data from 2012 show that consumer spending only accounted for about 36 percent of GDP, far behind the developed countries. …

The government knows that to increase consumer spending it must increase incomes and reduce savings. Chinese households don’t have much of a safety net to fall back on, so they save almost 30 percent of their income to cover health care, retirement and education.

One of the common myths surrounding China is that they save prodigiously, and the banks aren’t nearly as leveraged Western banks were at the onset of the financial crisis. But what if the capital on Chinese bank’s balance sheets is an illusion?

The problem with Chinese bank’s collateral backing its loans is complex and requires some background explanation.

Global agenda: Rehypothecation

By PINCHAS LANDAU, 06/26/2014

Frankly, I don’t expect many readers to be familiar with the term above, let alone to know what it means. So let’s begin by turning to the fount of all knowledge in our age – Wikipedia.

Here we learn that “hypothecation is the practice where [usually through a letter of hypothecation] a borrower pledges collateral to secure a debt or a borrower, as a condition precedent to a loan, or has a third party [usually an affiliate] pledge collateral for the borrower. The borrower retains ownership of the collateral, but the creditor has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer’s house becomes collateral until the mortgage loan is paid off.”

Hypothecation is the standard practice in the real estate industry. A borrower pledges the collateral to get a loan — but they can only pledge it one time to get one loan. The same collateral cannot be pledged multiple times to get multiple loans because if the borrower defaulted, multiple banks could not foreclose and resell the property to regain their capital.

We now advance to “rehypothecation” and, reverting to Wikipedia, we learn that “rehypothecation is a professional financial market practice, where the counterparty reuses a security pledged as a collateral for its own use. It is how the hypothecation mechanism fundamentally works in the security market, replacing the overhead of liens through actual title transfer against cash with the promise of an opposite transaction in the future [repo].

Counterparties receiving the security can use it freely.”

Rehypothocation is using the same collateral to get multiple loans. It allows both borrowers and lenders to become much, much more leveraged because the 1-to-1 ratio of collateral to loan is broken.

For most readers, that is impenetrable jargon. But the distinction is now clear – hypothecation is something everyone does, rehypothecation is something that only financial market professionals practice. Let us, therefore, stick with hypothecation and see what we can do with it.

You want to buy an apartment, house, building or property.

You don’t have money, so you go to the banks – “cos that’s where the money is,” as bank-robber Willy Sutton explained, when asked why he kept robbing banks – and they lend you money. But they want collateral, so they take a lien on the asset you are buying with their money, effectively making it their asset, until you have repaid the loan.

Now, suppose you tried to be clever and, having borrowed the money from Bank A and pledged the asset to them, you then went to Bank B and tried to borrow money from it, offering your asset as collateral. In Israel, as in all counties where the financial system, real-estate sector and government bureaucracies function properly (that’s not the same as efficiently…), Bank B would check and discover that the said asset was already pledged to Bank A. It would then refuse to lend you money, unless you put up another asset – and maybe it would throw you out in any event. If somehow the second loan was made (maybe you bribed the relevant manager) and the fraud was only discovered ex post, Bank B would probably initiate legal proceedings against you.

One of the main reasons we record all real estate transactions in the public record is to prevent rehypothocation. Many people attempted rehypothocation Ponzi schemes during the bubble, and some managed to get the loans by timing the loans to close on the same day at multiple banks so it wouldn’t show up in a title search. It’s fraud, pure and simple.

Now, we’ll play a different thought experiment. Supposing you had an asset, a real, hard asset – such as a consignment of thousands of tons of iron or copper, or even thousands of kilograms of gold. You had documentation proving that your asset was being stored in a secure warehouse facility – and on this basis, Bank A gave you a loan, against which the asset was duly pledged. But in the imaginary country we are talking about, you could go to Bank B and do the same thing, i.e. rehypothecate your asset, getting two loans both underwritten by the same lien.

You could, in fact, go to Banks C, D and E and do the same thing. In theory, if the lenders played along with you, for whatever reason (most likely, the one cited above), you could rehypothecate the same asset infinitely.

Each time a loan is rehypothocated, the amount any one bank can recover is reduced. The amount of outstanding debt the exceeds collateral value introduced potential deflation pressure in the system if any of the banks needs to foreclose. Further, a chain reaction of defaults, foreclosure, and subsequent resale could cause asset values to crash like they did with the US housing market.

Now, imagine that this imaginary country where multiple rehypothecation was possible really existed and it was called China.

OMG! Think of the scale of the debt not backed by any real assets in China! I question whether their central bank could print enough money to paper over this problem.

It imported huge quantities of raw materials and built endless housing projects, while its currency offered a one-way rise to slow, unspectacular returns that, if you used massive leveraging, became enormous. Imagine that eventually, this monstrous distortion of physical markets was uncovered – 100,000 tons of iron, 20,000 tons of copper, etc. were found to be “missing,” just in China’s third-largest port and the investigation is spreading.

In fact, they never existed, the import documentation was fictitious – but the loans given against them were real.

However, the money from the loans is gone, because the housing market has crashed, the currency has changed direction, the whole “sure thing” has fallen apart.

Now wake up. This nightmare is really happening in China and the scale of the fraud being unearthed – and hence of the banks’ losses – keeps growing.

We thought the 2008 crash was bad. What happens when the massive financial Ponzi scheme in China blows up?

The moral hazard of central banking

Central banks like our own federal reserve exist to promote moral hazard. Central banks seek to make recessions less painful by making money cheap and plentiful. If they print enough money, and steal from anyone with stored wealth, they can buoy nominal prices of most asset classes and make recessions less economically painful for those who deserve to feel the most pain — stupid speculators.

With each round of economic intervention, the people who are bailed out learn that the consequences for their wild and irresponsible risk taking isn’t as bad as they thought. In fact, after a few cycles, it becomes widely known that any irresponsible risk taking will be bailed out by the central bank. People respond to incentives, and if people realize they have huge potential rewards for wild risk taking and limited potential for downside risk, people take ever wilder and more irresponsible risks. That is the essence of moral hazard, and every policy of central banks nurture moral hazard into larger and larger financial catastrophes.

Most people don’t understand the economic cycle. After the deep double-dip recessions of 1979 and 1980, people really believed the federal reserve conquered inflation and made our economy immune to recessions. We all existed in a state of delusion and false security. Hyman Minsky noted that long periods of economic stability become characterized by increasing levels of Ponzi finance that introduces instability to the system and promotes the misallocation of resources. The purpose of a recession is to wipe out Ponzi schemes and correct these poor resource allocations. This restores the economy to health and promotes efficient use of resources in those areas where they provide the most benefit.

Central banks in their policies to lessen the impact of recessions prevents this natural cleansing from taking place. The Ponzi schemes of the bubble survive, people don’t learn their lessons about the dangers of Ponzi schemes, and the inefficient use of resources and outright theft of money continues.

Many people envision the Great Reset, the ultimate culmination of Hyman Minsky’s vision. So far central banks around the world have lowered rates and printed more money to prevent this reset from happening, particularly in China. Right now, the moral hazard in China is so extreme that nobody believes the central bank will allow the Great Reset to occur — even the central bankers believe it; however, when you consider the size of the enormous bubble in real estate in China, it’s hard to believe the central bank can print enough money to save it.

If China prints enough money to paper over its bubble, it will flood the world with its currency, and its value will crash. Ultimately, the value of any currency cannot exceed the value of a countries assets and the value of goods and services produced. If China’s real estate is 90% to 95% overvalued as I demonstrated above, the actual value of property based on the income of Chinese workers will force the Great Reset to occur — and it’s not like China can raise everyone’s income by 2000% to support real estate because such high wages would ruin its export base and further destabilize the economy.

The Chinese economy is a time bomb waiting to explode. I fear for the future.

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