Odd Lots - Understanding Evergrande, the Chinese Real Estate Conglomerate That’s Nearing Collapse

Episode Date: September 20, 2021

If you've been following the wild ride that is Chinese real estate, then you've definitely heard of Evergrande. The price of its shares and bonds has been tumbling lately amid concerns about its cash flow and its model. But what really is Evergrande? And who stands to lose in a theoretical restructuring? On this episode, we speak with Travis Lundy, an independent analyst based in Hong Kong who publishes on Smartkarma, about the company's business model and what comes next.See omnystudio.com/listener for privacy information.

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So Joe, how much do you know about China Evergrand? So I was going to start by saying, I think this is going to be one of the episodes where I sit back and do a lot of listening. I'm excited to participate in it, but I know that it's a very big real estate development company in China and they've had financial troubles. And that really is about the extent of my knowledge. I have no doubt that you're going to ask some really interesting questions. But I guess just to introduce the topic, I mean, China Evergrand has sort of loomed large in Asia for a long time. And I think anyone who has any interest in the Chinese economy or Chinese finance has

probably heard of the company. I've always described it as the poster child for politically well-connected but over-indebted Chinese real estate firms. And I know that sounds like a really niche category, but there are actually a lot of companies that would match that description. But China Evergrand was like the ultimate one of those. It ended up being this really weird mix of a property company, you know, a real estate developer, but it also had a health division, and it also develops its own electric cars, and it also has, like, a mineral water business and theme parks. And the interesting thing about the- Did you have like a soccer team? Yeah, I was about to mention. So, and the interesting thing is, like, they've always kind of aligned

themselves with the political goals of the Chinese Communist Party. So for instance, I think in 2014, President Xi Jinping made, like, this throwaway comment about how he wanted China to be a force in soccer one day and he was hoping they would win the World Cup. And like, suddenly China Evergrands starts splurging on this soccer team and spending millions of dollars on players to, you know, fulfill she's ambitions. So it's ended up being this really unique company that is very aligned with Chinese political goals. But what's been happening lately is that it has run into all sorts of financial trouble. To the point that people are talking about the possibility of, outright failure or maybe a bailout or some sort of restructuring.

I am very excited about this one. I mean, I think like, like I said, I don't really know that much about it. I assume that my sense is that the frailties of the model have been understood for some time. On the other hand, when you have a company, as many companies in China seem to be, but when you have a company that has such alignment with the government or with the Chinese Communist Party, you have to assume that betting against it is very risky because in theory there could be infinite bailouts or debt restructurings and so forth. I feel like I will just, I don't know, I will learn a lot about how everything works from this story.

And I got to say there's a ton of interest in this at the moment because some people are talking about this as China's Lehman Brothers moment, although I personally think it's not to go quite that far, but we'll get into it. And I'm really, really excited for this one because we're going to have on someone who I've been meaning to get on all thoughts for a really long time, and I just didn't have the right opportunity. But now China Evergrand has come up, and he's really the perfect person to talk about it. He told people to short the stock in 2018, so he's got the call consistently right for the past three years. We're going to be speaking with Travis Lundy. He's an independent special situations analyst who publishes on the smart karma platform based in Hong Kong as

am I. And one thing I should mention before we bring Travis on, we are recording this on September 15th. China Evergrand is a really fast-moving story. So a lot could happen between now and when this episode actually gets published. So please keep that in mind. And without further ado, Travis, welcome to the show. Thank you for having me, Joe and Tracy. It's a privilege and pleasure to be here. So I guess my first question is, you know, people have been writing and talking about how strange a company China Evergrand is for many, many years now. I described it as this weird conglomerate involving a bunch of different businesses. I think at last count, it had something

like $300 billion worth of total liabilities. Everyone knew that it had had, been borrowing a lot of money. And yet, the financial difficulties seem to have snowballed extremely quickly and come to the four of the market's attention, you know, just in the past month or so. I guess the question is, why now when we all knew about these frailties for some time? That's a good question. I think you're right in calling it a weird conglomerate of businesses. You can see that, you know, originally it was just a real estate developer. And then when it listed in 2009, almost immediately afterwards, they bought into Guangzhou Football Club in the Chinese Super League and then proceeded to turn it into Guangzhou Evergrand and then just Evergrand

Football Club Evergrand. And then they started spending, as you said, millions of dollars on players and they spent an enormous amount of money. Eventually they sold that. But they started a dairy business, a grains and oils business. They started a bottled water business. They're out of the dairy and the grains and they sold the water business. Then they bought the water business back and then they sold it again recently.

The Evergrand Health business was meant to be, you know, health care, but really what it was was really property related to health care. And then they decided to, you know, get into the new energy vehicles, electric cars a few years ago and, you know, political alignment, as you said. they have yet to make a car, but they've taken on a lot of debt. So the company has effectively built itself up and built itself up to be too big to fail. Now we're coming to that in a testing point of whether it really is. And I think what happens here is if you look at the way real estate development in China works, it's a very heavily levered business. It's just structurally, hugely levered for the people who grow quickly. You end up, you put a little bit of, you put a bit of capital down, you borrow a bunch of money, you buy some land, you pay for some of it later,

you build a foundation, you get people to put some deposits up, you start hiring people to work, you pay them three months, six months later, and then as the people put down the mortgage money, you draw down the mortgage money to pay off the contractors. You end up putting a dollar down to put together a billion dollar project. If you end up with $200 million at the end, that's a pretty good result. If you do that again and again and again, you end up with a huge amount of debt. And then you say, great, well, I want to do this again and again. So I need to go buy some land. So these companies have, you know, built up land banks with five years worth of land. So you take down a huge amount of debt to build the land bank and you hope that the land bank appreciates

and the average real estate property price, which is going to go on top of that land bank, it appreciates at a rate higher than your funding. So if you're you're funding a coupon at 10% for your debt and your asset in place appreciates by 15%, you've got 5% carry on a very, very large business. So it's been a very good plan to grow, but you have to keep on growing. You can't ever stop growing. If you do stop growing, you actually have to take on the goal of selling down assets. You have to shrink your gross balance sheet by selling already developed properties or selling off assets which aren't growing fast enough, and then you have to start repaying debt because at some point, if you ever get a margin squeeze,

it's all over. And right now, you ask, you know, why now? And that's really what's happening. We saw a brief dip in the total value of residential real estate sold in 2015. It picked back up again. And, you know, this year, it's a pretty grim environment for everybody. part of that is policy driven. And I think that the government has a significant influence on that to say that the government has set in place policies which make it less attractive to buy real estate and less attractive to sell secondary real estate. And if that continues, then there's there's going to be weakness. What do you just put in perspective of the size of this company? Obviously, we know real estate is this massive share of the Chinese economy.

We know that for millions of Chinese citizens, real estate is a sort of crucial savings and investment vehicle. How big is the industry and how big of a role specifically does Evergrand plan? The industry is, it can be difficult to measure. There are different ways of looking at it. One way of looking at it would be to say that, It's about 16 to 17 percent, I think, of GDP, which is, you know, high. It's higher than the U.S. was, I think, in 2007.

It was higher than Japan was in 1989. If you take the combination of residential and commercial construction and development, we're talking close to 30 percent, which is, I think, not quite double the peak of the Japanese experience in the late 1980s, early, very early 1990s. Evergrand was the second largest in terms of sales last year, I believe. If not quite the largest, they trail Vankey, I think, ever so slightly. You mentioned $300 billion of liabilities. Yes, that's the number.

$300 billion of liabilities. That's not perhaps everything out there, because one of the ways companies deal with their business is that they develop things where they don't actually consolidate it. They go into a joint venture. They buy the land in 2016. They sell it to a joint venture in 2017. The joint venture starts building things in 2018.

They do contracts with Evergrand, but the actual ownership of that vehicle which is doing the development isn't more than 50% owned by Ever Grant. There are a bunch of developers in China which have an extraordinary amount of their assets and sales coming from those joint ventures. The companies are basically tied to Evergrand or tied to the developer in question, branded that way. Everybody knows it's exactly that particular developer, but they're not accounting-wise. They're not consolidated on the balance sheet, which means the debt which is on those entities

is also not consolidated. We just don't know how much there is. Among the companies, if you talk to them and about them, Evergrand will claim to not have that much of that kind of debt. Others will. A company like Sichuan Languang or Al-Yuan had substantially more debt in the JVs. If you look at the employment, it's officially something like 160,000 employees. It's something like 1,300 project sites across 200, I think 270 cities across China. It's a very, very big operation.

The average project takes between 12 and 24 months. It involves really many, many hundreds of thousands of workers in Evergrand and in the supplier community. I saw something on Twitter in one of your... one of your competitive stories, that the $300 billion was 2% of China GDP. I'm actually not sure of the number, but that's a big thing. However, if you look at the next largest liability total out there, it's country garden holdings, and they're also competitive in the same space, and they're about $270 billion in liabilities. And then Vanky, which is the healthier big dog in the tall weeds, they're about $270 billion.

and $50 billion of liabilities. The industry is very big. It's a very big piece of the economy. Those liabilities mean debt which needs to be paid to banks. It means payables which need to be paid to contractors who have done the work but haven't gotten paid yet. Taxes to be paid, it's employee salaries. And it is, of course, homes which have to be delivered to millions upon millions of people who put down their hard-earned money to buy their dream. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world.

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And on the West Coast, catch up in the evening. That's the Bloomberg Law Podcast. with me, June Grasso. Subscribe today wherever you get your podcast. I want to get into the sort of funding mix or the creditor mix in a little bit. But before we do, you mentioned China clamping down on the real estate sector. And, you know, you and I are both in Hong Kong. So I wouldn't ask you if this was a policy mistake by China to actually, you know, go after a sector that makes up something

like 30% of its GDP at a time when there's a global pandemic and an economic slowdown. But what I would ask is, isn't it a little weird that we've had this crackdown, the three red lines policy for over a year? I think it was like introduced in August of 2020 and it was supposed to make the real estate sector safer and start cutting down on leverage there. So we've had it for over a year. And yet like it seems like people weren't really paying attention to it until potentially the summer. And suddenly it kind of exploded into the public consciousness. And it became clear that this was actually a problem for a company like Evergrand. Yeah, we can actually go back a little bit further. Evergrand had its explosion in the

stock price in 2017, 2018. In 2017, Chairman Huay Kayaam became the wealthiest. The man in China. At the time, he also said, we want to reduce debt. At the time, in the mid-teens, late-teens, Evergrand was issuing a lot of bonds. They were issuing a lot of bonds at a relatively high coupon. By the time we got to the end of 2018, the PBOC had decided they were large enough and, you know, basically publicly made them and the world aware that they were, you know, red-flagged for being a very indebted company, which could cause some systemic risk if there were a big problem. So that was November 2018, where it's almost three years ago. In early 2020, I think April 2020, the chairman stood up and said, we plan on reducing debt by 450 billion

R&B over the next three years targeting 150 billion R&B per year. And then the summer kind of progressed. The shares were down in May and they entered a buyback program and they bought. the stock, I'll be gentle about how I say they bought the stock, but the stock went from $13 to $20 in the space of probably six weeks. Just a couple of days into July, they released a press release saying, hey, we just did really great in the first six months of the year. The stock jumped 40% in three days. The stock dribbled back down. The company sold some shares in some of its units, which had done well. And that was, I think, to raise capital. And then they warned, they came out with a profit warning. Now, you're out there saying, we're going to do

great things, and we're buying back the stock, and you're buying back the stock into the end of the first half, and you know what's going on here. And then you come out with a profit warning. That's not exactly something which is terribly encouraging. Four days after the profit warning, they were called onto the carpet to talk about the red lines, and then four or five days later, we had that episode of the magic letter, which wasn't real, but, you know, caused some concern. I think at that time, people understood. They'd been warned that they had to reduce debt, and that was the line in the sand, where that red line meeting came in. Just around the time in the meeting, it was pretty clear that the PBOC and the CBIRC had decided that banks were not

going to lend more to the real estate developers. And so they had already been quietly rejecting them, and then the red line meeting went through, and then they systematically started rejecting them going forward. I think that people ignored the risk, and maybe, you know, the letter being denied regarding the possibility that Evergrand get help from the Guangzhou government. Officially, that made everybody, you know, comfortable. Un Officially, you know, they launched a an equity offering, which managed to sell about half of what it wanted to sell. The stock went, it was a huge discount. The stock went down, you know, 10, 15 percent in the following week or two.

They bought back some stock. The stock rallied a bit. They canceled their program to list Hungda in the A share market. Things just kind of snowballed. And I think that people were complacent. I think that's the safest thing to say. that it's obvious. It was, if things are slowing down, that's something which just, it rolls into a problem

relatively quickly. Even though it's not a problem yet, it rolls into a problem relatively quickly. And, you know, the credit market was relatively prepared for this. I mean, back in November 2018, when the PBOC said that, Evergrand went out there and raised money at 13%. So it's not as if the market was unaware that this deserved a very, very, very important. high credit risk attached to it. I don't know that commentators in general were that tied. You know, obviously, you had Dan Wang on. He was talking about how this sector had really taken over the

imagination of how people invest in China. And it had gotten maybe a little bit out of hand. Well, you know, real estate developers have not been a very popular place to be invested. So it's not like hedge funds go chase their equities. High-yield investors like them because they think that the sector itself is too big to fail. But I don't know that the level of interest has been high enough to sustain ongoing conversation about the danger. Can we talk about this too big to fail question? Because I brought it up, I think, in the intro, and from a very distant perspective, this seems to be one of the problems with any sort of shorting of China. And, of course, for years, people have talked about leverage and debt and unsustainable speculative booms and banks that make all kinds of bad loans.

And, of course, the real estate developers. And yet there is this perception that at least for many companies, either they are state-owned or highly state-affiliated. And that means it's very difficult to bet on their demise. Can you talk a little bit about, I guess, perhaps the gradations of too big to failness and how much that's worth to various companies to be seen or to be affiliated with the state or with the party such that that does provide investors with some level of protection? See, Joe, that's a good question. That is a good question. It's a sensitive question. And I think it's, I think that the sensitivity and actually the answer itself will oscillate with the times. If you look at real estate by itself, there are some SOEs, state-owned enterprises, who are in the real estate business, but there are a number which are private. Those which are private have always had to have, you know, political connections.

How you actually get your hands on the land in the first place is a really good question. You know, you have a government sales process. Well, you know, government sales processes across the way. world are sometimes questioned for their fairness. And when one particular party ends up with a very big piece of that business, one wonders even more. So there are obviously all kinds of interesting problems about discussing what the opportunity set is for a private company when they're competing against Cato and Enterprises. And what generally private companies end up doing in China, is they go find a niche and they find a niche which state-owned enterprises aren't doing,

or they find a niche which is politically supported enough that they get support by themselves from the local governments. You know, Evergrand is a company which does a lot of, they spend a lot of money selling and they do a lot of stuff in second and third-tier cities rather than first-tier cities. And that endears them to a large number of cities because they provide funding through the land sale process to a large number of cities. They are politically connected. They are, they are a partner, as much as you can be. Anybody who's that big and that important to the local economy is a partner. And so then the question becomes, would they get pushed out because they're, you know, not an SOE? I think it's difficult to say, though I think

that if you go back to what your podcast with Dan Wang touched upon, there was really a question about whether unbridled speculation and unbridled land grab, forgive the pun, is an appropriate use of the national resource. And as Dan said, you know, a very common phrase these days picking up more and more interest in both the local and the international press is common prosperity. And, you know, one guy who's the biggest, the wealthiest guy in China, based off of selling the savings assets that millions of Chinese people will then own as their primary source of household wealth, you kind of wonder whether that's in line with the common prosperity. So I think this, the idea that President Xi Jinping had come up with, you know, years ago at this point, which is that housing is for living in, not for speculation. I think that came over the top. And obviously some of the other policies that Xi Jinping has come up with have been pushed relatively hard more recently. And you asked the question, Tracy, about whether this was a wise idea or maybe we don't ask the question whether it's a wise idea. But the goal of making housing affordable when it grows out of affordability every single year, it grows further and further away from the range of what a median person would call affordable. Bringing that back in line is is kind of an

obvious thing for a centrally managed economy. I think the real question one could ask is, why did it take so long? Sorry, do you have an answer to that or a thought? Yeah, I was going to say, what is the answer to that? What is the answer to why it took so long? I think that the Chinese Communist Party led by Xi Jinping is and has been, if you look at, if you look at, you look at at the writings and the emphasis on policy and policy study and study of his philosophy, governance of China. The goal really here is to instill a sense of Chinanness and unity across the population. It doesn't work on all people immediately. And so the goal here is, I think, to, you know, as they increase the number of Communist Party cadres sitting inside the Communist

Party sell inside a company, or they provide guidance, or they try to direct GDP in a certain direction. Companies like Evergrand or, you know, indeed, bank your country garden, they're all kind of, they're pulled back and forth. You can't get smaller and shrink suddenly in order to save yourself because that would hit GDP. And you can't default on things because that would hurt the homeowners. You know, one of the big places where people protest in China is actually when housing developers lower the prices of the properties they sell. That's kind of a weird thing. But what happens there is that the existing property owners don't want to see a mark-to-market at a lower price when it's, you know, sold to somebody else down the street. That

makes them feel really bad. And they get really upset and they go protest in front of City Hall. Now we've got slightly different protests this week, but historically, developers have been, you know, obviously self-interested in producing profits and producing size, but they have been constrained by not causing systemic risk. Indeed, the PBOC called Evergrand onto the carpet a couple of months ago and basically said, get your debt in debt house in order, but at the same time, don't cause systemic risk, which was, I think, code for don't lower prices too much, because it'll affect, you know, how all the other developers are out there. So why did it take so long? I think if you look, the central government is not quite as all-powerful in terms of managing

local business as people seem to think it is. When it comes to really big policy, changes. Yeah, that's the permit of the state council and the party. When it comes to, does somebody buy this piece of land, does somebody build a project on this piece of land? Will that cause excess housing in that particular area? That's not the state council coming down on that. That would be the local government. But the problem is the local government is incentivized to sell the land in the first place because that's how they fund themselves. So really, there's an entire ecosystem here. You know, private property ownership really didn't exist until just over 20 years ago. And then in 1998, there was a new law which allowed a land management law, which allowed local

governments to sell the land and transfer the land usage rights to private parties. And that finally allowed them to cover their budget deficit because in 1995, there had been a budget law in the run-up to the Asia financial crisis, they've been a budget law which required the local governments to, A, balance their budgets, but also not borrow money from external parties. So they had their hands tied. And so when you had the ability for them to sell,

they grabbed that with both hands and they started selling. That's how they've been funding themselves ever since. So you have the local governments in bed with the real estate developers who are all kind of aligned with seeing property prices, prices go up because they own the land bank, which they bought five years ago. And then all of the populace, you know, that's their savings vehicle. Obviously, they want the value of that savings vehicle to go up. So no one's really interested in seeing prices go down except for those people who don't have

real estate already. But, you know, home ownership is relatively high. I think that description of the sort of patchwork of incentives at play is really, really important and probably an underappreciated point when it comes to the way people think about the Chinese government and the economy. One thing I wanted to ask you was, you know, on a related note and also just going back to the common prosperity point, could you perhaps describe a little bit what China Evergrand's relationship is with, you know, the average retail investor or homeowner? Like, how exactly does the company interact with those types of small creditors? because I think that that's probably going to play into, you know, our next question, which is going to be, what are the chances of financial contagion and, you know, what might the end game here actually look like?

Right. You asked about the way that Evergrand funds itself, and I think it's worthwhile thinking about that. Basically, if you look at the balance sheet right now, the balance sheet is something like $12 or $13 billion of underage. restricted cash. It's about, you know, $25, $30 billion of receivables, and it's about $200 billion of inventories. That's stuff which is work in progress or stuff which has already been built. That's the asset side. The liability side is something about $90 billion worth of interest-bearing debt. That is to say, you know, U.S. dollar bonds, which foreign investors know about, or local bond issuance under the local entities. And then there are another, call it $180 billion worth of on-balance sheet supplier payables and contract liabilities. Those payables, they are

depending on what financial statement you're looking at, they will either be trade payables or other payables. But embedded in that is a bunch of commercial acceptance bills, which are basically commercial paper issued to the suppliers. The suppliers then take it. It's probably got a three to six month maturity. And if they really need the cash, they'll go to a bank and say, buy my note from me. And then the bank will charge a certain interest rate on that.

There's no interest paid on the note itself. It's just a zero coupon note. The company will then issue those notes also to people who they owe money to, you know, for random reasons. Sometimes they don't actually pay those off, and we saw some situations here in July where the company paid off some of its trade payables by delivering them apartments, big swaths of apartments. And they deliver them, you know, call it a 20% discount to the market value of the apartment, and then they let the recipient of those apartments go off and do what they want. sell them or not sell them. Sometimes they have a lock-in. If you look at that inside the debt portion, there are loans and there are what we call trust loans. Some of those trust loans are interest-bearing.

Some of those trust loans are non-interest-bearing zero-coupon assets. Some of those are sold to trusts, which are often they're called wealth management products, W&Ps, and the WMP manager will buy those inside a portfolio of a whole bunch of debt issuers and they will provide an income stream. It's like a short to medium term bond fund. Sometimes those commercial paper notes will be sold to investors directly by a bank and sometimes they will be put into a business which Evergrand itself set up. Evergrand set up a financial entity which was a wealth management product issuer, which meant that it bought these notes.

And basically, they ended up stuffing a whole bunch of Evergrand notes into this entity. I don't know what the waiting is. I have kind of a creepy feeling that it's extraordinarily weighted towards Evergrand notes, but they encouraged employees to buy them. They encouraged employees' families to buy them, contractors to buy them, et cetera. So, for example, they end up with the note,

the note gets paid to the contractor. Then they go off to the contractor and say, please put the money that we just paid you here. Please invest in this other note here. It yields 10%. And there's a little bit of a pushing and shoving to see what they can do that. So there's a group of trust loans which are in the wealth management products offered by Ever Grant itself.

There is a group of these commercial paper or commercial acceptance bills stuck in the wealth management products offered by, you know, independent asset managers. All told, retail has exposure to Evergrand paper in a concentrated way to something like 40 to 60 billion Rmb is what I've read. In terms of a non-concentrated way, it could be larger. So I saw a quote just, you know, a couple of days ago suggesting that the number of people invested in Evergrand WMPs was something like 70,000 people. Wow. It's a lot.

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and sometimes it has to do with a local real estate developer. We'll be cutting prices on some unsold properties, and people who recently bought the properties are really upset because, and you described that a few minutes ago, how angry everyone gets at the thought of a property cuts or price cuts when everyone needs the prices to go up. And then we're recording this September 15th. I think earlier this week, maybe on the 13th. There are these videos of protests again. Who is protesting? What is the specific complaint or cause of action this time? I've seen a few videos and I can really only

go by what's in the news. So just to just to cover that. Some of the protests appeared to be employees protesting that they hadn't been paid. There were protests today suggesting that some suppliers were looking to get paid. Protests yesterday were, I think, about trust product buyers demanding their money back. There had been an announcement by the company to its product buyers that they would seek to restructure the payment. So you would get, for a hundred cents on a dollar, you'd get, you know, 10 cents soon, and then you'd get 10 cents every quarter for the next 10 quarters. And if you wanted to, you could instead receive an apartment at a 28% discount, or you could receive a parking space at a 52% discount to the market value of the apartment or the parking space. That wasn't received well. Basically, people are saying, you know, well, you can promise you have pay me $100.

for two and a half years here. But, you know, what if you go bankrupt later this year? I want my money now. And that seems to be a sentiment which is increasing. There was situations at the end of August, I believe, where a couple of institutional trust managers who had been told that Evergrand wasn't going to be able to pay off all the money at the maturity of the paper, they said, I want my money back. And Evergrand said, well, you know, I'm going to have to delay you. Let's have a mutually agreed result on this and the trusts said, you know, I want my money back. There have been companies who have said that. There have been contractors who say that. There are individuals who say that. I think the more that this gets in the paper locally and the more that it passes around,

you know, Chinese social media, the more that it happens and the more likely they're going to be either planned or spontaneous eruptions of displeasure. I think that it happens. I think, I think when people have a very large portion of their savings on the line and they can see the rest of the market not having a good time of it, you know, property prices declining and declining, ever grand offering ever bigger discounts month by month, those people who are already invested, that is to say they've already put down their deposit, they've already taken a mortgage, they've signed a presale contract, they just want to be sure to get what they paid for. They worked a long time. They went into debt. They borrowed money from friends and family. And now they have their thing. And suddenly Evergrand is threatening them with the loss of their life savings. I think that that's that kind of sentiment is not, shall we say, unworthy. People invest in what produces a return. And when the Evergrand notes were returning 10% and 20% people put the money in because obviously, you know, Evergrand's a big safe company because, well, They are, you know, housing in Guangzhou. And I think that this is a delicate, this is a delicate situation here where the government has to figure out who they're going to play nice with and who they're going to play less nice with.

What's the possibility for wider contagion here? That the troubles at Evergrand start reverberating through the financial system, you know, potentially start affecting other real estate companies. You've done a great job of describing the funding mix and, my understanding of it is a lot of the domestic stuff seems to be somewhat secured, a lot of the offshore stuff, you know, maybe there's more of a question mark around it. But where exactly could we see Evergrand Troubles morphing into wider pressure points on the Chinese economy? That's a good question. As I mentioned before, there's a, there is a, an underlying context here where

the government is trying to, shall we say, slow down real estate speculation. And that affects everybody, including Ever Grant. But let's imagine Evergrand were to be saved. Someone comes up and says, hey, Evergrand, you've discovered the cure for cancer. Well, that doesn't absolve all the other companies in the industry from their collective sin, shall we say, over the past decade. I think that The two parts here are how much of this situation is driven by the market itself and how much of it is driven by contagion from Ever Grant. There is obviously some contagion. You can see this in the offshore high-yield bond market. Once Evergrands started tanking, a whole bunch of the other ones started tanking because people needed to start selling their exposure, their Chinese high-yield bond exposure. and developers make up a very large portion of any portfolio.

If you look at what Vanky said in their comments in July after the first half, it was very clear that they had expectations of weaker second half. They said the first half was weak. The second half is going to be weaker. And we really don't know where it's going to end up. And, you know, the development business is not a great business anymore. And that's a little bit interesting because Vanky had, you know, gone a little bit unfocused a few years ago and then refocused on the development business. And now they're finally saying, you know, we need to we need to broaden our income stream here.

So there's more fee-based and less, you know, development base. I think that the entire industry is facing a slowdown here. The debt was taken in the good times and now the debt has to be paid in the slower times. That hurts everybody. In terms of contagion, I think there's a, the analogy that I would look at here is the pizzeria. The pizzeria goes bust, but that doesn't stop the people from eating pizza. You know, the workers at the pizzeria are going to go find another pizzeria to work in. Maybe the owner will go, you know, borrow some money and start another pizzeria.

But the people will have their pizza. The troubles that Evergrand is running into here are somewhat Evergrand specific. They're very highly levered, but there's also an underlying. context of government suppressing land price growth and suppressing real estate speculation. And, you know, there's some aspect of people being full. You know, they've built a lot of property. And if you build a little bit too much too quickly, it takes a little while to digest. And if you have the magic moment here where policy pressure comes down and debt pressure is up and financing pressure is immense, you could see, you know, some pizzerias going by.

So I love the pizzeria analogy, by the way. But one of the big questions that the market seems to be focusing on right now is what happens in a restructuring scenario. So ostensibly, you have creditors of different seniority who will get owed money, you know, before other creditors of other types of seniority. But on the other hand, you know, you've laid out perfectly how politically sensitive. a lot of this is. And I can't imagine that the Chinese authorities would be happy, for instance, to see a bunch of banks get paid back before retail investors who are currently protesting outside of Evergrand offices. Yeah, it's a good question. And obviously, everything is in flux. However, I think that if you start from the ranking of who ends up coming out well on this, if you had to ask the Communist Party of China, who's the most important stakeholder in this? Obviously, it's the Communist Party of China. They're number one.

The second one is going to be the prospective homeowners, which number 1.2 to 1.5 million people, depending on who you ask, they have deposits or they have mortgage, and they're waiting for delivery of their product from Evergrand. I think third in the list would be the 160,000 plus workers who get paid and the hundreds of thousands of other workers who are contractors to the projects. These are the pizzeria employees. Inside there somewhere, there's probably a ranking of people who have already done the work and are waiting to get paid. You know, the contractors who are not in line to do another contract, but they already did the work, and they've been waiting to get paid for six months, and they still haven't been paid. They should be paid already.

You end up with the people, shall we say, at the top of the list. Below that, you end up with investors, I think, in onshore ever-grand debt. Those would be the banks and the trust products. And the question is, do any of those get a haircut? And the answer I think is, and this is just my opinion, but I think that everybody takes a haircut. I think that haircut gets delivered through delay, but it could also get delivered through an option. You have a chance to, you get, call it 70 cents on a dollar now, or you get 100 cents on a dollar plus a 2% interest rate if you take 10% each quarter for the next 10 quarters. And obviously those percentages could change.

in terms of the question about offshore bondholders and equity holders in the company, oh boy, that's a really good question and one where I recommend not being long. Let's put it that way. I think the issue here is that there are layers of seniority even above the ones which are obvious. Evergrand owns a bunch of assets like its subsidiaries, Evergrand Property Services and Evergrand Auto, and Fang Chevao, which is the FCB, which is the online marketplace, which is said to be worth something like $20 billion. They've got a bunch of assets sitting on the Evergrand side, and then they also own 60% of the real estate operations which are onshore. Those 60%, that company owns several hundred companies, you know, somewhere between 500 and 1,000 actual subsidiaries plus equity interests and a whole bunch more. which they don't break out. And every one of those companies downstream owns a project or operates a

project. And that project has an asset. And it probably has a liability. It has bank debt, local bank lends against the real estate, which is inside that little project company. If push comes to shove, that guy gets paid first. That bank gets paid. Then the project guys get paid. And then if there's anything left over from that project, then the equity gets paid up the hill to Hengda. And then that goes to pay off all the debt, which is at the Hengda level, which is not secured against assets. Then if there's anything left over, that goes to the shareholders of Hungda, of which Evergrand is 60%. Now, some of that may end up flowing up, but may not, and then Evergrand itself has a bunch of offshore debt plus its equity. Now, if we go back to that, that

that matrix or that ranking of people who need to get paid, my gut says that the offshore bondholders are probably in the worst spot. The offshore equity holders is a question. And I'm going to put that in a way which maybe is not very politic. But it's very rare to see insiders and founders, especially those who are politically connected, losing their stake in a restructuring. So if you look at the Kaiser restructuring several years ago, also in the real estate sector,

they tried to cram down bondholders. Eventually the bondholders got paid, but they really tried to make the offshore bondholders suffer. But the founder didn't lose his stake. And if you look at some of the other equity situations where there has been a restructuring, but there has been no complete bankruptcy, been a managed, or organized restructuring, it's not clear that the equity holders lose. And, you know, the chairman of the way is politically connected. He was the wealthiest man in China. He was on the dais at the 100th anniversary. He's a member, I believe, of the people's consultative conference.

He's a tough man to knock down, I think. And plus, he owns 77% of the company. If there was a restructuring, you might find that the equity in the restructuring, he was given a chance to redeem himself through sweat equity, perhaps a little bit like the managers at Noble Group, which effectively forced a restructuring on their bondholders, and they got some equity, but management ended up, I think, taken 20% of the company out of that. You could see a situation where the equity holders who have insidership are not damaged as much as equity holders who don't have insidership. So I think it's the people at the top where, you know, if you asked 100,000 average Chinese people on the street, what do you think is fair?

I think if you take their answers, that would be a pretty good indication of who should get paid first. And obviously that means that foreign equity holders and foreign bondholders are at the bottom of that list. Well, Travis, you've laid out a really complicated issue very, very well. So thank you so much for coming on odd lots. Yeah, I'm glad. I'm glad we can finally, finally get you on to talk about Evergrand, no less. So thank you so much. It's been my privilege.

Thanks, Travis. Thanks, Travis. That was great. So, Joe, I really enjoyed that conversation. And again, one of the very interesting things about China Everground is people have been warning of weaknesses in its business model for a long time. And it seemed like everyone just kind of look through them. you know, it was this idea that China can just keep rolling over debt indefinitely. And then finally, in 2021, they seem to be actually coming into the fore and everyone's paying attention to them now.

So that's point one. The other thing that I thought was very, very interesting or very relevant was the way Travis laid out the importance of real estate, not just to the Chinese economy, but basically to society, right? Right. That was really interesting. That's just sort of like this. society-wide need to have real estate prices go up. And I also thought it was interesting, too, to see some of the tension, and he talked about a bit at the end in response to your question, some of the tension that emerges between the formal seniority of the capital structure versus the political realities of capital structure.

And so, you know, you think like at a traditional bank, like, depositors at a bank are typically the last to get a haircut, right? You know, it's like you do everything you can. The bondholders get hit. The stockholders get hit. Only in the most extreme situations do you hit people who are sort of like retail depositors or customers. But when you have entities that are as complicated as a real estate company and you have employees that are getting paid and wealth management products and customers who own a house and part of their expectation or part of the purchase of the house, is the assumption that home prices only go up. You can start to see where you have this sort of bifurcation, so to speak,

between formal capital structure seniority and what people think is, like, right and just. And I feel like a lot of the tensions that we're seeing with Evergrand have to do with sort of this divergence. Totally. And I would say there are still so many unanswered questions swirling around Evergrand, and no one really knows what's going to happen. But one thing I would say with some certainty is that if, If there is a restructuring, it's going to be a really interesting and probably intense workout process in terms of who gets what haircut.

Yeah. The one other thing I would say is I'm just thinking about China trying to rebalance its real estate sector overall and bring down leverage and try to de-risk the overall industry. And I'm thinking, again, back to that point about housing being such a big part of the economy and society. And in many ways, the Chinese government has incentivized home ownership as a place for people to put their money. I mean, in China, there are capital controls. So people have limited places. You can put it in stocks. But, you know, those are pretty volatile. You can put it in wealth management products, but the government doesn't really want you to do that anymore. Or you can

buy a house. And now that seems to be in doubt. So I'm wondering, like, where will that excess ball of money kind of roll into next if that outlet gets cut off or put in doubt. Right. And then it gets to all kinds of questions that, you know, we could have like Matt Klein or something or Michael Pettis back out of the show and talk about, you know, financial repression of workers and households and the lack of income they get and the way this forces them to engage in speculation as a matter of course because they don't get enough from income. So all of these things seem to stem from prior policies that had some other goal. And Evergrand seems like a particularly florid result of many, many economic decisions that came before it.

Floreid result is a good description. I like that. Thank you. Thank you. Okay. Shall we leave it there? Leah, let's leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. you can follow me on Twitter at Tracy Allaway. And I'm Jill Wisenthal.

You can follow me on Twitter at The Stallwart. Follow our guest on Twitter. Travis Lundy. He's at Travis Lundy Asia. Follow our producer, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts.

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