WRFH/Radio Free Hillsdale 101.7 FM - Wall Street Weekly: Not Much Grand at Evergrande

Episode Date: February 2, 2024

In this episode, George and Patrick discuss the recent CCP-forced liquidation of the Chinese company Evergrande and analyze its similarities to the 2008 housing crisis. In other news, the U.S tries to establish itself as the worldwide leader in AI for years to come.

Welcome to Wall Street Weekly, a show where your host, George and Patrick, cut through the financial jargon to keep you educated and informed about the markets that affect our lives. Enjoy the show. You're listening to Wall Street Weekly on Radio Free Hillsdale 101.7 FM. My name is Patrick Scott, and with me is George Akela. And today we're going to talk about the Chinese Evergrand Company and also AI and what the recent story in the headlines is all about. Just as the future of AI is unclear and perhaps even risky, so is investing. And that's why this show is for entertainment purposes only. And you should always consult trusted financial authorities before making any decisions.

Patrick, how did you like that tie-in right there? That was pretty clean. It'll pass. It'll make the airwaves. Okay. So let's jump right in with the Evergrand story to understand this company, which is a very significant company that most people had no idea existed until maybe this week when it declared liquidation. It had declared bankruptcy or insolvency earlier in 2021 when it wasn't able to pay debts. But to unravel this story in 22 minutes or less, you have to understand Chinese culture as a whole.

From what I understand, the home is a big part of their culture. And I've got data to back it up. The average American spends 28.5% of their wealth and their home's equity, which basically means that 72% of what you own is going to be tied up in material things like cars. but most likely it's going to be your 401k mutual funds and those type of equities and bonds. Would you say that that's a high number or a low number for equity, I guess, compared to the rest of the world? Compared to the rest of the world, it actually seems maybe a tad bit low, but when you start getting into Eastern Asian countries, that really goes up. So for the Chinese, that number actually balloons to 70%. So 70% of each family's wealth is tied up in their home?

Yeah, that would be tied up in their home. and a lot of people, it's their primary residence versus other real estate ventures. And over the last few decades, there's been a lot of homebuilding activity, as hundreds of millions of Chinese citizens have left traditional subsistence farming in favor of manufacturing, retail, and construction, which translated into a much higher demand for urban housing. This is a story of incentives, like the Great Recession, as Patrick will talk about. When you look at it now, it seems crazy or unthinkable that a company could have gone

$350 billion into debt like Evergrand did. But when you realize the incentive structure that was presented, you might leave wondering whether you would have done the same thing had you been CEO of the company. Real estate developers were printing money for the large part of the last couple decades. And to beat out the competition and build more quickly, they needed leverage. They needed to use money that wasn't really their own money. And foreign investors were more than willing to funnel money into one of China's biggest companies. exchange for bonds, which bonds are debt instruments just like you might get a car loan if you're buying a car. They're just getting loans for the real estate that they're producing. And even as

cracks became visible in Evergrand's business development, many investors refused to believe that the CCP, the Chinese Communist Party, would allow a big real estate developer to fall. There was always this idea that the government was going to be the backstop to limit any downside risk. The only thing you needed to price in was the upside. You mentioned cracks in Evergrand before it started a fall. Do we know what they were? A lot of it was their model of robbing Peter to pay Paul. We'll talk about that a little later, as right now we're just trying to look at the upside of Evergrand's business and maybe if we would be bedazzled investor, what we would have seen. Their CEO, Huay Kyan, who is also consequentially, the majority owner of Evergrand Group, was a darling to the Chinese political establishment.

He was a part of the CCP's 2015 delegation to London, and he also endeared himself to a lot of the politicians because he owned one of China's most successful soccer clubs, and China actually has made a big push to become one of the top soccer countries in the world. Obviously, international competition has shown that they're not there yet, but it's something they really want to dominate in because it would show overall Chinese domination in a weird sort of way. Yeah, well, that's interesting, you know. outside of the U.S. if you want to get good public relations by a soccer club and do well. Because if you don't do well with soccer club, then you're definitely going to be hated. Yeah, public perception can turn on a dime. As I mentioned before, in 2021, Evergrand first defaulted on an obligation, which was bad, but those were to foreign investors. In January of 2022, it defaulted on some Chinese citizens' obligations.

So Chinese citizens lent Evergrand money. A lot of times it was through like a savings. account. You could put money towards the real estate sector so you could earn a return on that. And people actually protested at the main office. In September 2023, their CEO was placed under police surveillance after Evergrand's stock price hit nearly zero. On Monday of this week, the CCP formally announced that Evergrand would be forced to liquidate what assets it had. Evergrand had been making the case that if we can just stay in business for a couple more years, we'll become profitable again, and we can repay our debts.

The judge said, no, you're just going to keep losing money for investors. Cut your losses right now, sell everything, and try to at least get these guys pennies on the dollars that they lent you. Well, earlier you mentioned how first they were defaulting on some obligations from foreign investors and then they were defaulting on citizen obligations. Is there a reason why the citizen one is worse? I think it's because of public perception. Okay.

And that, you know, foreign investors, you factor that a little bit into your cost calculation, they were getting paid high interest rate because these were seen as very risky bonds. And so people got less sympathy than the average Chinese citizens who are working a nine to five and all of a sudden they're not getting the payments that they deserve. And a big problem with the debt that they owed both citizens and foreigners is that it can be a very useful tool, but debt can also make incentives worse. Without debt, a construction company would have to be more cautious to measure perceived demand before they built an apartment complex. And in many cases, Evergrand built complexes without the assurance of any buyers. This strategy had worked extremely well

when the Chinese economy was booming and people kept moving to the city. But obviously, that strategy quickly turns sour. Well, I think another thing that's interesting here is how they're focusing so much on housing for just massive numbers of people. Obviously, you've got huge cities like Shanghai. I assume they're putting apartment complexes there too. But that's really interesting because sure, China is one of the most populous places. But you also have to factor in like the birth rate in China and how abysmally low that is. For the future, is this really the best business option perhaps? Just massive apartment complexes if you know that in the future China just might not have a lot of citizens.

It's a very tough business going forward. And I think it normally would be even if there were zero empty apartment complex units right now. Some estimates have it between 65 and 80 million housing units that are currently unoccupied right now. But for a country of 1.4 billion people, and that number doesn't look to grow in the foreseeable future, that's a large percentage of housing as almost a buffer between when you really would need to, I would assume, even build more housing at this point. So yeah, the construction companies have it really tough. And I'm sure that factored into the judge's decision not to let them continue operating

to try to pay off their debts. Evergrand also had been robbing Peter to pay Paul, as the old saying goes. What happened is when person A bought an apartment in China that had yet to be built, it includes a significant down payment. So if they're buying a $500,000 apartment, it would maybe be a $200,000 or a $300,000 down payment. Well, instead of using that to build that apartment complex, they would use it to build a different apartment complex. Why would they not just do it with the first apartment complex? because it would take time before that one was being built, months of buffer before you receive the payment and then can put that money back to work for you.

Instead, they put that money towards an apartment complex that was just starting to be built, and then for Person A, their apartment can only start being built when Evergrand gets more buyers below them. It's not quite a pyramid scheme because the base doesn't get bigger at the bottom. It's just a one-for-one, but basically you're using someone else's money

to pay an obligation that you already incurred, and hoping you can get other people to pay the person you just robbed and forward and forward. And eventually, when that bottom person doesn't exist anymore, you're kind of left out to dry. Right. Got it. And when I was thinking about this, it seemed similar to 2008, maybe not necessarily like the pyramid-ish aspect to it, but just the widespread building of housing that there wasn't necessarily even a demand for. Yeah.

So I'll get into this. And so it sounds like with the Evergrand, it's basically like they're just getting ahead of themselves. right they start building and then they decide to try to find the people to live in them and pay up for those apartment complexes and it is sort of just like a domino effect because if they can't find people then right as you said they're just left out to dry and it worked in a bit of a similar way in 2008 so in 2008 on a microscopic level the problem was that a homeowner would make a loan to a bank The bank would sell that loan to the investment bank, so that the investment bank would receive the payments from the homeowner and carry the risk. The bank would loan money to the homeowner.

Right. The original bank would loan money to the homeowner, and then the bank would sell that loan to an investment bank. The investment bank then makes what's called a mortgage-backed security, and if you listen to our earlier episode on Wall Street's biggest bets, then you remember that MBS mortgage-backed securities, that's, That's when the investment bank takes that loan and combines it with a bunch of others. And that's also called a CDO, a collateralized debt obligation. So then the investment bank would take that CDO slash MBS, and then they would sell it to investors, and then they would take different portions of those CDOs and MBSs, and then make another one with the different portions of the different CDOs originally.

And it's super complex, but that's the point, right? it's super lucrative based on all the interest rates and risk shifting around, but it was so complex that people couldn't see the problem. And that is that risk is shifting around so much that if the original homeowner does not make the payment on their home, it sort of starts this domino effect. And then all of a sudden, all of those players in that system are going to be affected by, you know, the homeowner not making a payment on their loans. And of course, you know, we've talked about how the MBS is a collection of hundreds or even thousands. of loans. So therefore it's diversified and it's safe, right? Well, that's what the problem with 2008 was, was that they were using subprime loans, right? Because they were running out of, they were running out of home loans mortgages to put into those MBSs. And so they had to look for

less than reliable people to make home loans too. It reminds me a little of 2020, and this was a story that got brushed under the rug a little, but when there was some forgiveness or it was like decriminalized to be a squatter because they expected people not to pay, make their payments for things like Airbnb or rent payments. And the general consensus from a lot of people were these landlords, they have enough money, they don't need, a month or two isn't going to kill them, when in reality you're requiring one payment to be able to pay utilities on six other apartment complexes. And if you can't do that, like the whole, the first domino falls and it can really have catastrophic effect and I think that was partly what was happening in 2007 and I think that was

partly what you're saying what was kind of happening in 2007 2008 right and it's interesting with the great recession case that there's there's a scene in the big short and this is of course one of your favorite movies George where Mark Baum is talking to and Mark Baum is one of the guys who figures out what's going on he's talking to a CDO manager right so that's the collection of loans and they sell it as a security to investors. He's talking to a CDO manager who's explaining this whole process to him and how everything here works with the CDOs. And then Mark starts to realize that the business for insuring the loans, the original home loans, is far larger than the business of the actual loans themselves. And I'm not sure if this is an actually true statistic,

But what the guy says is that for $50 million in, you know, home loans, there could be $1 billion betting on that as part of the insurance, basically from all those other different companies like the banks and the investment banks and the investors, those all put way more money into it than the original loans. And so there's a lot writing on like simple loans. Yeah. And though not exactly what's happening for Evergrand, that kind of describes what leverage is that if you have an investment and it goes down 10%, and you just own the investment, you lost 10%. But if you're leveraging it two times, it's 20% of a loss there,

because two times 10%, you get exposure to double the upside and double the downside. Evergrand was the most indebted company in the world with $350 billion of debt. When things were going really well, that meant explosive growth beyond imagination. it started in the late 90s in the hundreds of millions of dollars for a company. So they were able to grow at an astounding pace. But when the losses start to pile in and you're leveraged that heavily, it's a recipe for disaster. Just to quick finish up this story, I feel like I've been giving a lot of credit to the Chinese real estate sector because of how incentives shape their decisions.

And some of that was probably outside of their control. but there is a particularly bad business decision that I can't just let get swept under the rug. A representative of the wild speculation during the mid-2010s was Country Garden, which is another gigantic Chinese real estate company. They made the Garden City project. And it's this really cool modern city. The best way I can describe it is Miami Beach, but like more luscious, more futuristic, I guess, all of it is very closely contained, but you can do shopping, you can do hiking, you can do a lot of different things. And it was in a hundred billion dollar housing development in Malaysia. Seemingly using the field of dreams, build it, they will come as their mantra.

Country Garden with a backing of banks and foreign entities designed and built a futuristic city with a capacity for, wait for it, 700,000 residents from nothing. Well, to be honest, it's not anywhere I would want to live. It's just like a forest of apartment complexes, just these skyscrapers of just massive buildings, all one right after the other, right next to each other. And yeah, man, wow. One problem was that they built it next to a lagoon or a lake or a sea

that had crocodiles in it, so you couldn't actually go swimming. But that wasn't the biggest problem. The biggest problem was Xi Jinping restricted foreign spending for Chinese residents. to $50,000 per year, meaning that Chinese residents who were going to buy a vacation home in Malaysia, you can't buy a vacation home for $50,000. And the project was designed explicitly for upper middle class Chinese families.

Now Country Garden had to rely on the Malaysian population. An issue with that was all the signage was in Chinese. It was literally designed for the Chinese culture. And it was too expensive for most Malaysian residents because it was. built using Chinese prices. Out of the 700,000 people who could fit in Forest City, approximately 7,000 people currently live there. And to put that all in perspective,

that would be similar to the city of Detroit in geographical size, having the population of Hillsdale, Michigan. Man, wow. So do you think those 7,000 people are paying virtually nothing? The fact that there's only 7,000 people makes me think that they haven't lowered prices a crazy amount. But I honestly have no idea. I've looked at people taking tours of the city, and it looks pretty peaceful because there's no one there.

Sign me up. Yeah, unfortunately, there's no one working the shopping malls either, so you can't really do much. Yeah, I would hate it if there were 700,000 people around there. But if there's, you know, 20 apartment complexes, but only 7,000 people, that sounds kind of nice to me. Yeah, but I think that project is very indicative of where Chinese real estate is right now. and like I said with 65 to 80 million empty units and a lot more companies teetering on the edge of bankruptcy, I think there could be worse things to come. Yeah, you know, thinking once again about 2007 and 2008, the problem wasn't just limited to the housing market, right?

It turned into a recession worldwide. Whole economies were just crashing. And so, you know, this problem is not just going to be contained just within the Chinese housing. market. Yeah, I definitely wouldn't think so. But on a brighter note, let's talk a little bit about AI. Patrick, you have a great story regarding this. Yeah, so this came from a notification that popped up on my phone from Yahoo Finance last week. So it's not the newest story, but it's, it was really interesting nonetheless when I first saw it. So this is the story of a U.S. government partnership with huge AI research programs, the likes of Nvidia, Google,

Microsoft and some other of the largest companies out there in the world. And so according to Yahoo Finance article that I read, it said that a bunch of federal agencies like the Department of Defense, the Department of Energy, and all that these departments and agencies are joining forces with all of these companies to sort of establish this giant AI research program across the country. it's called the National Artificial Intelligence Research Research Resource Program. There's always been much conversation about AI and robots. And it seems like everyone is on one of the two sides.

You know, it's AI is a tool or it's going to take over the world. And so the U.S. government seems to say here that they see it as a tool. Or maybe they want to take over the world, but that's probably more of a politics show topic. Not unlike governments to want to take over. the world. But I think it is, from a strategic standpoint, probably pretty smart to try to get ahead of this AI stuff. And to make the intentions clear, like, hey, we're not going to do this top secretly. We're going to let you guys know that we are using AI. This is probably clears up some of the speculation that would occur if you can get on the front end of it. So Nair's aim is to

create a pool of AI research and tools to ensure that the U.S. stays on top of the international political competition in AI. And ultimately, where it kind of gets down to the ground, the U.S. just kind of wants its citizens to learn about AI. And so this program is working to make sure that, you know, people in rural communities and all across the U.S. can have the capacity to do AI research, because that would benefit the country in a number of different ways. And so I thought of this analogy, I'm not sure if it's, I'm not sure if it's spot on. You can correct me if I'm wrong, but the way I'm thinking of it is The United States wants to become the nation with the best basketball players and teams for a hundred years. And so, you know, they recruit the dream team from the 90s, you know, Michael Jordan, Scotty Pippin, Larry Bird, Charles Barkley, Magic Johnson, and all the others to establish basketball camps around the country to start developing young phenoms with the goal of the U.S. never losing an Olympic basketball game ever again.

And so I kind of see, I don't know, maybe that was wrong, but that's kind of how I see this AI program. you know, they want to establish, I don't know, young talent, what would we say, just so that citizens are more informed and can become innovators and in AI and, you know, do some good for the country. Yeah, and I think countries are generally better off when you're able to take advantage of new emerging technologies, I think, of the difference between a country like Taiwan that's extremely well off, in large part because they have a lot of technical research capabilities versus their neighbor China or South Korea. Granted, there's a lot of other factors that play into that, such as government, but all

the same, I think it's a big advantage if you're able to export information technologies and have access to the best and the brightest. Well, that's about all the time we have for today, Patrick. Well, thank you for tuning into this episode of Wall Street Weekly. We will be back next week, not sure what with, but I'm sure it'll be a good episode, and we look forward to that. So thank you for listening to Wall Street Weekly on Radio Free Hillsdale 101.7,000. Thank you.