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Mother of All Bubbles -- China


JEast
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A follow-up on my earlier post about Chinese real estate.  GMO strategist Peter Chiappinelli is calling China the Mother of all bubbles and is shorting.

 

http://www.investmentnews.com/article/20120216/FREE/120219938?template=printart

http://brazilianbubble.com/gmo-is-short-china-we-are-very-concerned-all-bubbles-pop-eventually/

 

Cheers

JEast

Hugh Hendry is suggesting a Michael Burry-esque trade to capitalise on a Chinese slowdown by betting against Japanese shipping, banking and steel companies.

http://online.barrons.com/article/SB50001424052748703786004577221590093305080.html?mod=BOL_twm_fs#articleTabs_article%3D1

So how do you make money?

 

Would you believe that the AIG strategy of selling too much credit protection in risky assets like mortgage-backed securities is alive and booming today in Japan? It doesn't concern mortgages. It is credit-default swaps on individual Japanese corporations.

 

Do you seriously believe Japanese corporations are going to fail?

 

Clearly, they can and do go bust. I'm buying the CDS on investment-grade Japanese corporations because of the overpricing anomaly. Japan had a bust 20 years ago, and yet today the banking stocks, relative to [Japanese bourse] Topix, are making fresh lows.

 

If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company. So suddenly, the yield has gone from 1% to 1½%. Compare that to five-year Japanese government bonds, yielding 30 basis points. The bank thinks: This is a great trade! Japanese steel companies are investment-grade and won't go bankrupt. So, the bank gets this huge yen yield, and thinks it is not taking any risk. You'd better believe it will sell way too much of that good thing.

 

One of my partners told me about Japanese steel: Here is a country with no energy, no iron ore or coal, yet it's the largest exporter of steel in the world, exports half its output. To put that in context, China manufactures 700 million tons of steel and exports perhaps 30 million. Japan produces 110 million tons and exports 40 million. As long as Asia is strong, they are fine. But if Asia hiccups or reverses, plant-utilization rates go from very high to very, very low very quickly.

 

Then we discovered that Warren Buffett owned shares of South Korea's Posco [5490.S. Korea], and that Korea was the biggest importer of Japanese steel, but Posco and Hyundai [5380.S. Korea] are building huge, integrated steel plants. They have a surplus of steel capacity and—guess what?—they're exporting to Japan, because the yen is so strong.

 

Initially, I wanted to buy a three-year, out-of-the-money put on Nippon Steel. My broker said, "I've been in a 20-year bear market; my boss will kill me." Then I thought, being long credit protection is being long volatility. I redialed his credit counterpart. I said: "I'm thinking of purchasing up to a billion yen of five-year credit-default swaps in Nippon Steel." The first thing he said was, "Would you consider 10 billion?" So one part of the bank is banned from selling volatility, and the other part is having a party. I bought reams of the stuff.

 

In August 2010, we set up a stand-alone fund to buy this credit protection. You no longer pay 50 basis points, you pay 130 basis points. U.S. Steel credit protection is more like 650 basis points, because in America, people are cautious on selling protection on such volatile businesses. They don't share that worry in Japan. It could make them very, very vulnerable.

I believe his short-credit strategy worked out spectacularly last year.
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"If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company."

 

If the business defaults within five years, what would he get by owning the CDS? what is his upside? For cost, my understanding is that he is paying 0.5% per year on the paper's amount.  Does he actually have to pay it yearly? Can the interest rate change? Thanks.

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I really don't know what to think about China anymore. So much is rotten with their system, but at the same time, they are starting from such a low base and still have so many low-hanging fruits to harvest... I don't pretend to know how it will play out and on what timeframe.

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"If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company."

 

If the business defaults within five years, what would he get by owning the CDS? what is his upside? For cost, my understanding is that he is paying 0.5% per year on the paper's amount.  Does he actually have to pay it yearly? Can the interest rate change? Thanks.

 

In this case the upside is 200 times the yearly interest he must pay, which is .5%. So after 5 years he would pay a cumulative 2.5% of the notional value of the CDS and then would recieve the entire principle if it defaulted after year five.

 

One might devote 1% of your portfolio each year to this trade, and therefore every year there is no default it's a 1% drag on performance, but if a total default happens, your entire portfolio would make 200%.

 

The interest rate is locked by contract, so that cannot change, but at any time he can sell it back to some other buyer in the market for more (less) if the rates of the CDS have risen (fallen), so the opportunity cost of holding the contract rises and falls with the market.

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Hugh Hendry is suggesting a Michael Burry-esque trade to capitalise on a Chinese slowdown by betting against Japanese shipping, banking and steel companies...

 

Japanese, Canadian, US, Australian all have a decent amount of companies that depend partly or fully on exporting to China's bubblicious Real Estate market. The Australian and Japanese banking systems will be in awful shape if building materials exports to China stop.

 

That's what people don't get. RE prices don't have to fall 90%. Construction just has to slow. There is a supply demand imbalance right now that exists mostly because of self-reinforcing rising prices and the idea that RE prices in China can't fall.

 

When the inevitable happens, countries/companies exporting to China will be in for a rude awakening. I wouldn't rule out the decade long commodity bull market coming to an end.

 

This is way bigger than China. It will be a global shock if merely construction slows from the unsustainable rate.

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Jim Grant mentions a way to play this is by holding Treasury Wine Estates.  It's an Australian wine producer that's been hurt by the strong AUD.  The thesis is that if China slows down it will drag down the AUD and TWE will start to report record profits.  Sales are mainly to AU (so no effect of currency there, maybe demand though), US, and Europe (lower AUD nice tailwind).

 

The thesis is interesting, too many moving parts for me to invest on that alone.  I do own TWE but purchased for entirely different reasons (spin-off, selling below book, selling for 1/4 of replacement cost), but if the AUD weakened from China I'd take that as well.

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Why go so far? Just short a steel exporter to china- like RIO or VALE.

 

And BHP. Doesn't have to be steel, any company that exports building materials. I'm short them all.

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I really don't know what to think about China anymore. So much is rotten with their system, but at the same time, they are starting from such a low base and still have so many low-hanging fruits to harvest... I don't pretend to know how it will play out and on what timeframe.

 

+1.  this is what makes me afraid to short.  On the one hand, I'm cautious with anything exposed to china (commodities, japan, australia).  On the other hand I don't know if I'd actually short because of what you've said here.

 

I'm by no means an expert, but from what I've read I believe only a small fraction of their population is educated and/or urbanized.  In addition, China nationally has massive reserves - it would seem to me they could just use this to fund any necessary stimulus if they hit a speedbump.

 

On the flip side, as a believer in free-markets, I would have to bet that 1 of 2 things happens in the long run.  Either they will have a massive correction because of government mis-allocation of resources (ie, building empty towns, as rumors mention), or they will continue to become more and more capitalistic/democratic.

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I am very cautious  regarding all things relating to China because of some of the things posted here. Not that i think I have any real amazing insight into it but everything I see gives me an uneasy feeling around it.

 

But it is interesting ready 3rd Avenues (Marty Whitman) quarterly reports and see them concentrate more and more on the Hong Kong and china real estate related positions.

 

Has anyone else been reading the same thing and wondering about it?

 

I wonder if I am missing something about his positions that makes them safer then they appear.

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I am very cautious  regarding all things relating to China because of some of the things posted here. Not that i think I have any real amazing insight into it but everything I see gives me an uneasy feeling around it.

 

But it is interesting ready 3rd Avenues (Marty Whitman) quarterly reports and see them concentrate more and more on the Hong Kong and china real estate related positions.

 

Has anyone else been reading the same thing and wondering about it?

 

I wonder if I am missing something about his positions that makes them safer then they appear.

 

I keep wondering about the same about Whitman. I think his asset value centric approach leads him to place a little bit too much emphasis on "readily ascertainable net asset values" which might overlook overvaluation when the underlying assets are overvalued. I think Whitman is very smart but I cannot help but think this is his weak spot.

 

Vinod

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"If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company."

 

If the business defaults within five years, what would he get by owning the CDS? what is his upside? For cost, my understanding is that he is paying 0.5% per year on the paper's amount.  Does he actually have to pay it yearly? Can the interest rate change? Thanks.

 

In this case the upside is 200 times the yearly interest he must pay, which is .5%. So after 5 years he would pay a cumulative 2.5% of the notional value of the CDS and then would recieve the entire principle if it defaulted after year five.

 

One might devote 1% of your portfolio each year to this trade, and therefore every year there is no default it's a 1% drag on performance, but if a total default happens, your entire portfolio would make 200%.

 

The interest rate is locked by contract, so that cannot change, but at any time he can sell it back to some other buyer in the market for more (less) if the rates of the CDS have risen (fallen), so the opportunity cost of holding the contract rises and falls with the market.

 

Regarding what you write about the RE bubble, IMHO you are spot on 100% and the RE bubble is just the tip of the ice-burg.

 

As for the CDS, what you're saying is that they just have to pay the insurance premium of 0.5% a year to get a full 100% of the insured principle? That is completely insane.

 

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"If I'm a Japanese bank and I lend money to a new business, I get 1% on 10-year paper. Then the bank gets a call from me, and I'm willing to pay 50 basis points for five-year protection on this same company."

 

If the business defaults within five years, what would he get by owning the CDS? what is his upside? For cost, my understanding is that he is paying 0.5% per year on the paper's amount.  Does he actually have to pay it yearly? Can the interest rate change? Thanks.

 

In this case the upside is 200 times the yearly interest he must pay, which is .5%. So after 5 years he would pay a cumulative 2.5% of the notional value of the CDS and then would recieve the entire principle if it defaulted after year five.

 

One might devote 1% of your portfolio each year to this trade, and therefore every year there is no default it's a 1% drag on performance, but if a total default happens, your entire portfolio would make 200%.

 

The interest rate is locked by contract, so that cannot change, but at any time he can sell it back to some other buyer in the market for more (less) if the rates of the CDS have risen (fallen), so the opportunity cost of holding the contract rises and falls with the market.

 

Regarding what you write about the RE bubble, IMHO you are spot on 100% and the RE bubble is just the tip of the ice-burg.

 

As for the CDS, what you're saying is that they just have to pay the insurance premium of 0.5% a year to get a full 100% of the insured principle? That is completely insane.

 

Right, but remember for it to pay in full there needs to be a full default, the underlying debt worthless.

 

It is insane that anyone would take that risk for such a small interest rate, but there are far crazier prices that have happened. In 2007 CDS's on Dubai sovereign debt were trading at .04%.

 

That's right, the market was pricing a default once every 2,500 years. This for DUBAI, when oil happened to be peaking.

 

I think Klarman and a few others made some money off that.

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