Investment Strategy

Is mortgage non-payment China’s Lehman moment?

Jul 22, 2022

Authors: Alex Wolf, Yuxuan Tang, Kendrick Cheung and Donna Tang 

Cross Asset Strategy

U.S. equities rallied on the week to a one-month high on the back of solid earnings. Both the real and digital economy saw bright spots from the earnings reports released so far, which stood in contrast to the dim expectations of the market. The tech-heavy NASDAQ outperformed the broad market. Bonds and commodities were relatively muted, with the 10-year Treasury yield stabilizing at around the 3% level. We think volatility may stay elevated as recession concerns linger, and see 3,500 – 3,600 as a more reasonable entry level for the S&P 500 (see detailed analysis in the previous Asia Strategy Weekly).

Nonetheless, Europe seems to be the focus of the week. The ECB held its policy meeting on Thursday, hiking the interest rate by 50 bps. It was the first hike delivered by the central bank since 2011 – in the midst of the European sovereign debt crisis. Since then, the ECB cut its policy rate all the way to zero, subsequently bringing the region into an era of negative interest rates in 2014. The ECB was increasingly an island before this meeting, being one of the only central banks that had put monetary policy on hold. Because of widening interest rate differentials and the precarious growth outlook due to the war in Ukraine, the Euro had briefly touched parity with the dollar before rebounding to 1.02 on Thursday. Energy shortages and fragmentation risk remain major challenges. That said, we see EURUSD at 1.05 by year-end as the movement of EUR rates back into positive territory may encourage flows.

Strategy question: Is mortgage non-payment China’s Lehman Moment?

It’s déjà vu all over again in China’s property sector. If last summer was marked by the (yet unresolved) Evergrande saga, this summer mortgage non-repayments are sparking a new source of unease. Over the past two weeks, homebuyers of unfinished residential properties indicated their intention to boycott their mortgage payments. The number of projects involved has since been rising every day, reaching 300 across 50 cities at the time of writing.

Reminiscent of the 2008 Global Financial Crisis that originated from a wave of mortgage defaults, many are asking whether this is China’s Lehman moment? First, it’s important to note there are a number structural differences between the two. The most important being the level of household leverage. The U.S. subprime crisis was built up on highly leveraged buyers paying very low down-payments (low single digit or even zero). In China, however, effective loan-to-value ratio is much lower at around 40% (see chart) meaning down payments and other sources of financing make up a much larger portion of the purchase. Banks also benefit from a larger buffer against potential credit losses.

Additionally, financial derivatives in the mortgage space is not as advanced, thus contagion risks due to mortgage defaults could be relatively limited. Though a key difference lies in the structure of balance sheets – when a homebuyer in the US defaulted there was at least an asset (the home) for banks to seize and auction; whereas in China if homebuyers default on an unfinished property the banks don’t have an asset to seize in many cases other than a barely finished property, making the risks slightly skewed to the banks.

At this moment, the direct impact from the mortgage non-payment saga still looks manageable. We do not see systemic risks as an imminent concern just yet. So far, 17 major banks have responded with statements that their exposure to the affected mortgages remain minimal on their balance sheets. According to estimates by J.P. Morgan Investment Bank, about 20% of mortgage loans are collateralized by work-in-progress projects; assuming 20% of pre-sold projects see delayed delivery and 50% of affected homebuyers suspend their mortgage payments, the mortgage non-performing loan (NPL) ratio could rise by around 200 bps on average, leading to a material, but manageable drag on the banking system.

That said, the potential risks could go beyond the missing mortgage payments. While it is still too early to call, some worry that it could be just the tip of the iceberg. We will likely see stricter control on access to funds in the escrow accounts, which could further deteriorate the liquidity of the developers, among which many are already in distress. More importantly, if mismanaged, the wave of boycotts may further dampen homebuyer confidence, leading to further downside in housing sales and investment, and potentially a negative feedback loop affecting even healthier property developers. As shown in the below chart, key housing market indicators have been in a 40-50% decline year-on-year during Q2, and a further collapse could increasingly threaten the overall property-related asset quality on banks’ balance sheets (i.e. loans to developers and their suppliers). Furthermore, if concerns reach beyond construction suspension and more people join the boycott on various grounds (i.e. we’ve seen some suppliers/contractors halt debt payments due to payment delays by developers), the situation could get worse.

The impact of further contagion on the macro environment could be material, as property-related industries account for roughly 30% of the country’s GDP. China’s Q2 GDP slowed to 0.4% year-on-year from 4.8% in Q1, largely due to the severe disruptions from the Omicron-induced lockdowns in April and May. As we wrote in a previous note, while the worst of the lockdown impact is behind us, recovery in 2H may not be easy. Constraints on policy easing and lingering Covid impact would weigh on growth, and weakness in the property sector seems to be a persistent drag on the recovery. Furthermore, if land sales further collapse due to property weakness, cash flows to local governments and their financing vehicles could suffer. This could disrupt Beijing’s stimulus plans, which rely on local governments to deliver infrastructure investment.

The key to watch from here is whether we see effective government interventions. Over the weekend, China’s banking regulator came out to reassure the market and encourage banks to provide credit to eligible developers to help them deliver the homes. In addition, the authorities are reportedly considering payment holiday for mortgages of delayed projects. A comprehensive plan to help resolve suspended constructions and deliver the pre-sale properties would be needed to restore confidence. There are recent reports that Henan province is considering a bailout fund and gathering SOE developers to help complete unfinished projects.  In the longer term, a thorough review of pre-sale property regulations might be needed to mitigate systemic risks. 

What does it mean for investors?

With the fluid situation on the ground, volatility in the property and banking sectors will likely remain elevated. For equities, negative earnings impact and media coverage will likely continue to drag on trading sentiment for both sectors in the near term. For the property sector, with contract sales underperforming and the overall slow progress of asset disposals, the number of unfinished projects are expected to go up. Homebuyers will likely be more cautious about buying unfinished projects from financially fragile and non-SOE developers. SOEs and private developers with solid credit metrics will likely enjoy market share gains, although this has largely been priced in given the resilience in their share prices. Before more effective government interventions kick in, we believe it is still too early to ‘bottom fish’ China property stocks. For the banking sector, a rise in project suspensions would lead to higher NPL formation in developer loans, thus dragging banks’ earnings, especially those with fast mortgage loan growth and large mortgage loan sizes. Investors could also become more cautious on SOE banks that may need to provide uneconomic assistance to developers for the “greater good”.

From a fixed income perspective, we maintain our bearish view towards China property credits, as we may see more distress in the sector with another maturity wall coming in August and September. As for bank credits, asset quality headwinds may lead to a further widening of spreads. Despite the fact that large state-owned banks generally enjoy robust solvency ratios, risks are skewed to the downside with rising credit impairment from mortgage exposures. In addition, valuations still look unattractive as spreads remain tight, while global peers have seen spreads widen significantly over the past months. 

All market and economic data as of July 21, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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