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  • Dec 20, 2014
  • Updated: 8:56am
PUBLISHED : Wednesday, 13 March, 2013, 12:00am
UPDATED : Wednesday, 13 March, 2013, 4:41am

South Sea Bubble warning for wealth management investors

CBRC probe into pooled funds either good news or cause for concern institutions will hit problems repaying investors in existing products

In his classic Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay detailed some of the investment absurdities of London's South Sea Bubble of 1720.

In one case, the prospectus for an initial public offering described simply "a company for carrying on an undertaking of great advantage, but nobody to know what it is".

It sounds ridiculous to us, but the issuer guaranteed investors they would make annual returns of 100 per cent. His office was promptly besieged by eager punters, and in the course of just six hours, he took subscriptions - and deposits - for £500,000 worth of shares. Today that would be worth HK$668 million.

It's easy to laugh, but many of the mainland savers currently queuing up to buy wealth management products from their banks have no more idea what they are purchasing than those 18th-century Londoners. Just like their forebears, they have been beguiled by offers of high returns.

So depending on your point of view, a report yesterday in the quasi-official China Securities Journal that the China Banking Regulator Commission is to launch a major investigation into these products is either good news or deeply worrying.

Specifically, the CBRC is leaning on banks to stop pumping the money they raise selling wealth management products into common pools.

Typically the buyers of the products, which usually have maturities of just a few months, are promised an annualised return of 4.5 or 5 per cent.

That might not sound like much, but with inflation running at 3.2 per cent, it's a lot more attractive than the 2.6 per cent interest rate paid on three-month bank deposits.

Unfortunately, from the buyers' point of view there are big dangers when banks pool their money.

For one thing, savers have little idea what they are really investing in, which means they are unable to make informed decisions about the risks they are running. China Construction Bank, for example, recently offered one product saying only that between 30 and 70 per cent of the proceeds would be invested in debt.

According to a study published last week by Spanish bank BBVA, around a third of wealth management product capital is invested in stocks and bonds, a third in short term money market instruments, and a third in "other" assets (see the first chart).

Other assets typically means investments structured by trust companies, which in turn means loans to local government-backed infrastructure and private companies which can't borrow directly from the banking sector.

The problem is that while the wealth products usually expire within three months, the trust loans are much longer term, typically three to five years. That means the banks have to rely on selling new pooled products in order to pay out investors as the older ones mature.

This is what makes the CBRC probe worrying. If the regulator enforces a ban against financial institutions pooling funds raised by new wealth management products, they will run into problems paying back investors in existing products.

And although many investors are under the impression they are guaranteed the return of their principal plus interest, in reality it is the buyers - not the sellers - who bear all the risk.

As a result, there is a danger an official probe could trigger a collapse in the market. With an estimated 13 trillion yuan (HK$16 trillion) of products, worth 25 per cent of China's gross domestic product, outstanding at the end of 2012 (see the second chart), the effect could be devastating.

It is likely many of those who structured and sold the products won't wait around to find out. As Mackay wrote of the issuer of that South Sea Bubble stock, "he was philosopher enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again".

Buyers of mainland wealth management products may just see their money vanish in a similar fashion.



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This article is now closed to comments

As they are described here, these funds are no more a pyramid game than are bank deposits.
Banks will also fail if there is a mass withdrawal of funds, as they also are invested in longer term assets such as mortgages. Of course, for this reason, banks tend to be heavily regulated as to the level of solvency capital, and often have implicit or explicit taxpayer guarantees.
A pyramid scheme typically uses new funds to pay returns to existing members, and signs up yet further participants by advertising these high returns. It has few actual assets and is required to grow in order not to crash (as implied by the geometric shape).
These funds are "merely" required to replace any existing investors that decide to leave when the term is up, to the extent that they cannot liquidate assets fast enough. They are poorly regulated funds, but not pyramid schemes.
I wonder to what extent this WMP business has already contributed to, or caused a bubble in the Chinese loans that these products are derived from.

My concern would be less about the duration mismatch (always inherent in the banking system) nor with the liquidity risks for the bank (see below - investors getting out of WMP's would likely go back into regular deposits, making little difference for the bank).

I would worry a lot more about how demand for these products might have brought the cost of credit down to unhealthy levels for the trusts, debt issuers and mortgage holders on the other end of the supply line. We have seen something like this happen before, and very recently. The demand for (perceived as safe, 'AAA') MBS and other pooled loan products in the US during 2005-2007 was the oil on the fire for the subprime lending sector. And we know how that ended.

Apart from the worrying aspect that WMP investors are badly informed, how much do even those that are supposedly well-informed (the banks) know about the credit quality of the underlying loans? That is the crux of the matter in my opinion. If the underlying is more or less safe and sound, then even a massive pull-out from investors in WMP's won't pose a systemic risk, assuming the bank manages the liquidity and can carry the transferred-back credit, duration and other risks well. If the whole thing turns out to be built on quicksand of NPL's and so on, then this could get very nasty indeed.
John Adams
For a very sobering view on all this: read Greg Smith's book : "Why I left Goldman Sachs"
“The problem is that while the wealth products usually expire within three months, the trust loans are much longer term, typically three to five years. That means the banks have to rely on selling new pooled products in order to pay out investors as the older ones mature.”
The short term management products in China work no more than a pyramid game – new comers pay the old. Equally bad is also the subprime mortgage in US which based on bringing ‘uncertain’ risk to one’s investment. There is a common thread through the two – disrespectful of time. Both the seller and buyer use a shorter period to hurry up the maturity of an investment. For the banks, a three to five years trust loan or a thirty-year housing mortgage standard is compressed into maturity in few months or instantly respectively.
Making quick money still lures many. Perhaps it is a fool’s gold. An apple must take its time to grow to be most tasty. .
I have to agree with taihang here.

If investors in WMP's would pull out en masse (for whatever reason), in all likelihood they would switch back into normal deposits. For the banks, the difference in liquidity requirements in such a scenario is not very big. True, if all these WMP's investors would pull out, withdraw their funds to cash and put it in an old sock, there would be a problem. But this would not be fundamentally different than a 'regular' run on deposits, which would occur, but not because of these WMP's.


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