Timely and Relevant News: Why Evergrande Isn't The Next Lehman Brothers

Chinese property developer Evergrande’s liquidity crisis has sparked fear and massive selling in Chinese property stocks over the past several weeks. The big question is could this be the first domino to fall, sparking a systemic risk scenario, similar to when Lehman Brothers went under 13 years ago this week? The good news is we don’t think so based on our thoughts outlined below.

With more than $300 billion in liabilities, Evergrande is currently the world’s most indebted real estate developer. Worries are mounting that starting next week it won’t be able to pay interest due (according to Bloomberg), along with potentially missing a principal payment on at least one of its loans.

With Evergrande’s share price down more than 80% this year, investors are clearly voting with their pocketbooks, while the chart below shows the pressure its dollar bonds have been under as well, at deeply distressed levels to the tune of 28 cents on the dollar recently.

Multiple downgrades have happened the past two weeks and some rating agencies are noting that an outright default is probable. Should this happen, what could the fallout be? With 1,300 real estate projects in 280 cities in China, could China’s government intervene to avoid a messy default? So far that answer has been a resounding no, with the company instead looking to banks and other creditors to help the impact of a default.

The bad news keeps coming - Evergrande suspended trading of its onshore corporate bonds, after yet another downgrade - taking it one step closer to restructuring or default. So is Evergrande China’s version of Lehman Brothers?

Here are three reasons we don’t think so.

First, the dollar bonds will likely get restructured. Most of the debt is in global mutual funds, ETFs, and some Chinese companies and not banks or other important financial
institutions. Remember, Lehman Brothers was held on nearly all other financial institutions’ books, so not nearly as many institutions will be impacted by this versus Lehman.
Secondly, we think the odds do favor the Chinese government will get involved should there be a default. They are holding out as of now, however the fallout could be too great for them to avoid intervening.
Finally, Evergrande has tangible assets that can be sold off to settle financial obligations. Their assets aren’t great and creditors know that the company is in financial trouble, so the value of its assets aren’t likely worth as much as they think but it will still help settle some debts. Remember, Lehman didn’t have hard assets it could sell off whereas Evergrande does.

“Although the impact from Evergrande’s liquidity crisis is enormous, the good news is the fallout hasn’t started to spillover to other markets,” explained LPL Financial Chief Market Strategist Ryan Detrick. “Short-term funding markets are acting just fine in China thus far; remember, it was the money markets in the U.S. that first started to show cracks in the system in early 2008, well before the wheels fell off.”

As shown in the chart below, China’s money markets aren’t showing any signs of systemic risk. These tend to be the canary in the coal mine and the fallout appears to be fairly contained as of now.

This is a very fluid situation and one that could change. Although the Chinese government has avoided helping Evergrande so far, we think the odds do favor some type of eventual bailout to limit the ripple effect from a potential default.

We have been saying in recent months, including during ourMid Year Market Outlook that a pickup in volatility would be normal at this stage of a strong bull market. We think suitable investors may want to consider "buy the dip" opportunities as they arise. We will continue to closely monitor action in the short-term lending markets as the current situation evolves. It is important to not lose sight of your long-term goals and to maintain your perspective in the midst of market ups and downs.

If you have specific questions related to your own investment strategy or financial planning needs, we welcome you to call us at 302.234.5655 or email us at contactus@covenantwealthstrategies.com to set up time to discuss further.

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This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

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All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.