How can we resolve the Hengda crisis as soon as possible？

At present, the most crucial thing is to stop the bleeding of Hengda, stop allowing its risks to accumulate and spread, and at the same time, we should preserve good evidence to lay a good foundation for future accountability through the rule of law.

Author | Li Wei

Source | Caixin

Li Wei

Professor of Economics, Cheung Kong Graduate School of Business

Director of the Case Study Center of Cheung Kong Graduate School of Business

Director of the Big Data Economics Research Center of Cheung Kong Graduate School of Business

Vice President of Asian Markets

On September 24, 2023, China Evergrande Group (referred to as Evergrande) issued an announcement saying that "in view of the ongoing investigation of Evergrande Real Estate Group Co., Ltd. (the main subsidiary of the company), the current situation of the group cannot meet the eligibility for the issuance of new notes".

Public information shows that Hengda is in a serious insolvent situation. At the end of 2021, the end of 2022 and the end of June 2023, the company’s insolvent gap is 473.10 billion yuan, 599.10 billion yuan and 644.20 billion yuan respectively.

Judging from this set of data, Evergrande has not "stopped the bleeding". What should be done for such a large real estate company that is in crisis and the situation is rapidly deteriorating?

Market-oriented solutions

The current situation of Evergrande is not optimistic. If the government does not intervene in this crisis and the market comes up with a solution, then there are only two outcomes. One is that Evergrande goes bankrupt, and the other is that market-oriented institutions acquire and integrate Evergrande without the help of the government.

Let’s look at the first outcome. Logically, this is the most likely outcome if Evergrande’s crisis continues to worsen. If Evergrande does go bankrupt, what consequences will we face?

In principle, companies, like people, no matter how big or small they are, will die one day without much fuss. However, the reality may be much more complex than we think, especially for large companies with a wide range of implications.

A classic example of this is the impact of the collapse of Lehman Brothers Holdings Inc. during the 2008 financial crisis.

In 2007, the pressure on financial marekts caused by falling house prices became increasingly obvious, and a series of Financial Institution Groups began to experience insolvent problems, but the overall situation was still under control.

After entering 2008, the situation took a sharp turn for the worse. Lehman, the fourth largest investment bank on Wall Street, began to thunder continuously, and the problem of insolvent gradually appeared. At that time, there was a huge disagreement in the whole society on whether the government should rescue Lehman.

In fact, the government also wanted to raise resources to rescue Lehman, because Lehman was one of the core nodes of the US financial network, but it was ultimately concerned about moral hazard (moral hazard refers to the fact that under the condition of asymmetric information, the responsible economic actors do not bear the full consequences of their actions. For example, Lehman took excessive risks in the course of its operation, making money for himself, and losing money can be required for government rescue based on its importance), and gave up the rescue.

The collapse of Lehman Brothers brought the financial crisis to a climax, causing the largest crisis in the US economy since the Great Depression.

The government’s abandonment of the Lehman bailout quickly escalated the financial crisis, but if Lehman is bailed out, it is likely to exacerbate moral hazard in the financial system in the future. As moral hazard builds, it will only be a matter of time before a larger financial crisis erupts.

The failure of Lehman’s self-rescue brought an unexpected result, which was the successful self-rescue of Merrill Lynch (Merrill Lynch for short).

Merrill Lynch is the third largest investment bank on Wall Street. As the parties discussed how to rescue Lehman, John Thain, the last Chief Executive Officer of Merrill Lynch (CEO), who participated in the discussion, immediately realized that Merrill Lynch had a similar problem. If it did not act immediately, then Merrill Lynch would be the next Lehman.

In order to save himself, Thain contacted Bank of America and sold himself to the latter for $50 billion, thus avoiding the end of Lehman.

In fact, from the perspective of game theory, the decision of the US government not to rescue Lehman, a Financial Institution Group that was so large that it had systemic risks, was somewhat random.

This means that the government will eventually rescue the vast majority of Financial Institution Groups that may cause systemic risks, but it should not let the market know the government’s trump card when choosing to give up a Financial Institution Group that can detonate systemic risks to curb moral hazard.

After all, there is a huge social cost to detonating systemic risk.

Government intervention solutions

The above describes the situation of relying on the market to solve the crisis, but in fact, when a major crisis occurs, the government will intervene more or less. Here are three examples according to the degree of government intervention.

First, the government only plays a coordinating role, and it is mainly handled by market forces.

The most typical example of this is the crisis resolution of Long-Term Capital Management (LTCM).

Founded in 1994, LTCM is a hedge fund specializing in highly leveraged carry trades.

LTCM became famous for its outstanding performance once it was established, but in 1998 LTCM suffered a huge loss. Due to LTCM’s highly leveraged trading strategy, its counterparties included many Wall Street Financial Institution Groups, so the crisis of LTCM once led to a possible systemic crisis in financial marekt. To avoid this dangerous situation, the Federal Reserve Bank of New York convened many Wall Street Financial Institution Groups to discuss ways to rescue LTCM. Finally, many Wall Street Financial Institution Groups raised $3.625 billion to rescue LTCM. The Wall Street Financial Institution Group’s investment not only saved the LTCM from the verge of collapse, but also eliminated its threat to the entire financial system.

During the entire incident, the Federal Reserve Bank of New York played a convening and coordinating role, but it did not provide capital or guarantee, and its intervention in the market was limited. It mainly relied on market forces to solve problems.

Second, the government provides some funds for rescue, but the main transactions are still completed by market institutions. A more typical example of this is the handling of Bear Stearns by the Federal Reserve Bank of New York in 2008.

Bear Stearns is the fifth largest investment bank on Wall Street and a very important Financial Institutions Group in the US financial system.

In order to prevent the collapse of Bear Stearns from hitting the entire financial system, the Federal Reserve Bank of New York coordinated JPMorgan Chase’s acquisition of Bear Stearns. In the process, the Federal Reserve Bank of New York funded the purchase of Bear Stearns’ assets for $30 billion, which helped to complete the entire acquisition.

In this deal, the government offered real money to rescue the problem company, but the amount was relatively small and only played a supporting role. The big problems were still solved by the market itself.

Third, the government fully intervened to take over the companies at risk, a classic example of which was the handling of Silicon Valley Bank by US regulators in March 2023.

Silicon Valley Bank, a bank whose main customers are high-tech companies, experienced a severe run in March 2023 because it did not do a good job of risk management. Fearing that panic would spread and trigger a chain reaction, the US Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) acted together and quickly intervened in the crisis.

After regulators took over Silicon Valley Bank, the FDIC announced an unlimited guarantee on all deposits, breaking the previous limit of $250,000. For Silicon Valley Bank, the regulator ousted all its executives and zeroed out the equity value.

From this series of actions, it can be seen that the government took a comprehensive intervention approach in response to the crisis of Silicon Valley Bank, taking complete control of the company, which is the deepest form of government intervention.

How can we resolve the Hengda crisis as soon as possible?

The above discusses different ways to resolve the crisis from the perspective of the market and the government. What is the significance of this for us to deal with Evergrande’s problems?

Here is the first thing to say, some people may say that the examples mentioned above are all Financial Institution Group, Evergrande is a real estate developer, not Financial Institution Group, there are substantial differences between the two.

Indeed, Financial Institution Groups, especially those large Financial Institution Groups that are at the heart of the financial system, often have a direct and huge impact on the entire system, even the macroeconomy, so once these institutions are in crisis, they are often prone to systemic crises. This is the case we saw in the Lehman bankruptcy.

Institutions with systemic risk are often large Financial Institution Groups, but systemic risk is not the patent of large Financial Institution Groups. All institutions that have a direct and huge impact on the economy and finance as a whole are institutions with systemic risk. Evergrande is one of them.

There are three reasons for this.

First of all, the real estate itself in China belongs to the giant industry, and its upstream and downstream implication is very wide, from steel and cement to home appliance decoration, some studies believe that these industries together ** the country’s gross domestic product (GDP) ratio may be close to 30%;

Second, real estate is closely linked to the financial system. When real estate goes wrong, the land market will soon follow. A large amount of financing in China is based on land and real estate as collateral. Once the value of these collateral shrinks, the risk will immediately spread from real estate to the financial sector;

Finally, Evergrande is a typical leader in the real estate industry, and its survival has a significant impact on people’s views on the entire real estate industry, and even on China’s economy.

Evergrande is so important, so how should we handle the current crisis?

First, Evergrande’s self-rescue seems to be very difficult to succeed. Evergrande has been in danger for two years. If self-rescue can work, we don’t need to discuss whether to rescue Evergrande today.

Second, use a market-oriented approach to solve Evergrande’s problems.

First, let Evergrande go out of business. This is difficult because Evergrande is a company with systemic risk. Second, let other companies in the industry merge and acquire Evergrande. This is a better approach because real estate is a sector with a certain technical threshold, and companies in other industries do not easily learn how to run a developer efficiently in a short period of time.

But there are two difficulties here, one is that Hengda’s scale is too large, in 2020 before Hengda’s accident, Hengda’s housing sales area was as high as 80.86 million square meters, ranking first in the country; the other is that Hengda has been suffering for a long time, and no one knows how big a hole there is. The resources required to acquire such a giant company may not be what a developer can have.

Third, the government intervened to rescue Evergrande.

First, the government only plays a coordinating role, allowing companies in the industry to acquire Evergrande, or establish a consortium, with money, such as the Financial Institution Group, and powerful contributions, such as developers. However, as mentioned above, this path is currently not feasible.

The second is that the government provides a small amount of funds, and then joins social funds to jointly acquire Hengda. This method is better, but the coordination cost is higher.

The third is for the government to directly take over Evergrande. This approach is the simplest and most straightforward, and can control the spread of risk in a short period of time. But the biggest problem is that the government does not know how to run a real estate developer well, and it is still such a huge and opaque developer.

From the current situation, each plan has advantages and disadvantages. Rescuing Evergrande, no matter what method, will create a certain moral hazard, but because Evergrande is a company with systemic risk, this forces us to compromise.

Rescuing Evergrande requires two resources, one is technology and the other is funding.

The government and some large companies outside the industry have capital but no technology, and companies in the industry have technology but no capital. Therefore, the best way is to form a consortium and give full play to their respective strengths.

But the drawback of this is also obvious. How to assemble a suitable team is very difficult, which takes time, but whether Evergrande’s crisis has left us enough time is something we don’t know. A direct government takeover can immediately stop Evergrande’s bleeding, but subsequent operations are beyond the government’s ability.

But this approach is not completely impossible. In this regard, we can still learn from the treatment of Silicon Valley Bank by US regulators. On March 10, 2023, US regulators took over Silicon Valley Bank. Just 16 days later, the regulatory bank found the next home for Silicon Valley Bank – First Citizens Bank (First Citizens BancShares).

Many people now have an understandable sense of anger towards Evergrande, especially those who paid for a house but couldn’t get it.

In the future, even if we rescue Evergrande, it will not be all bailouts. We should rescue homebuyers who cannot get houses and suppliers who do not get the money, but we should let Evergrande’s equity go to zero, most of its debt is impaired, and all executives are dismissed, just like the way US regulators handled Silicon Valley Bank.

But the most important thing at the moment is to stop the bleeding of Evergrande and stop allowing its risks to accumulate and spread. At the same time, we should preserve good evidence to lay a good foundation for future accountability in a rule of law manner. Looking at the overall situation, the government should find a way to take over Evergrande as soon as possible.