There’s Gold in Them Thar Vaults, Boys! Um, Maybe Not

If the vaults are in China, that is. Over the weekend I posted on the fraudulent commodity-based lending (collateralized by aluminum) in Qingdao. Now a Chinese government auditor claims that the gold used as collateral in $15 billion of loans does not exist.

To put this into context, Goldman (GS) (ha!) estimates that there are about $80 billion in loans in China collateralized by gold. Thus, the auditor’s report means that at least 20 percent of those loans are fraudulent. Given that it is likely easier to verify the existence of gold pledged as collateral than is the case for copper or soybeans, this suggests that even higher percentages of these other commodity-based loans (totaling another $80 billion) are backed by warehouse receipts that aren’t worth the paper they are printed on.

This situation creates the conditions for a horrific information contagion, which is the worst sort of systemic risk. Many analyses of systemic risk focus on counterparty credit risk, where the failure of one institution topples a set of interconnected dominoes. But historically, the domino problem has been less of a source of financial crises than information contagion. For instance, information contagion was arguably a far more important cause of the 2008 crisis than counterparty contagion.

Information contagion is a panic that results when the quality of assets in one part of the financial system leads people to question the value of other assets, usually similar but not always. For instance, in 2008, the problems at Bear and Lehman were the result of bad mortgage investments by these firms. This raised questions about the solvency of other financial institutions that held, or were believed to hold, similar assets. Suddenly all banks became suspect, and had problems funding their assets. They started dumping assets to raise cash, which cratered prices and thereby created problems in institutions that had to mark their assets to a (now depressed) market. Banks that had extended liquidity support to SIVs had to bring them back on their balance sheets, threatening to make them undercapitalized.

Information contagion is most likely to occur, and is most severe when it does, when (a) asset values and balance sheets are opaque, and (b) financial institutions engage in a lot of maturity transformation (i.e., borrowing short to lend long). When asset values and balance sheets are opaque, market participants are more likely to draw inferences from revelations about the values of other firms/assets, because they can’t evaluate the firms/assets directly. In these circumstances, bad news about one firm or one type of asset can lead to a massive loss in confidence in other firms and assets. When these assets are funded with short term borrowings, firms can’t roll over their loans under these conditions, and are more likely to go bankrupt. Moreover, they are more likely to dump assets in fire sales that impose externalities on other firms holding similar assets.

China’s financial system is nothing if opaque. This is particularly true of the shadow banking system, but the banking system is also incredibly murky. For instance, the actual quality of loans on bank books is very difficult to assess. A lot of loans reported as performing are actually quite dodgy.

Information contagion is especially likely because the nature of the revelations about commodity loans raises serious questions about the monitoring of loans and the evaluation of the creditworthiness of borrowers and the quality (and existence!) of their collateral by financial institutions. If banks do a bad job at evaluating commodity loans and borrowers, and commodity collateral, it is reasonable to infer that they do a bad job at monitoring other loans and evaluating other borrowers. It is these sorts of inferences that lead to information contagion.

Moreover, maturity transformation is ubiquitous in China. This is especially true in the shadow banking system.

What this means is that although a few tens of billions of loans backed by non-existent collateral may not seem like a big deal in a financial system with about $17 trillion in credit outstanding (about 35 percent of which is in the shadow sector), the ramifications are far more serious than the value of these commodity loans suggest. There is a serious risk that doubts about the quality of the commodity loans will lead to growing doubts about the quality of other assets, especially in the shadow banking sector. This creates the potential for panics and runs in that sector, and given the connections between shadow financial institutions and mainstream banks (connections which are themselves opaque) this could spillover into the conventional sector.

In other words, the potential for information contagion in a highly leveraged (with credit at about 250 percent of GDP), highly maturity transformed, and exceedingly opaque financial system is what makes the fraudulent commodity loans a big deal. Potentially a very big deal.

About Craig Pirrong 228 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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