A “bubble” is a sustained but temporary major misalignment between perceptions of value (momentarily reflected in market prices) and actual underlying value (eventually reflected in actual cash flows over time). In this sense, it is primarily a psychological phenomenon, caused by unrealistically high expectations of profit and/or underestimation of risk. I stress the words “sustained” and “major” because minor misalignments are taking place — and being corrected — constantly, which is what markets are all about. If all of us knew what returns would actually be over time, we wouldn’t even need markets — or entrepreneurs — in the first place. But there are times — we call them bubbles — when these misalignments persist and feed on themselves until, somewhere down the road, the market loses faith and valuations suddenly come crashing back to reality in one fell blow.

Some economic bubbles that we’ve experienced:

• Tulip Mania, Netherlands, 1637
• South Sea Company Bubble, UK, 1720
• Compagnie d’Occident / Mississippi Company, France, 1720. (Leveraged)
• Railway Mania, UK, 1840s
• Canal Mania, UK, 1790s
• Stock Market Bubble, US, 1920s (Leveraged)
• Japan Real-Estate and Stock Bubble, Japan, 1986-1990 (Leveraged)
• Internet – Dot Com Bubble, US, 1998-2000
• Housing Bubble, Worldwide, 2000-2006 (Leveraged)

Non-leveraged bubbles are still bubbles, but fortunately their ends are not as dramatic and there effects are not as long lasting as leveraged (credit boom) bubbles. Frederic Mishkin pointed out this distinction in the Financial Times (Not all bubbles present a risk to the economy [FT subscription required]).

Like the start of the Internet Industry, there were also bubbles at the start of the Automotive, Radio and Television revolutions. Each one changed our life. Each time, too much speculative capital chases too few good assets. Additionally, the excess supply of capital creates an excess supply of assets that can be purchased.

The common thread in these three bubbles is over-excited investors putting money into a relatively new product, financial scheme, or industry that seems, given its limited track record, to offer a sure-fire path to riches but whose real risks and rewards they do not yet fully comprehend. Funding those investments via debt is not a necessary ingredient.

I have not yet been able to find a lot of 3rd party sources covering real-estate leverage in China, for now I’ll quote Prof. Chovanec on the subject (Leverage and China’s Property Market).

According to current rules, Chinese developers must use their own capital to secure land. Once they do so, banks will lend them 65% of the money they need for construction and related development costs, with the land pledged as collateral. But saying developers must use “their own capital” to buy the land is a bit misleading.

Residential Sector: Developers build and offload projects rapidly to buyers, half of whom are paying cash.

• Many developers do raise such funds by listing on the domestic or Hong Kong stock exchanges
• Many bring in private equity investors.
• I’ve also seem them raise it in the form of debt
  • Parent company take out loans and then inject the funds as capital into a real estate subsidiary. (most common)
  • Issuing high-yield bonds (if they’re listed)
  • By taking on loans at multiple layers of holding companies, a developer can leverage up considerably to cover his “capital” commitment to the banks.
  • It’s very hard to quantify the extent of this exposure, due to the indirect way many of these loans were raised and channeled into real estate.
• Approximately 50% of all residential purchases in China today are financed with mortgages
• China’s mortgage market is relatively small — about 10% of GDP, compared to 48% for Hong Kong.

Commercial sector, developers are building properties mainly to hold and lease. That means they are raising debt — both from banks and subordinated creditors — and they are not deleveraging.

• Many commercial buildings sit nearly or completely empty
• Where does the cashflow to pay the loans on the property come from?
  • Does the bank care, or is it happy rolling over the loan because the (supposed) value of the collateral has risen?
• This is the Dubai story all over again — multiple layers of leverage, no tenants, no cash flow.

Credit vs Collateral

• In the West, banks usually make commercial loans to businesses based on an evaluation of their expected profits and cash flows — will they earn enough to repay?
• In China, as in many developing markets where banks’ technical skills are not so sophisticated, most business loans are made on the basis of collateral — are there assets the bank can seize if the loan goes bad?
  • Asset Chinese banks like most as collateral is real estate
  • Therefore SOEs enjoy both preferential access to land AND lion’s share of bank loans in China
• Nobody is really arguing that Chinese banks are over-leveraged.
• It’s their clients, the developers and SOEs, that are leveraged up on real estate.
• It’s loans to those clients, should property take a tumble, that would hit the banks as losses.