Chasing Subprime Credit : How China's Fintech Sector Is Thriving 9781623201739, 9781623201722

Citation preview

Chasing Subprime Credit: How China’s Fintech Sector Is Thriving

Published by Enrich Professional Publishing, Inc. Suite 208 Davies Pacific Center 841 Bishop Street Honolulu, HI, 96813 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: Unit A, 17/F, 78 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China English edition © 2017 by Enrich Professional Publishing, Inc. With the title Chasing Subprime Credit: How China’s Fintech Sector Is Thriving By Joe Zhang Edited by Glenn Griffith and Barbara Cao All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without prior written permission from the Publisher. ISBN (Paperback) ISBN (ebook)

978-1-62320-172-2 978-1-62320-173-9

Enrich Professional Publishing is an independent globally-minded publisher focusing on the economic and financial developments that have revolutionized New China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate, and engaging information on China. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. This book is based on facts and the author’s understanding of the facts. It has been written in good faith. Investment is a risky game, and neither the author nor the publisher will accept any responsibility for losses as a result of reading this book or acting on its views.

Contents Disclaimer ...................................................................................... v By the Same Author.........................................................................vii Introduction ..................................................................................... ix

Chapter 1 “Fraudsters Are the Biggest Winners!”....................1 Chapter 2 Subprime Financing in the U.S. vs China..............13 Chapter 3 Horror Stories............................................................25 Chapter 4 Data, Data Everywhere. Which Is Useful?............31 Chapter 5 Rotten Apples Everywhere......................................43 Chapter 6 Common Joe Plays the Online Credit Market......55 Chapter 7 Two Leaders: 51 Credit and Feidai (CredEx)........65 Chapter 8 Qudian and Other Winners Will Not Take All......89 Chapter 9 Why Is Every Chinese Company Dabbling in

Finance?...................................................................105

Chapter 10 Tackling the Used Car Finance Market................117 Chapter 11 Home Equity Loans for New Urbanites..............125

Chapter 12 Too Many Limited-License Banks?.......................135 Chapter 13 The Tidal Waves of Subprime Credit...................143 Chapter 14 Cleaning Up the Mess............................................153 Chapter 15 Valuations, and Not-So-Cynical Conclusions.....159 Afterword ...................................................................................165 Appendix ...................................................................................167 Select Bibliography.........................................................................171 Acknowledgments..........................................................................173

Disclaimer In writing this book, I took advantage of corporate filings, media reports, and extensive interviews in good faith. All the company data is based on the author’s analysis rather than the company’s official sources. It is possible that I might have been misinformed, misled, or that I simply misunderstood the situation, or that I was just wrong. If so, I apologize. This book is not intended as investment advice. I take no responsibility for any loss as a result of your reading this book. I declare my commercial interests. I am a director of the following companies mentioned in this book: 1. China Rapid Finance (XRF NYSE), 2. China Huirong Financial (1290.HK), 3. Shandong Financial Asset Exchange (unlisted), 4. China Smartpay (8325.HK), and 5. Fosun International (656 HK)

v

By the Same Author Books: Inside China’s Shadow Banking: The Next Subprime Crisis? Honolulu: Enrich Professional Publishing, 2013. Party Man, Company Man: Is China’s State Capitalism Doomed? Honolulu: Enrich Professional Publishing, 2013. All the royalties from the sale of this book, in both English and Chinese, will be donated to the students from low-income families at Maliang High School, Jingmen, Hubei Province, China. Shenzhen-based Tiantu Capital (天圖投資) and Beijing-based Lingfeng Capital (領渢資本) have made a generous donation to the same school for the same purpose.

vii

Introduction Fintech Helps PSDs Tackle Subprime Credit In the summer of 2017, I was re-reading The Rise and Fall of Bear Stearns by Alan C. Greenberg, the investment bank’s former chairman and CEO. The book remains interesting to me for two reasons. First, it described how an extremely successful institution and, indeed, almost the whole U.S. business community, was misled by “a chronic wishful optimism.” He was talking about his Bear Stearns, but he could very well have been talking about today’s China. China’s real estate developers have been flying high. They can do no wrong. Those who invest in real estate can do no wrong. Of course, we confuse luck with genius. The U.S. subprime crisis brought down Bear Stearns and many others. But in China, credit in general, and subprime credit, in particular, are still booming! When is this hot game going to grind to an abrupt halt? I am not smart enough to predict it. I am not even bearish. I am an investor in the industry and sit on the boards of directors of several industry players. Although I am cautious, I also see lots of upside potential for the industry. Call me a nervous

ix

Introduction participant. But I refuse to allow fancy terms such as fintech, artificial intelligence, or machine learning to cloud my already-poor judgment. Greenberg wrote about his admiration of the so-called “PSDs” when he was running Bear. PSD stands for people that are “poor, smart and have a deep desire to become rich.” In China’s subprime credit sector, and indeed everywhere in China, there are fortunately still many PSDs. In this short book, I salute a large number of colorful PSDs in the fintech and subprime credit industry. Subprime is not a dirty word. It is neutral. Lower credit scores should not deny anyone the access to credit. In this book, I talk about our collective efforts in tackling the fast-growing subprime market. Fintech should not be a plaything for the rich. It would be much less meaningful if it cannot help the world reach the subprime credit population safely, accurately, and cost-effectively. The collective work of the vast number of non-bank financial institutions in the subprime credit space has helped to shield the commercial banks from capital destruction. Their heroic sacrifice helped China avoid a banking crisis in the last four decades. China’s regulation of the financial sector is incoherent and full of pitfalls. Specifically, its regulation of the online lending sector is often criticized as being too weak and too ineffective. However, I think it is conducive to innovation and allows space for experimentation. Rather than disrupting the banks, the chaos in the online credit sector (and the subprime credit sector at large) is making the banking sector much safer, and much more profitable.

x

1

Chapter “Fraudsters Are the Biggest Winners!”

CHASING SUBPRIME CREDIT

Who doesn’t love a good conference? The office grind is put behind us, we have some fine food, and enjoy a stay at a decent hotel in a sunny tourist spot. What’s not to love? For those of us invited to speak, the actual contents of our speeches don’t even matter as the audience-members are too busy networking or glancing at their smartphones, with some even dosing off. What matters is that our presence at a conference gets our company a few more internet clicks and our very attendance at the event supports the Chinese government’s call to be part of the nation’s transition from a manufacturing economy to a serviceoriented economy. I personally have a problem with conferences. In China and elsewhere, they always get movie stars, TV personalities, or some other famous person to moderate the panel discussions. And in those 20 or so seconds where the celebrity is reading off the list of achievements, I feel like I don’t have any to really speak of. And so, those 20 seconds or so stretch out to 20 minutes in my mind. My New Year ’s resolution in 2016 was to never attend a conference again. But I was talked into speaking at a fintech investment conference hosted by Securities Market Weekly in Shanghai in early 2016. As a panel speaker, I asked the audience who, in their views, the biggest beneficiaries of the decade-long financial liberalization were. One raised his hand, and hesitantly said, “The private equity investors!” Another in the back row shouted, “The corrupt regulatory

2

“Fraudsters Are the Biggest Winners!” officials who controlled financial licenses!” As I waited, still another murmured, “Maybe those software engineers. They have really pushed up their salaries.” “No. It is the fraudsters!” I nearly-shouted. Bobby Chen, the conference moderator, this time a government official, became visibly anxious, and his face turned red. He quickly glanced at me, the audience, and then back to me. He didn’t know what to do or say. In the audience of nearly 100 regulatory officials, industry executives, and investors, there were murmurings and some rumblings in the crowd. I saw many people staring at their notes or taking out their phones to avoid making eye contact with me. Never a good speaker, I had rehearsed this episode at home and prepared myself for this moment. So, I paused for effect and then continued. “I am only half-joking. But look, since the government opened the floodgates for the microcredit sector around a decade ago, close to 10,000 firms have obtained licenses and started operations amid great fanfare. You all know what’s happened to their great expectations. According to Wu Xiaolin, a prominent figure in the National People’s Congress and a former vice-governor of the central bank, about one-third of these firms went belly up or have ceased operations, while about one-third are barely surviving and only the other third are still operating normally. I think she is being generous in her assessment.” By now, the audience was at least paying attention to my words, even if the attendees were clearly a bit uncomfortable with my

3

CHASING SUBPRIME CREDIT

bluntness. “I speak from my own painful experience. I personally invested in three such firms and ran one of them — Wansui Microcredit Company in Guangzhou — for 12 months in Guangzhou. I am still a director there. But I have suffered losses, anxiety, and hardships. From what I have seen, even those that are still operating have suffered tremendous levels of capital destruction. Yes, they are hanging on, but just. As these are all private companies, they do not generally have audited accounts. For reputational reasons and political reasons, they only report their accounts to their local regulatory agencies — the government’s Finance Department — but they tend to hide most of their non-performing loans. So, they only report minimal bad debts. That sounds very strange, you may say.” Having offered up the points of my opening argument, I continued with more confidence. “There are three practical reasons why microcredit firms only present the bright side of their businesses. First, the controlling shareholders who run the shows want to pacify their minority shareholders. Second, to pacify debt investors, some of these firms borrow from the banks or the capital markets in the form of ABS (asset-backed securities). Finally, even if the controlling shareholder or the management wants to write off more assets, the local tax department will not allow them to write off ‘too much’ for fear of tax reductions. Where did all the capital go? The fraudsters and the defaulters got it. “As an industry, we are losing the subprime game,” I said with a note of finality.

4

“Fraudsters Are the Biggest Winners!” The audience was silent. Several came to me to say that I was dead right, but I could see pain on their faces as they admitted that. Clearly, I had not said anything the audience had not already known. But no one would say in public the dirty little secrets everyone acknowledged. I knew I was being politically incorrect but someone had to say that the emperor had no clothes. And there remained so much more I could have added to that speech. The 10,000-strong micro-credit industry had a total asset of 3–4 trillion yuan. The micro-credit industry had mushroomed into existence between 2008 and 2011. I was personally sucked in when I quit my job at the UBS Investment Bank to run Wansui Microcredit Company in Guangzhou in 2011, only to beat an embarrassing retreat a year later. The microcredit industry’s primary customers are consumers and small-and-medium enterprises (SMEs). But frauds and defaults have wiped out the industry mercilessly in the short space of only a few years.

Guaranteed Failures During the same period, the credit guarantee industry had also boomed and busted. That industry had a much bigger number of operators scattered across the country with many state-owned, many private-sector controlled, and some hybrids. They charged an average of 2–3% to the SME borrowers but assumed the full risk of any loan delinquencies. In the event of the borrowers defaulting, the

5

CHASING SUBPRIME CREDIT

guarantee company would have to repay the loan on the borrowers’ behalf. When the economy was ascending, this guarantee fee of 2–3% seemed like free money. But when the economy slowed and, as a result, the defaults rose, the guarantee companies were quickly crippled almost across the board. Only then did people start to question the business model as well as the pricing of such guarantees. The China Financing Guarantee Association, a quasigovernmental body that regulates the guarantee companies, says it has 194 member institutions, though their ranks have thinned in recent years. Many guarantee companies have simply not bothered to become members of this club, and many do not qualify for one reason or another. These guarantees are essentially the same as the credit default swaps (CDS) which are popular in the U.S., especially so in the lead-up to the subprime crisis. But the guarantees in China have one deficiency: they cannot be traded or passed around easily and, so, there is no secondary market for such financial products. Maybe some people would say that this lack of a secondary market is actually an advantage for the industry because this forces the deal’s originators to eat what they cook, thereby minimizing the irresponsibility in the origination process of these guarantees. But, regardless, the sector quickly plunged to a near-death point when the economy slowed in 2012. Until this day, only a few of these companies are still operational but their main mission is to unwind their old, long-duration guarantees and liquidate

6

“Fraudsters Are the Biggest Winners!” the collateral they have repossessed (dubious equity stakes here and there, land, or real estate). I recently visited one such stricken guarantee company in Shenzhen which counted a veritable “who’s who” in the global private equity industry as its shareholders. The chief executive, who was also the founder, told me that his mission was to salvage the maximum value for himself as well as for other shareholders. His company sold a US$200 million unrated bond listed in Singapore some years back. That bond was now worthless, and finger-pointing was continuing as to why the chief executive had siphoned company money off to dubious real estate projects at tourist spots in central China. One other such company in Guangzhou which also boasted a prominent private equity investor as a shareholder is now involved in several court cases trying to recover its money from fraudulent corporate borrowers. The head blamed his failure on his eagerness to expand too fast in order to tap the stock market as quickly as possible, as well as his own stupidity in failing to see the inherent weakness in his business model. To add insult to injury, the microcredit company he personally controlled and managed has also been ruined. In a reflective mood, he acknowledged the reality that both his companies had operated in the subprime credit space, the industry that politicians and industry insiders sometimes gave flashier names within the industry. The most frequently-used tags for the sector included “puhui,” meaning “universal finance,” “equality of access to credit,” or “democratization of finance.” In the West, politicians speak warmly of SME finance for the creation of jobs. But

7

CHASING SUBPRIME CREDIT

the subprime nature and the high rates of defaults and frauds are quietly swept under the carpet. In a parallel with the American obsession with home ownership that led to the formation and the surge of Fannie Mae and Freddie Mac, the federal housing finance agencies, the Chinese government has in the past few decades done its best to promote small and medium-sized enterprises by providing them with credit guarantees. Tens of thousands of state-owned, private, and hybrid guarantee companies have come into being. And just like Fannie Mae and Freddie Mac, China’s guarantee companies are all thinly capitalized. This is due partly to the misconception that a third-party guarantee is sufficient for SMEs to tap commercial credit. Mispricing in China’s CDS market is severe and chronic. For only 2–3 per cent guarantee fees, China’s guarantee companies assume the full risk of their customers’ loan delinquency. This story is of interest to the general public because it holds a key to understanding the strange longevity of China’s credit bubble. It is true that the country’s credit market is far too big, but against the doomsday scenarios some analysts have painted, the bubble has refused to burst. And that is because of the many non-bank financial institutions that have served as plumbers for the banks. China’s economic slowdown in the past five years has decimated its microcredit sector and, to a lesser extent, the trust companies. Their destruction has also helped shield the commercial banks. As one grateful commercial bank chief recently remarked to me, CDS, bridge loans and wealth management products have served as

8

“Fraudsters Are the Biggest Winners!” the banks’ sewage pipes. Half-jokingly, he described the CDS issuers as “selfless and heroic.”

Microcredit or SME Loans In January 2012 when the Microcredit Association of China awarded me “A Microcredit Person of the Year” prize at a conference in Beijing, I gave a short talk to a crowd. While other speakers were talking about our industry being “nice” and “noble,” as if we were somehow doing God’s work, I rocked the boat by emphasizing profitability as being crucial to our sustainability. To ensure profitability, I argued, the microcredit sector must price our loans according to the default risks and fraud risks. Otherwise, I maintained, we were not being honest to ourselves. In hindsight, despite the seemingly high interest rates of 24 percent per annum, these loans were still priced too cheaply. As a result of high default rates, some operators raised their lending rates (and fees) substantially despite the officially sanctioned cap of 24 percent. But more challenges came: their borrowers’ risk profile worsened accordingly and that had offset the benefits of the higher interest rates and fees they charged. Some have shut down operations out of frustration.

P2P: Petty Crimes? All said, it is the peer-to-peer credit sector (P2P) that has been hit the hardest by frauds and defaults. Since Lending Club in the U.S and Wonga in the U.K. became well-known in China, tens of thousands

9

CHASING SUBPRIME CREDIT

of internet operators have sprung up to play the role of credit intermediaries. Everyone saw the charm of the business logic: The vast untapped lending potential, lazy and bureaucratic banks, and no restrictions on financial leverage and locations. In other words, being a bank without bank branches is the name of the game. It sounds very cool to lend Peter’s money to Judy, and take a cut in the process — even without such things as a bank branch to get in the way. The advantages of P2P lending are clear although its drawbacks are either downplayed or not even recognized. Everything about the industry was new, and everybody was zealous. The outcome was massive frauds and defaults. In 2011 to 2012, Yirendai (part of the CreditEase Group) and China Rapid Finance (CRF) — both are now listed on the New York Stock Exchange — were among the pioneers of the online lending industry. But both had their origins in brick-and-mortar operations and thus felt uncomfortable leaning entirely on algorithms. After all, most Chinese consumers had no credit history or a profile in a centralized place like FICO or Equifax in the U.S. The Credit Bureau at the People’s Bank of China (the central bank) only has patchy information about the credit history of those who have dealt with the supervised institutions such as banks. It is not very useful as far as Yirendai and CRF were concerned. So, a compromise solution for them is to maintain both online and off-line forces. For example, CRF had a total of 3,119 employees and 2,080 temporary employees as of the end of 2016, of which around two-thirds worked at data verification centers to ensure that the information submitted by

10

“Fraudsters Are the Biggest Winners!” prospective borrowers was accurate. For a small company with a revenue of only US$56 million, the infrastructure costs were enormous. And it was no surprise that it had suffered losses (due to operating costs and dead loans). Yirendai was profitable partly because of its bigger scale and partly because it shared some infrastructure costs with its parent company CreditEase. When tens of thousands of copycats, as well as innovative operators, joined the industry, competition became fierce. Due to a limited amount of information these marketplace lending platforms had on millions of essentially first-time borrowers, the small sizes of each loan, and thus the prohibitively high costs of pursuing overdue borrowers (let alone outright cheats), fraudsters saw an open invitation to make a killing. They did not squander the opportunities. Due mainly to frauds and diseconomies of scale, the industry suffered a ruinous defeat from 2013 to 2015, and this lead to several hundred voluntary closures each year. Many entrepreneurs who personally borrowed heavily to fund their start-ups went bust and some ran away with the company’s shrunken pot of cash, giving the P2P finance industry a bad name.

Smartphones and Fintech Come to the Rescue Just when the P2P industry seemed hopeless, three crucial developments in 2015 saved it:

11

CHASING SUBPRIME CREDIT

1. The growing receptiveness of the P2P sector. It was like an inflection point; 2. The surge in smartphone use; and 3. The growth of data analytics technologies. An ecosystem was now in place. Many observers have argued that fintech (including P2P) would eat the traditional banks for lunch. I visited some banks to gauge their views. While they were generally anxious, they have all along been very pleased about what they have seen so far. For smaller banks in underdeveloped regions, the presence of fintech and online lending platforms is great news: they have now one extra avenue to deploy their deposits. Instead of selling their funds cheap in the safe interbank markets, many now team up with online lenders such as WeLab (我來貸), Feidai (飛貸), and China Rapid Finance (信而富) under the “assisted lending” schemes where the online lenders take a junior portion of the loans. The net rates can be as high as 10% a year while the rates at the interbank market are about one-third or less. The potential to work with Hangzhou-based 51 Credit on consumer financing is even greater. Many already work with the likes of WeBank that is 30%-controlled by Tencent where non-performing loans rates are as low as 0.3% — much lower than the banking sector’s credit card default rate of, say, 3%. In a slowly saturated credit card market, for most of the thousands of banks (i.e., the smaller ones), trust institutions, and credit unions, the cheapest way to tap consumers may be through collaboration with online lenders. It may even become the only way.

12

2

Chapter Subprime Financing in the U.S. vs China

CHASING SUBPRIME CREDIT

Much has been written on the 2008 subprime crisis in the U.S. But the writers were mostly Americans and their writings, in my view, were often stuck on a need to assign blame, or relate technical details, share financial crime stories, and define acronyms. Why did the subprime crisis take place in the U.S.? If I were to summarize the reasons given, the writers seemed to blame one of these things, or a combination of them: 1. The fat bonuses for the bankers, traders, and Fannie Mae executives; 2. Weak regulations and lax lending standards; 3. Criminal activities on the part of the mortgage originators, borrowers, or the securities traders; 4. The greed of the rating agencies such as Moody’s or S&P; 5. The politicians, or Fannie Mae, Freddie Mac, and the hedge funds; 6. The banks were “too big to fail”; 7. The American public’s obsession with home ownership; 8. The acronyms are too complex for anyone to understand; 9. The banks’ inadequate capitalization and off-balance sheet leverage; 10. The huge volumes of derivatives; and 11. The Federal Reserves’ stupid monetary policies, including cutting interest rates too low. Now, all of these reasons, I am sure, properly explain a certain aspect of the subprime crisis. But having read huge volumes of

14

Subprime Financing in the U.S. vs China the subprime literature, I get the view that there was a far-more important reason behind the origin of the crisis, and that the crisis was inevitable. This is my argument: no amount of derivatives could cause such a crisis if all the underlying mortgage debts were safe and sound. So, the only reason why there was the crisis was because too many mortgages went bad. And layer upon layer of derivatives simply sparked the crisis of confidence and accelerated the spread of the fire. But, why did the banks and the non-bank lenders lend to so many weak borrowers? You might say that it was because the banks or institutions were foolish, or took too many risks, or were run by incompetent bankers. I know there must be some bankers who deserve that tag, but for the vast majority of lenders — and possibly even for the incompetent and fraudulent ones — there must another reason. And that reason is that there were not enough good borrowers to go around. It was simply too hard to find enough prime borrowers and, therefore, they were “forced” to go down the credit pyramid to search for ever-weaker borrowers in order to meet their growth target and deploy their capital. If they had to choose between a good and a bad borrower, almost all bankers would choose the good one. Lending is not rocket science, and lending criteria are plain and simple. You say, why did the bankers not simply stop their lending business once all the good borrowers had been served? Were the bankers not being too greedy in the name of lending growth? But, like it or not, seeking an ever-bigger profit is the core of

15

CHASING SUBPRIME CREDIT

capitalism. If you embrace capitalism, you have to accept that. The bankers did not suddenly drop, or forget, their lending standards in one day; it was a gradual process. And, the weakening of lending standards had been going on for decades. The competitive pressure in the marketplace was constant, and one clever bank might have decided that the pursuit of more mortgage business had become silly but another bank would have quickly joined or expanded its business to take your market share. Karl Marx warned us more than a century ago. Capitalism creates excess capacity and excess capacity gets destroyed through crises like the one in 2008. Trying to avoid it is to try to avoid aging and death. There are tricks to slow aging and prolong life. But there are limitations to those tricks. One must ask why the subprime crisis did not happen in the U.S. in the 1980s or the 1990s. I am sure the bankers at that time were just as greedy, some borrowers just as fraudulent, the regulators just as clueless, and the bank bonuses just as fat (by the standards of that time). So, my answer is that, in the 1980s and the 1990s, there were still plenty of prime borrowers to go around and, for the bankers, it was not too hard to find enough of them so they could afford to avoid the subprime borrowers. But, when the pool of good borrowers got gradually depleted, where else could they find growth? Not surprisingly, the bankers had to convince themselves to go easier on the lending criteria. Of course, competition also played a role. All this is human nature, regardless of the political institutions or the ethics of market participants.

16

Subprime Financing in the U.S. vs China So, my view is that the subprime crisis was inevitable. It had to happen, though the precise timing of the crisis, the format, the sequence of events or the trigger might have been different. Observers who argued that lessons must be learned and measures taken to prevent the next subprime crisis are wrong. Crises of this kind, in my view, will recur to cleanse the system, and wash away the excess capacity in the system. Failing that (I think the West is indeed failing that, because the lending capacity has not been destroyed since 2008, and in fact has been boosted), the crisis will at least change the behavior of the economic participants, but the participants’ self-restraint can only last so long. Slowly but surely, they will lower their guard and relax their self-restraint. Another crisis will start to brew. This cycle will repeat itself again and again.

Subprime Financing in China The Chinese like to compare their market with that in the U.S. partly because of the sizes of the two markets and partly because America is what most Chinese like to see as their country’s role model. In the U.S., the subprime credit customers (consumer lending, home mortgages, or car loans) are mostly made up of low-income citizens plus a relatively small number of genuine frauds. In the long term (maybe over the next few decades), China’s subprime market will look the same. But, currently it is different. There are still many high-quality customers or prime prospects out there who are not yet served by the banking industry. Still, that point is admittedly often over-emphasized by promoters of the online lending industry.

17

CHASING SUBPRIME CREDIT

This is due to these facts: 1.

China’s market for credit cards and mortgages has a short history, and thus low penetration;

2.

Social mobility is still unfolding in Chinese society and, therefore, a large section of the population is still climbing the income ladders rather quickly; and

3.

A not-so-subtle change within the consumer culture from always living within our means to living beyond our means has occurred over the last few years, or even last decade. In other words, Chinese consumers are embracing the idea of mortgaging their future incomes for today’s needs.

Through my own experience I can see how this cultural shift is unfolding. In 1979, when I went from a remote rural village in Hubei Province to Wuhan, its capital city to study for a university degree, China was just ending its decade-long Cultural Revolution. My family was dirt poor, but I found my classmates — mostly boys and girls from the cities — equally poor. Most of us lived on the 11-yuan monthly stipend (some exceptionally needy students got 13 yuan). It was just enough for very simple food. There was no extra money for luxuries. The prevailing ideology at that time was frugality and austerity. That lifestyle of ours was regarded as “glorious,” and at least normal. I did not remember feeling miserable or any wallowing in self-pity. In fact, for many of us, those four years were among the happiest periods of our lives. Austerity is easier to enforce when everyone is equally poor.

18

Subprime Financing in the U.S. vs China But it becomes harder when you can see other people around you living a much higher style of life. It is fair to say that the market for mortgages and consumer credit is predicated on inequality. The have-nots want to push up their consumption today, short-selling their future consumption. Inequality is more blatant and cruel in today’s China than the U.S. has ever seen. That is one reason why the Chinese are turning themselves into debtors at an unusually rapid pace. In the meantime, those who have a small amount of spare cash, even for a brief period, have a reason to make it produce something. I am not judgmental enough to say if this trend is good or bad. But it is what it is. The sea of information about credit can overwhelm anyone. Smartphones and digital applications have made both lending and borrowing so easy, and even addictive. I confess that I lend money through my smartphone all the time, though I have never borrowed from the peer-to-peer market. When I have 30,000 yuan or much smaller amounts in the bank account, I will send it through to an income generating outlet, be it wealth management products or online lending platforms. I will not allow it to sit on my bank accounts as deposits. I tell myself: I am working hard. Why should I allow my money to sit idly by? Even when I sleep, my money must work for me. People in the West will find this unusual: China is fast becoming a nation of creditors and borrowers. You often hear people chat about which P2P account to send your money to, and other moneymaking tips. Having just spent three years in London, I must say that I never overheard such chats in my Tube rides.

19

CHASING SUBPRIME CREDIT

Democratization of credit sounds nice. Libertarians must be celebrating it somewhere. But in China, when a nation of mostly novice people suddenly enter the credit market, you can imagine the chaos that follows: rules, cheats, grievances, and waves of panic. This is the new face of subprime financing. We eat subprime, talk subprime, and sleep subprime.

Who Are You Calling Subprime? There are three ways to define subprime credit: by the origin of the money, by the outcome of the deal, or by its quality. Subprime credit is a question of quality, and quality depends on the borrower’s willingness to repay, and ability to repay. But in China today, we can also define subprime credit by the origins of the money. It is a good enough proxy to the quality of the credit. Why is this so? China’s banks all live in a greenhouse, one built and nurtured by the state at the taxpayer’s expense. They are whiteglove institutions which do not have to get their hands dirty. Why bother? The state sector was dominant and has become ever bigger (rather than smaller). Making a billion-yuan loan to a state-owned enterprise is so much easier than making a thousand thousand-yuan loans to desperate chefs, lorry drivers, delivery boys, and office clerks. It is also much safer, counterintuitively and paradoxically. The taxman and the printing press stand right behind an SOE credit. The more financial liberalization there is, the less important it becomes for the banks to ever venture out of the greenhouse. My analysis shows that the booming non-bank financial sector has

20

Subprime Financing in the U.S. vs China made the banks much safer, and more profitable as the Non-Bank Financial Institutions (NBFIs) have plowed the subprime space and, knowingly or unknowingly, played the role of the banks’ plumbers. Through their sacrifices and capital destruction, they keep the banks ever more entrenched in the SOE credit sphere and prime mortgage domain. Their credit cards business also happens to be the cream of the crop in the consumer credit sector. You argue that the banks have lots of bad debts. True. But the banks have far lower bad debt ratios, and are better equipped to deal with the bad debts. Delinquent borrowers fear the banks more than they fear, say, a microcredit lender or a P2P company. Why? Bank transactions are part of the Credit Bureau of the People’s Bank of China, but transactions with most of the non-bank financial institutions are not. An indication of how much the borrowers fear being put on “the list of the tainted” came when the Liaoning Provincial Government requested or ordered Huishan Dairy’s panicky creditors to not put Huishan on the black list of the Credit Bureau of the People’s Bank of China. Even when a company was virtually dead, it was still concerned about the central bank’s credit bureau! Even then the local government was still worried about that list! In fact, this is by now a standard request of the creditors from the government. So, for simplicity, I define subprime credit as credit made by non-bank financial institutions where interest rates are far higher and, by and large, credit quality much lower. There are millions of exceptions to that statement for convenience reasons and for technical reasons, but most readers would agree with me on the supremacy of the banks in China over NBFIs.

21

CHASING SUBPRIME CREDIT

My table below shows the relative scale of these sectors. Using our definition, around 15% of all financial assets in China (i.e., totaling 31 trillion yuan-plus) were defined as subprime as of mid2017. This figure does not even include inter-company loans and inter-personal loans that do not go through a formal P2P operator. One caveat is that most (by assets) of China’s leasing companies are controlled by the banks and they are probably as prime as bank loans. Table 2.1 China’s finance assets, as of August 2017 (Unit: billion yuan) Total assets Depository institutions (mostly banks)

188,799

68 trust companies

23,000

Microcredit

2,500

Guarantee companies

3,000–4,000

P2P and online lenders

1,200

Leasing, factoring (mostly within banks)

3,000

Source: China Big Report, PBC.

Why Are Interest Rates So High in the Subprime Market? The interest rates on the subprime markets are high anywhere in the world. But China has its own characteristics. Despite the very high growth rates of money supply four decades in a row, interest rates in the marketplace refuse to fall.

22

Subprime Financing in the U.S. vs China From time to time, the People’s Bank makes politically correct noise about cutting interest rates to stimulate the economy (and helping SMEs and consumers), but the reality is that it only helps the state (reducing government’s debt burden), SOEs, privileged entities, and prime-quality consumers. The rates in the subprime market do not seem to decline accordingly. For the liquidity providers in the subprime market (like my relatives and myself), while the prime benchmark interest rates (the opportunity costs of their funds) have fallen, the rise in the risk premium often offsets the benchmark decline. As a rate cut by the central bank often follows a sluggish economy, it is the subprime sector that takes the brunt of higher delinquency rates. Therefore, interest rates in the subprime market stay high. Moreover, the regional and local governments do not care about the interest rates as much as the private sector but command better security and market standing. So, their aggressive stance in the subprime market forces the private sector to accept higher interest rates. The ill-fated interest-rate cut in late 2014 only served to cause a stock market surge straight away but the bubble crashed spectacularly within six months. Now, even the zealous promotors of interest rate cuts (like the stock market people) and the People’s Bank feel too embarrassed to talk about rate cuts for the sake of the economy and consumers.

23

3

Chapter Horror Stories

CHASING SUBPRIME CREDIT

On a late morning in mid-September 2017, the autumn sun was gently sprinkling on the mild waves in Hong Kong’s Victoria Harbour. On the east bank of the Harbour was the Four Seasons Hotel. Mainland Chinese tycoons liked to hold court here when they came to town. It used to be a hot place to see and be seen. But a lot has happened here in the past few years to make this hotel too much of a spotlight. Some entrepreneurs have begun to shy away from it in favor of more discreet places like Conrad Hotel or Island ShangriLa. I was sitting at the famous Lobby Lounge, drinking latte with Chris, the departing chief operating officer of a mid-size P2P firm in China. He had flown to Hong Kong the day earlier to attend a Yale alumni reunion. Chris was visibly anxious as his boss, Terrence, had just “regrettably” accepted his resignation since Chris wanted to “spend more time with his family.” But Chris felt duty-bound to stay on as a consultant, at least for six months, to facilitate the transition and to help the company tide over the liquidity crunch. “In fact, it is more than just a liquidity crunch. There is a giant black hole. We have lost a lot of money for the investors,” Chris said. “We, no, I mean the company, must somehow magically find ways to plow our way back to solvency, and at least to make good the investors’ money. Tens of thousands of retail investors. I feel awful. I do not know how my predecessor got the company into such a deep hole.” More than six years ago, when I left UBS investment bank to run a traditional microcredit company in Guangzhou, I attracted lots of attention in the industry. Terrence visited me together with

26

Horror Stories his then boss, a real estate tycoon. They operated a much bigger but now defunct microcredit company attached to the real estate business in Guangdong Province. I have kept in touch with Terrence since then. Four years ago, he set up a P2P company, Black Horse, but without the sophisticated IT infrastructure you would normally expect of such a big operation. In essence, his was more like a giant microcredit company without a license, plus a wealth management operation. A strange hodgepodge. To make matters worse, due probably to a lack of a centralized IT system, his company was like a UN with seven member states, all pulling in different directions. Another problem with this structure was that each division suffered inefficiency and bloated costs. In this sprawling jigsaw, it was hard to implement risk controls and foster sharing of expertise when there were fiefdoms and inflated egos with separate accounts. Black Horse operated in 80-odd cities with ten thousand employees across the country. It was a typical operation that proliferated in the past few years in the country. There must be thousands of such institutions out there. It was quite a scene. They all have fancy names: this-and-that wealth management company, so-and-so speedy lending platform, or blah-blah-blah financial services company. Sometimes I think perhaps they all looked like old fashioned banks without ATMs on the exterior and without IT in the interior. Two of the three companies in the industry that I invested in looked a bit like this. For a country boasting one of the highest smartphone penetration rates, this landscape is a bit strange, to say the least.

27

CHASING SUBPRIME CREDIT

About two weeks earlier, Terrence had asked me to assist him to find a big investor in his company to “fund growth,” since, as he said to me, “You must have some friends in the business world given your investment banking background.” I told him that I did not have the license to provide financial services advisory work, though I could probably make a few useful introductions. So, the meeting with Chris was part of my efforts to understand Black Horse a little better. I was taken aback to learn he was leaving the firm just nine months into the job. But who could fault him? “I can see there is a giant hole in the company. I mean billions of yuan of a hole. Almost half of the outstanding loans are overdue and it is not of my making. I inherited it from my predecessor.” Chris showed me his company’s cost structure in 2016: 1. Their average interest rate was 39% annualized, including various types of fees and penalties for overdue loans. For loans lasting as long as two years and sums as big as 500,000 yuan (or much bigger in some cases), “pushing up the interest rates further would be like a commercial suicide.”

2. Minus direct interest rates paid to online investors (mainly retail, small sums each investor): 11% annualized. And you have to take delays in capital deployment into consideration, since their IT and direct fund matching was problematic.

3. Minus 11–14% in expenses at retail outlets and slightly lower from online sources, but online funding was a small portion of the total, and online funding was usually shorter in maturity. That means “we have to pedal very fast to try to roll them over.”

28

Horror Stories 4. Minus 6–8% in the form of marketing and corporate overheads.

5. Minus bad debt provisions of 8%, unlike Yirendai, CRF, and others that have a fully-funded separate risk reserve fund, Black Horse did not have it. Instead, it took a provision of 8% in its profit-and-loss account. So, Black Horse ran a primary deficit of 2–3%. If this were to continue, it would make the business unsustainable. “But the real trouble is in bad debts. What if the loan loss surged to 30–40% as was the case in 2016 as compared to the 8% provided, the company would be killed really quickly,” Chris moaned. This is the reality: since 2016 Black Horse has been using money from the new investors to pay off the old investors. “Is this not a Ponzi scheme?” I asked Chris. He looked around the room quickly, lowered his head, and buried his body deeper in the sofa as if to duck an attack from someone near him. “I do not know how you define this stuff. But it is what it is, and I bet you, we, I mean Black Horse, are not the only culprit. What do you do when you are in my position or my predecessor’s? I hate him but I guess I am also sympathetic to him.” I started to hear strange noise in the background. Maybe it was the traffic outside the hotel or my ears were reacting to my shock in a curious way. In any case, I had not prepared myself to hear what Chris had just told me. I rushed to the bathroom to splash some cold water on my face, and came back quickly to continue our conversation. I remembered clearly that the regulations since 2015 prohibited P2P operators

29

CHASING SUBPRIME CREDIT

from pooling funds together to lend to others, and in other words, peer-to-peer has to be literally true. With a few exceptions, the vast majority of P2P companies have no lending licenses, and can only act as an intermediary between individual lenders and borrowers, and the matching has to be direct although not necessarily oneto-one. It can be one to many, or many to one. There are other restrictions on the borrowers (though not on the lenders). For example, a borrower must not borrow more than 200,000 yuan at any given time from a given platform, and a corporate borrower must not exceed 1 million yuan at any given time. These rules are often poorly enforced, as the regulators seem to give the industry an unspecified phase-in period in which to comply. In addition, how do you ensure compliance when the borrowers can access as many as hundreds of P2P operators at the same time, and they do not share a central database? In Hangzhou-based Tongdun, the database is said to record all lenders’ inquiries of borrowers’ creditworthiness. But this was only limited to the participating institutions. Luckily for the industry, the likes of Tongdun and Bairong have grown their client bases rapidly and their combined coverage of the borrower base is growing to be meaningful. Chris felt bad about abandoning ship at a troubled time, but assured me that the company had recently made five impressive hires from Citibank and Ping’an Bank. “These people are experienced professionals and I like them a lot. They should be able to steady the ship soon. But I am too tired to soldier on.”

30

4

Chapter Data, Data Everywhere. Which Is Useful?

CHASING SUBPRIME CREDIT

On a sunny September morning, I came to the offices of Pailie Technology (eCreditPal 排列科技), a credit risk analytics start-up with a history of just 16 months. Thanks to its business expansion and second-round funding, they were busy moving into a bigger place in Hangzhou’s quiet, “new-economy” campus in Yuhang District. All the buildings in the campus were new and less than 10 stories high. Trees and grass covered most of the campus, and right in the middle of it was a pond with waterlilies, lotus flowers, and trees full of chirping birds. What a place for data crunching and deep thought! I told myself. My friend Xia Ming, the chairman of the Microcredit Association of central China’s Jiangxi Province, had introduced me to the founders of eCreditPal. The co-founders, Xia Zhen and Zoe Chen, held doctoral degrees in E&E and computer sciences, respectively. Chen worked for some years in the anti-fraud unit of Lending Club and Xia at IBM Watson and Yahoo!. When they decided to start up this business in China, they almost instantly received funding from a fund affiliated with Silicon Valley, and soon second-round funding from Beijing-based China Growth Capital. Xia Zhen is a cousin of Xia Ming’s. Xia Ming and I shared some tough experiences fighting and lobbying in the now-dying microcredit industry and our bonding was that of comrades. We sometimes joked about our shared ignorance of China business and the tyranny of regulations. Beating a retreat from the traditional lending business, we ate an elaborate meal to celebrate our deal and shared a few tales of our suffering and belated understanding of the subprime lending sector.

32

Data, Data Everywhere. Which Is Useful? Xia Ming came with me to the eCreditPal meetings. Our discussions with the founders at eCreditPal started with a discussion of their business model. Unlike their by-now established nextdoor neighbor, Tongdun, a company that gathers and monetizes information on fraudulent borrowers, eCreditPal ranks all credit applicants and suggests an interest rate accordingly. It had a total of 30 corporate customers (and counting). These included companies in the center of the logistics industry who wanted to lend to their upstream and downstream customers but did not know how to evaluate them properly. They also included less sophisticated finance companies who wanted to optimize their underwriting decisions to minimize defaults. In addition, it also helped these customers attract borrowers. One of the most prominent lenders in the country also hired ECreditPal to simplify its app in order to improve the overall customer experience. In essence, it was a risk analysis and pricing business based on data and financial models.

Risk-Based Pricing Hot Air? I was skeptical of the much-touted risk-based pricing; what’s the point of charging higher interest rates to weaker borrowers only to lose the principal? Based on my experience, I felt that credit should be priced uniformly and there should be only two decisions for the loan officers to make: lend or reject. “If you charged a marginal or weaker borrower a higher interest, would you not further weaken his affordability and push him into a higher risk of delinquency?” I

33

CHASING SUBPRIME CREDIT

asked Chen. Chen conceded to such a possibility, but pointed out that it was relevant only for standalone cases. In a large-enough sample, riskbased pricing is just fine because the higher yields from those wellperforming loans more than offset the delinquencies. Xia Ming and I had become tired of chasing unpaid credit, and were cautious about the rapid growth of short-term cash advances in China. Someone called us half-hearted believers. The co-founders also acknowledged the possibility of the non-bank credit sector in general (i.e., the subprime sector) rapidly growing ahead of the genuine underlying demand. “It is probably not yet alarming. But the capacity of the sector is building up too quickly and there are too many brave and ignorant entrants in the sector,” cautioned Chen. But, when is it alarming and excessive? Like other bubbles, we only know of their existence well after they burst, as Alan Greenspan, a former chairman of the Federal Reserve, was said to have remarked in 1996 when he coined the famous term “irrational exuberance.” Chen continued, “You see, the population base for China’s instant cash loans — the Americans call them payday loans — is estimated at about 50 million. How reliable is that estimate? I do not know. Now some optimists say it has grown to 70 million. OK. Let’s say it is 70 million. But how much real demand is there? Three trillion yuan, or two? What’s the actual market size we have already achieved? We do not know for sure. Is it possible that some new entrants are already taking over the old short-term loans, giving the old loans a new lease on life? We do not know.”

34

Data, Data Everywhere. Which Is Useful? I suddenly recalled the famous stumble of Chuck Prince in 2008 when he was still the CEO of Citigroup. The United States mortgage-fueled derivatives market was red hot. When asked about his views of the mounting risks, he told reporters, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Recognizing a bubble, and particularly the end of a bubble, from a genuine paradigm shift is tricky, I noted. Xia Zhen interjected, “All that you have said is reasonable. But there is one other thing to consider: demand is a function of supply, and vice versa. Millions of people have never thought about borrowing to fund their consumption but now they are part of the credit market. So yes, a lot of genuine demand is being created.” On that Chen concurred, “That is like the real estate market. You build it, they will come. However silly that may sound, the construction activities themselves do generate incomes, the purchasing power, and the willingness to buy. That’s the biggest puzzle faced by the China prediction industry of the past decade or more, having embarrassed so many economists and laypeople alike who had always called for the bursting of the bubble on the basis of affordability without knowing that affordability also keeps improving on the back of the construction activities and their spillover effect.” There is an analogy in the capital markets. As George Soros, the American hedge fund titan, was quoted as saying half-jokingly, in the capital markets, corporate fundamentals determine the stock prices, and the stock prices — when sustained for a while — also determine the fundamentals.

35

CHASING SUBPRIME CREDIT

Who can fault this argument? But, if taken too far, it is a recipe for disaster. Take the commodities’ “super-cycle” theory, for example. The theory was fashionable for a few years around 2004 or so, until 2007, when the prices of energy and commodities were at their peak. But when the commodities market tanked from 2012 to 2017, no one was still willing to champion the theory.

My Self-Doubt Xia Zhen asked if I was negative on the online lending sector. “No, not at all. I am just weary. I am troubled every day by a few cold calls from online or offline credit companies. Is this not a sign of oversupply, or the peak of the industry?” Chen expressed optimism about the sector citing the fact that the marketplace interest rates had been trending downwards since 2014. “In a credit bubble and a boom fueled by false demand, or too much distressed demand, you would expect the marketplace interest rates to trend up, not down.” “Fair point,” I conceded. But caution is always a virtue. After you repeat a theory too many times, the most loyal believers are often yourself, while the market may have moved on. In 2011, a founder in the financial guarantee business in China went on roadshows in Hong Kong, Shanghai, and Singapore to convince investors of the merits of his business model. He also spoke at a few conferences to drum up support for his funding rounds. He did raise some funding thanks partly to his enthusiasm and eloquence. But the more he articulated,

36

Data, Data Everywhere. Which Is Useful? the more logical he sounded and the more convinced he and his top brass became. Their own initial concerns and doubts slowly evaporated. They dug in and doubled down when the numerous defaults hit the fan, and when frauds rolled in. They eventually went “illiquid” and finally became insolvent. On the sidelines of a conference in Hangzhou in September 2017, he confessed that, like stock market research analysts who have to be independent of the companies they follow, corporate executives also must have a detached mindset. At this point, Xia Ming asked, “Is the falling interest rate in China in the past few years a sign of a healthy credit market, or merely the result of the central bank’s credit relaxation, which is proof of a sluggish economy?” No one answered, because only a fool would hazard a guess.

Garbage In, Dollars Out! What type of data is the most useful for credit underwriting? Of course, the multi-dimensional data that encompasses social media, purchases, credit history, incomes, and assets. Chen said, “Of the two types of data we have — the data from the credit bureau of the People’s Bank, and credit reports in the private marketplace — we found that the former offered a fuller picture of the borrowers. While the latter is more selective and patchy. Of course, the People’s Bank data is insufficient also. For example, it does not cover the activities of the non-bank financial institutions.” In 2013, Xia Ming noted, the People’s Bank allowed some

37

CHASING SUBPRIME CREDIT

microcredit firms to access its credit database and also to upload their activities to it. But this privilege ended in 2016, probably because the central bank’s IT system could not handle the increased volumes, or probably because the central bank was concerned about too much low-quality (and even fake) input from the huge numbers of quasi-financial institutions that neither it nor its spinoff, the China Banking Regulatory Commission (CBRC), supervises. Fairly or unfairly, these institutions that are licensed and supervised by the local governments’ finance offices were regarded as secondclass corporate citizens and possibly even loose cannons. One online lending outfit allegedly sent to the Credit Bureau and Tongdun a list of its good customers marked as “blacklisted” so that these customers stayed its captive borrowers. Chen sits on the governing committee of the China Internet Finance Association as a technical expert. The association is a quasigovernment entity inside the People’s Bank of China and one of its retired vice-governors, Li Dongrong, serves as the chairman. The association was set up only in 2016 amid the rapid growth of the online lending sector. Chen noted that the Association was trying to build a separate credit database based on the activities and input of nonbank institutions, but that the progress has been slow. Maybe a corporatized effort would be more efficient than those of a statesponsored association. But, so far, no corporate entity with enough political or commercial clout has stepped forward to take the lead for this database. Xia Zhen pointed out that no database would be comprehensive

38

Data, Data Everywhere. Which Is Useful? enough, and thus the users must not rely on any one database. Use of the Tongdun system is now entrenched within the industry, and so is Beijing-based Bairong and a couple of others. These firms incorporate input from their users in reciprocity and, over time, will become the industry’s gold standards, if they are not already so. Xia Zhen smiled when asked about his five-year target: “I want our corporate customers to see eCreditPal as a badge of creditability the same way they see Tongdun or Bairong today.”

Exhibit: Gauging the Population of Online Borrowers Each of the thousands of online lender boasts millions of registered users. Some have hundreds of millions. But there are only 1.3 billion people in the Middle Kingdom. How many of these registered users have maintained, and borrowed from, multiple online lenders? Do the online lenders know their borrowers’ financial activities elsewhere? What’s the addressable online lending market? To gauge that, I make the following assumptions: 1. People below age 22 or above age 51 are excluded. People above 51 are less active in online merchandise purchases and games, though their smartphone usage is just as common as younger people. The education authority is openly against online lending to students and most online lenders comply. So, we exclude people younger than 22, and add roughly 30 million high-school graduates who do not proceed to university.

39

CHASING SUBPRIME CREDIT

2. Some observers suggest that we should exclude those with a monthly income of 8,000 yuan or above. But my straw poll with three online lenders found that many online borrowers have a monthly income of as high as 20,000 yuan or even 60,000 yuan. Although the higher-income people are less likely to be active online borrowers, a fraction of them do borrow for consumption, for business, or for family emergencies. Many of these higher-income borrowers may have credit cards but there are tight limits on the amount of cash they can take out, so they resort to online lenders from time to time. Many young professionals have a reasonably high income but very little assets and often dip into high-interest debts for various reasons. Since incomes are a function of age, we assume half of the 22–36 age bracket and only a quarter of the 37–51 age bracket are addressable. 3. I take an 80% discount to the rural population as their ownership of smartphones is lower and peer pressure to consume is also less intense than in the cities. 4. There is the suggestion that most online borrowers are new migrants (those who have migrated to the cities in the past two decades). While on average their incomes are lower than those who were born and grew up in the cities, this assumption is disputed by some online lenders as big numbers of sons and daughters of well-to-do families borrow online from time to time (to avoid parental supervision), although they are less likely to be reliant on this source than rural migrants. However, periodically many of these borrowers rely on their parents to

40

Data, Data Everywhere. Which Is Useful? clear their online debts. 5. International data is not available but CredEx (Feidai), a big online lender with more than 5 million registered users reported in October 2017 that 77.86% of their registered users were male, and 77.88% of their borrowers were male. Pailie Technology confirmed the approximate gender split in the whole industry without giving specifics. However, two P2P firms (plus the former CFO of a top-3 wealth management firm in the country) said that there was no clear pattern by gender in their retail investor base, nor by age, except to say that there seemed to be more women and more senior citizens among the investors. In view of these facts, we take a 50% discount to the female population in the selected 22–51 age bracket. Table 4.1 The calculation of the online credit market’s addressable population Total population Male

Female

Urban area Rural area

Age 22–36

328,315,484

166,750,441 161,565,043 183,856,671 144,458,813

Age 37–51

339,918,126

173,521,604 166,396,522 190,354,151 149,563,975

Addressable 161,440,953 population

139,516,873 21,924,080

Addressable high-school 40,000,000 graduates Total addressable 201,440,953 population Source: National Bureau of Statistics, and the author’s assumptions and calculations.

41

CHASING SUBPRIME CREDIT

All these exercises give us an online credit addressable market of roughly 200 million. But actual borrowers of online credit should make up a far smaller number, and active borrowers a smaller number still.

42

5

Chapter Rotten Apples Everywhere

CHASING SUBPRIME CREDIT

China’s P2P sector has a reputation problem. To the uninitiated, it can seem like a digitized Ponzi scheme. And even for the sophisticated, it is hard to have too much faith in the system. Guo Guangchang, the chairman of Hong Kong-listed Fosun International once said that the P2P operators were mostly a bunch of “liars.” However, this has not prevented his company from investing in two private rounds of Beijing-based Quant Group (which is not a P2P, but an online lender). The Quant Group has solid technical background and is a respected player in the industry. Since 2012, several thousand P2P operators have sprung up in China because of its perceived low entry barriers and quick buck potential. Most operators started with poor funding, inadequate personnel training systems, and very little ethical preparation. Of course, real supervision was absent and, for a brand-new sector, the government had not put in place a regulatory framework to deal with consumer grievances, frauds, and disputes.

A Total of 2,090 P2P Operators According to China Economic Weekly, between August 2016 and August 2017, 887 P2P companies shut down operations. There were more quiet closures that happened below the radar. The industry tracker and consultancy firm, wangdaizhijia, reported that as of August 2017, there were still 2,090 P2P operators across China. For an industry that does not have geographical barriers to its business, this number of operators is insane. Considering the gradual tightening of regulations, the rising legal and operational

44

Rotten Apples Everywhere expenses, and polarization in the sector, one must conclude that the vast majority of these firms will shut down at some stage, perhaps within just a few years. There are three types of online lending institutions: 1. Pure P2P match-makers, such as Suzhou Qiandai; 2. Online lenders using institutional money such as Feidai in Shenzhen (the former ZTE Microcredit), and the Quant Group; and 3. A combination of the two, although for regulatory reasons the two types of lending may be conducted in different legal entities under the same roof. As a financial conglomerate encompassing lending, factoring, leasing, trust, and fund management, Shenzhen-based Hongling Chuangtou has been around for more than a decade. Since 2014, they have made big-ticket loans via the internet with insufficient due diligence. However, delinquency weighed the company down and the company announced in mid-2017 that it would shut down its online lending business by 2020, by liquidating all its loans and repossessed assets. The media correctly cited the company’s downfall as due to the average ticket size of its loans. In essence, it is an SME lending machine, rather than a consumer credit operator. For example, it had lent 50 million yuan to Hong Kong-listed company Huishan Dairy (6863.HK) in 2016. Due to Huishan’s heavy debts and creative accounting methods, the trading of its stock has been suspended

45

CHASING SUBPRIME CREDIT

since March 2017 following a stock price plunge. Immediately some key executives jumped ship, and the Committee of Bank Creditors started turning every stone around the company to find a way to meet its alleged 35 billion yuan of unpaid debts. Foreign banks that were not subject to the Liaoning Provincial government’s armstwisting are suing in the Hong Kong court of law to recover their debts. Hongling is by no means an isolated case of online lenders falling victim to big fraudulent corporates. E-Zubao and Pan-Asia (Fanya), before their demises in 2015 and 2016, respectively, lent big sums to problematic corporates. Even if these two companies had not collapsed because of their criminal activities, they would have been killed by bad economics. Hongling has acted honorably and promised to make good all investors’ money but the other two companies would not have the opportunity even if their management had the intention to do so. These cases reinforced the common view that online lending is only sensible for small loans, particularly in the subprime credit sector. The fact that so many P2P companies shut up shop in the past 12 months, and that most did so voluntarily, means that they were not all fly-by-night merchants and that most of these companies did have common sense and basic ethics. One regulatory official said that he was rather encouraged by the voluntary compliance with the rules even before the rules became effective and formal. (Strictly speaking, most rules at this stage were still just for consultation in September 2017.)

46

Rotten Apples Everywhere It is true that China’s regulations on the non-bank financial sector are patchy, and that enforcement is selective. However, when the rules are enforced, the penalties can be hefty. In some cases, a visit by the Economic Investigation Department is sufficient to bring down a business that is so dependent on public confidence. In the past few years, the state has proactively shut down a few operators. For example, the Zhejiangu-based Miaozi Financing was closed in August 2017 for gathering deposits without a license. For the government, the crucial task is to educate and protect retail investors. On that front, frequent exposure of high-profile cases on closures, and arrests, and cases of proprietors’ running away with investors’ money should have been sufficient education for anyone, in my opinion. For example, the rule that requires all money to be in custodian accounts of a bank since 2016 has gone a long way to protect retail investors. It is probably fair to say that few investors are unaware that the P2P investment platforms, and wealth management products, are not as safe as the banks. For the government, there is a delicate balance between encouraging financial innovation (and competition) and prudential supervision. This is similar to the regulation of the stock market. No matter how rigorous the rules are, there will be frauds because the incentives are obvious. Some investors will fall victim to frauds. Many will always speculate and get hurt again and again. But the state must not make the rules so tight that the market cannot function efficiently. I am of the view that the current system of online credit supervision works as well as, if not better than, the legalistic and

47

CHASING SUBPRIME CREDIT

codified system in Hong Kong or the West — given that this is a new and rapidly-changing sector in Mainland China. In Hong Kong, one simply cannot operate a P2P lending platform, for example. A large number of my relatives and friends invest in P2P platforms. So far, no one has been hurt. If they were, they would still be participating in the P2P market with their eyes wide open, the same way they speculated in the stock market.

My Own Failings On September 8, dianlicai.com, a P2P lending platform operated by my own company, China Smartpay’s associate entity, Zhicheng Holdings, announced termination of business. I learned it only from the media. Red-faced and half in disbelief, I immediately called the chief executive of Zhicheng Holdings, Wu Xiaoming. Wu confirmed the closure of that division. We had run into too many defaults and overdue loans. Concentration risks, lax internal controls, and the nature of SME loans, plus a heavy dose of bad luck, brought down our P2P business. We had a bunch of amateur managers there. Wu assured me that as the parent company, Zhicheng, had paid off all retail investors, and that the debts in arrears were being pursued in legal means. In fact, there were 14 ongoing court cases. Knowing the backlog in Chinese courts, and their inefficiency, I worried about long delays in the collection — particularly after Wu told me that some contracts were not properly done.

48

Rotten Apples Everywhere What went wrong? I started to search for answers. In the fall of 2016, some employees at Dianlicai took me to Qingliangfeng Township (清涼峰鎮) in Lin’an District of Hangzhou to see their borrowers. Lin’an lies between Hangzhou city proper and Mount Huangshan of Anhui Province. I immediately loved the place. My impression was that every bit of the hilly region was covered by either trees or lakes, and the roads were perfectly built and maintained. We spent the morning with Mr. Wang, a pecan plantation owner and processing businessman. He would probably make 20 million yuan in sales in a good year and 5 million yuan in net profits, but I could not see how he would grow much from there. Mr. Wang sold his fried pecans in small packages to online marketing companies such as Three Squirrels (三隻松鼠) under their brands because he did not have the marketing heft to reach enough consumers. Our lunch included fish from Mr. Wang’s family pond along with some organic vegetables. My colleagues were eager to press me for more allocation of financial resources for the lending business. Having been burned financially during the past six years in several credit ventures, I was non-committal as I reminded myself that all fatal mistakes lied behind harmless and even beautiful setups. I did not have a board seat, nor a managerial role at Zhicheng, although China Smartpay, where I was the chairman, was the biggest shareholder of Zhicheng Holdings. So, I treated the twicerescheduled trip as a learning experience. Wu told me that Dianlicai placed concentrated bets on the pecan farmers at Lin’an and I felt bad about making the trip with my

49

CHASING SUBPRIME CREDIT

colleagues. “Had my trip amounted to an endorsement and even encouragement in the eyes of my colleagues?” I asked myself. While in Zhejiang Province, George (not his real name), a local manager of the operations of Yilongdai (eloancn 翼龍貸), majoritycontrolled by the Legend Group, joined me and my colleagues in the visits to the pecan farmers. On the second day, we visited his offices at the main street. It was spacious and bright. I must say that it was more grand than some bank branches. George is a native of Helongjiang Province in the northeastern corner of China. He does not have high degrees but he is street smart. He told me tales about arranging long-haul transport two decades prior between his province and Zhejiang Province, where his humble background, hard work, and persistence helped him survive. He remarked that he eventually settled in Zhejiang Province and that his honesty had given him the business he now had. If I understand it correctly, Eloancn has a unique business model in the subprime credit industry: it sources funding from online retail investors and bundles it with its own capital and lends to the customers its thousands of outlets, like the one in Lin’an, recommended. However, this is where the uniqueness started: these grassroots offices are all subcontractors, rather than branches or subsidiaries of eloancn. They are the foot soldiers but also the second-lien or junior creditors in each loan. Eloancn in Beijing makes all underwriting decisions. This division of labor, and particularly the arrangement for the local loan originators to take a junior tranche of all the loans, is attractive to me. Given the shareholding

50

Rotten Apples Everywhere of Legend Group (a state-sponsored entity) and this smart structure of the loans, I have asked my client advisor to invest my personal money in the Eloancn platform since there is clearly no compliance issue or conflicts of interest. So far, I have not lost any money there. I had heard disputes between Eloancn and some of its contractors but that did not concern me. In fact, George was not totally happy about the arrangement either. He complained about interest rates being set incorrectly, and the split of the spoils being unfair, and so on. But he was full of praise for the Eloancn founder, Wang Sicong. I learned almost a year later that George’s company had acted as the guarantor for the loans Dianlicai advanced to Wang and 13 other pecan farmers, and he also lent to the same people. In addition, Dianlicai’s loan repayment had to go through George’s company. All this was now in the court and, to me, conflicts of interest seemed to have been ignored when the credit was advanced. China is climbing a steep curve in learning the concept of conflicts of interest. Many corporate executives strike deals with the companies they manage as the counterparties. They also do business with third parties in partnerships with the companies they manage. Some online lending companies’ executives told me that fraudsters’ collusion with their staff was a headache.

Bridge Finance Dangerous? While in Hangzhou, I stayed one extra day to visit my friend Chen Hangsheng, the founder of UPG, Uni-Power Group (中新力合). His

51

CHASING SUBPRIME CREDIT

business counts as shareholders the big-name institutions such as Cinda Asset Management and Silicon Valley Bank. It is a traditional business model: lending, guarantees, bridge finance, and advisory work for SMEs. I admire his efforts and energy. And in my darkest days as a microcredit lender in Guangzhou in 2011, I sought useful advice and encouragement from Chen. Without being nosey about UPG’s financial performance, I speculated that anyone dealing with SMEs would have had a difficult time since 2012 as the economy had entered into a severe recession. Whatever the official statistics about GDP growth, the nation’s electricity consumption, rail freights, road transport volumes, and the collapse of the prices of bulk commodities would not lie. Nor would the 3,000-plus listed companies’ shrinking net profits and cash flows. It is fair to say that SMEs had suffered proportionally more than the headlines said, and more than the companies on the stock exchanges. Several years earlier, UPG branched out to making bridge loans in collaboration with local government entities through its subsidiary Xinhehui (鑫合匯). Xinhehui has made a name for itself in the industry by focusing almost exclusively on bridge loans — a very dangerous business in my personal view. Under the banking sector rules in China, a business loan from a bank with, say, a 12-month maturity must be repaid in cash before a new loan can be granted. I understand the prudential logic behind the rule: it prevents bank managers from disguising a non-performing and even dead loan by extending a new loan to cover it. But this rule can be quite harsh as operational delays and unpredictable sales are facts of

52

Rotten Apples Everywhere corporate life. Every year, as huge numbers of SMEs are troubled by the renewals of short-term loans, some city governments have set up funds to provide bridge loans, sometimes in collaboration with the private sector. While I can see the state can play a useful role here, I remain skeptical of this business model for a private-sector operator. Okay, you charge 0.03% per day and make hundreds of good bridge loans. But if the bridge were to collapse on one deal, it will be enough to wipe out all the interest income you have generated in hundreds of loans. It is true that you have taken collateral, but the collateral can be extremely difficult to liquidate. Not to mention the long and expensive legal proceedings. Xinhehui has done well without any bad debts, and that’s a remarkable achievement. Some months earlier, I asked Suzhoubased China Huirong (1290.HK), where I am an independent director, to send a delegation to Xinhehui to learn a few tricks. My friends from Suzhou were impressed and started to do the same in Suzhou as the local government there also faced the issue of SME credit renewals. The Suzhou City government has an incentive scheme to reward the private sector for the provision of bridge loans. So far, Huirong has done well in this business. Maybe I am just wrong and overly cynical. A typical syndrome for someone who has had bad experience before.

53

6

Chapter Common Joe Plays the Online Credit Market

CHASING SUBPRIME CREDIT

Lehman Brothers’ Minibonds In the early 2000s, during the sluggish economy in Hong Kong and Singapore, banks had trouble finding enough profitable opportunities to deploy their money. Their loan-to-deposit ratios tanked. Accordingly, the interest rates on bank deposits also collapsed, creating a perfect environment for yield-conscious retail investors to scramble in search of exotic financial products. Lehman Brothers, the U.S. investment bank, rose to the occasion. It sold a series of financial derivatives products against the credit of some listed companies (Lehman Brothers itself, Freddie Mac, and Fannie Mae included). A total of 16 banks acted as selling agents of these products to retail investors. The products offered investors an annual yield of 4–5%, much better than deposits. In most developed countries, these complex financial products had long been banned for retail investors. Sadly, they were allowed in more lax environments such as Singapore and Hong Kong. Some argued that the so-called minibonds’ yield was more like the insurance premium while the retail investors wrote an insurance policy to Lehman. If that analogy were correct, I would offer an additional bit of information: except for the layers of derivatives, it was akin to the annual fees of 2–3% China’s guarantee companies collected from SME customers for their credit guarantees. That was nice money in fair-weather conditions, but disastrous when the guaranteed SMEs were unable to repay their loans. It was estimated that the Singapore retail investors bought US$500 million of the products while Hong Kong investors about

56

Common Joe Plays the Online Credit Market US$3 billion. As Lehman Brothers was the counterparty, the 2008 subprime crisis in the United States, and the demise of Lehman Brothers quickly made these products worthless. Mass protests ensued as blame was laid on the regulators for falling asleep at the wheel, and on the banks for misleading the unsophisticated retail investors. Five years of noisy protests and finger-pointing later, the regulators in the two cities finally pushed the 16 banks to pay 60%–90% of the original investment sums to the retail investors, depending on the different tranches of these products.1 I always worry that this episode could be seen as a dress rehearsal of some similar, but much bigger, accident in Mainland China, where thousands of colorful, dodgy, and complex financial products continue to be sold daily. The regulators CBRC, PBC, and the China Securities Regulatory Commission routinely force the regulated institutions to sanitize and simplify their offerings. But overly-zealous banks, trust companies, and funds marketing companies always find ways to sneak innovated products through their branch networks. In addition, many unregulated institutions are active and innovative. Fortunately, every week there is a group of disgruntled retail investors somewhere in the country protesting and demanding hard-earned money back from some wealth management companies, fund management companies, trust companies, 1.

The best description of the noisy episode and the final settlements and lessons we should learn was provided by Tom Holland at SCMP.com, http://www.scmp.com/ business/article/1311841/five-years-later-what-has-mini-bond-scandal-taught-us.

57

CHASING SUBPRIME CREDIT

commodities traders, and real estate developers. E-Zubao and PanAsia (Fanya) are but two recent prominent cases. Large numbers of smaller cases are quietly handled by the media-shy regional and local governments. This usually involves the arrest of some culprits, the liquidating of whatever assets there were, and the state-owned enterprises are forced to absorb the losses.

Guarantees, Implied and Explicit There is a uniquely Chinese phenomenon that requires all online lenders, trust companies, and the originators of wealth management products (be they the banks, the securities companies, or the trust companies) to guarantee the safety of the investors’ money, even when the regulation prohibits doing so. For example, the P2P operators are just the middlemen between investors and borrowers, and are not allowed to guarantee either the principal or the interest of the investors. But the P2P companies cannot function without providing actual guarantees. Their way of doing this is to either buy an insurance policy or a guarantee from a third-party guarantee company (often owned by the same shareholders, or by their representatives), or to create a risk reserve fund (for example, Yirendai and China Rapid Finance). In other cases, it is structured as a senior-junior structure or a bad debt repurchase program to give investors extra comfort and protection. Peter is a respected doctor who understands the political dynamics in the P2P industry. In September 2017 when we met on the fringe of the 51 Credit’s 5th Anniversary celebration, he said that

58

Common Joe Plays the Online Credit Market he had 13 million yuan in numerous accounts of five P2P platforms: Yirendai, China Rapid Finance, Kaixin, Yilongdai (eLonacn), and Feidai. Why these five? “I like their yields of 6–9%. I could have invested in many more platforms. But for simplicity, I picked these five. I know the risks but also know they dare not lose my money. The first two are listed companies and have too much to lose if they did not make my money whole. The next two are state-affiliated entities. Feidai is a proud company based in Shenzhen that used to be controlled by ZTE, a state-owned enterprise. Losing my money would jeopardize their franchise and they will be doomed. I know many of the P2P loans I invested in actually go dead. But why should I care? I am pretty sure the platforms will find ways to make my money whole.” His sentiment is pretty common among retail investors. I myself and some of my relatives also invest in P2P for similar reasons. Are we counting on the bigger fools?

When It Comes to Regulation, Less Is More I got into a shouting match with my 83-year-old father-in-law the other day in Shanghai. He had invested 300,000 yuan in an obscure peer-to-peer lending company based in Zhejiang Province. So far, he had not suffered a loss from his adventure but he had refused to pull his money out despite my insistence that he do so. My father-in-law does not fit the stereotype of an unsophisticated Chinese senior citizen. He was a senior engineer at China Petroleum

59

CHASING SUBPRIME CREDIT

& Chemical, known as Sinopec, before retiring over two decades ago. Since then, he has played the stock market and the housing market with mixed results. While the exposure of P2P site E-Zubao in January 2016 as a Ponzi scheme was a shock for many outsiders, for the vast majority of the Chinese public, it was just another familiar episode. The company had hoodwinked about 900,000 people into investing US$7.6 billion for what turned out to be largely imaginary ventures. In the past few years, several hundred similar sites have gone bust, voluntarily shut down, or been forced to close by the government, costing small investors enormous sums and great pain. Both the government and social media have done a great job of exposing the dirty tricks of unscrupulous P2P operators.

Far Bigger Losses in the Stock Market In other words, most small investors in the P2P sector have invested with their eyes wide open. This is similar to the Chinese public’s love-hate relationship with the rollercoaster stock market, where retail investors have lost hundreds of times more than they have on P2P failures. It is no secret that China’s stock market in the past quarter century has been afflicted with fraud. Yet, no amount of regulation can prevent the next mania and consequent crisis. So, is more regulation the answer to China’s chaotic P2P sector? Many think so, but while this kneejerk reaction is natural, such a move would be ill-advised and harmful. In China, regulation and red tape are often two sides of the

60

Common Joe Plays the Online Credit Market same coin. Today, red tape is more systematic than in the 1980s when the “open door” policy of economic reform had just got started. Massive red tape levels not only hurt economic efficiency, but also undermine fairness, as small businesses cannot afford to navigate the regulatory maze. In 2008, China created a formal microcredit industry to replace, and to compete with, century-old curbside lenders and backalley loan sharks. While large numbers of these traditional lenders quickly embraced the licensing requirements and prudential supervision of the microcredit industry, they regretted it just as quickly as soon as they discovered that formal regulations were just too costly to comply with. The microcredit regulations cover ownership structure, gearing ratios, caps on loan size and interest rates, and monthly reporting. Indeed, the onerous microcredit regulations helped fuel the rapid rise of the unregulated P2P sector. As a result of the regulatory arbitrage, most of the 11,000 microcredit lenders previously active in China have been mothballed after losing business to P2P lenders. In China’s stock market, the regulator not only vets each listing and fundraising, but also controls timing and pricing. Tedious though well-intentioned regulation like this has not only amplified cycles of boom and bust but also created extra scope for insider trading and corruption.

The Market Can Right Itself As has been shown in other industries, regulation begets regulation

61

CHASING SUBPRIME CREDIT

until you cannot breathe. To avoid falling into that trap, it is important to see regulation as a necessary evil that should be minimized, and to allow the market to function freely wherever possible. In China’s P2P lending sector, the almost-weekly announcement of closures of weak and fraudulent operators is a fantastic cleansing mechanism. The saga surrounding E-Zubao is educational for both the public and the rest of the industry. When scandals get exposed frequently, they serve to prevent pressure from building up into a volcano. As the rules of the game have been clear from the outset, very few small investors of collapsed P2P lenders have blamed the government for their losses. The E-Zubao case is a notable exception as some investors have claimed that they saw the embrace of E-Zubao by state media and government officials as an effective endorsement of the platform’s legitimacy. On the whole, the P2P lending industry provides much-needed financing to underprivileged consumers and small businesses. On the other end, it helps small savers achieve asset diversification and higher returns than are available from other outlets. The P2P sector is also putting pressure on the banks to better their game. Slowly but surely, the challenge has started to make an impact. It is conceivable that tough regulation of P2P lending will lead many operators back to dark street corners and back-alleys again. By global standards, China has surprisingly little to no regulation of e-commerce, P2P lending, or wealth management. That is a good thing rather than a bad thing. When an industry is new and fast-changing, no one knows how

62

Common Joe Plays the Online Credit Market it will shape up. It is therefore advisable to let it grow unfettered. Once regulation is imposed, vested interests will quickly form to frustrate innovation. Even when it becomes clear that certain rules are harmful, it will be hard to revise them, or do away with them for the larger good of the industry. The last portion of this chapter is based on a story I wrote for Nikkei Asia Review, 10 March 2016.

63

7

Chapter Two Leaders: 51 Credit and Feidai (CredEx)

CHASING SUBPRIME CREDIT

In mid-2016, as the chairman of China Smartpay Group, a payments company listed in Hong Kong, I approached Sun Haitao, founder and chief executive of 51 Credit about a potential collaboration. Sun had read my 2013 book, Inside China’s Shadow Banking: The Next Subprime Crisis?, and said that he liked it. So, he had asked his friend at Haitong International Securities where I had served as an advisor and later chairman of cash equities for two years to make an introduction. Thus, we “met” on WeChat. I went to Hangzhou to see him in July and was impressed with his stylish offices. A small furry dog, Wukong (悟空), ran around at our feet, barking excitedly. Sun’s two most senior colleagues, Kenny Zhao (趙軻) and Yang Yuzhi (楊宇智), joined our meeting. By that point in time, his company already had some prominent shareholders and a post-money valuation of over one billion US dollars. His shareholders included JD Finance, Tiantu Capital, local real estate company Xinhu Zhongbao, Intime Department Store’s Chairman Shen Guojun, and many others. Our deal eventually did not fly because of technicalities but I was impressed with the way Sun and his team handled things. With a little bit of due diligence, I also got to understand their business better. The trio drove a Tesla to Shanghai from Hangzhou very early one Saturday morning and spent a whole day conducting due diligence on us, as we had done on theirs several days prior. The next day, they came up with a deal structure, together with a detailed description of our business. Their views of our strengths and mostly weaknesses were also prominently identified. My senior colleagues and I had to agree fully. Through the few days of

66

Two Leaders: 51 Credit and Feidai (CredEx) intensive negotiations, I also got a chance to see how much influence Sun and the management team wielded over his shareholders and how much trust there was of them. Five years earlier, 51 Credit had been an aimless start-up company. That is to say, it did not have a revenue model. Its services were popular among multiple-card holding customers but it had not found a way to charge the customers. Its business was to help credit card users to manage their cards and installment loans. For example, a big number of consumers (especially younger ones) have multiple credit cards and rely on these cards for consumption, so 51 Credit would collect customer information about the terms of credit cards, and payment schedules of their installment loans. It also sent reminders to customers to ensure prompt payments. After a couple of years drifting and loss-making, 51 Credit discovered a winning business model: finding money for the huge number of its customers and chronic debtors to fund their current consumption and repay credit card debts. In the US, one would probably call it a credit card consolidation, or debt consolidation, loan business. The business took off following the embrace of its newlydefined mission. Of the 70–80 million (and counting) of its registered customers, there is an enclosed natural ecosystem: even the most cash-strapped customers have cash-rich days and those days can be turned into profits. Over time, 51 Credit has become an open system, as it also taps finance from outside its ecosystem to meet its demands. In addition, it channels funds from its customer-base to outside borrowers, either directly or via other P2P operators such as

67

CHASING SUBPRIME CREDIT

Yirendai. On its mobile app, there are partner-banks’ logos. For a fee, 51 Credit recommends qualified applicants to obtain credit cards at these banks. For the banks, this is a cheaper way to acquire customers. As of September 2017, almost one-third of 51 Credit’s loans were lent to borrowers in conjunction with more than 30 banks. 51 Credit takes a junior portion of the loan. The terms “assisted lending” or “joint loans” are given to this practice. I spoke to Jiang Yanqing (蔣燕青), the head of Financial Products at 51 Credit, effectively the division responsible for credit assessment, before, during, and after the underwriting decisions. Of the whole company’s 1,300 employees, more than 400 worked under him. He explained that the three products are as follows: 1. 51 Renping Loans target customers with credit cards. They have a ticket size ranging from 3,000 yuan to 100,000 yuan. As these loans are rather big for the unsecured online credit market, some underwriting involves human intervention rather than pure machine-driven decision-making. These loans have standard mature times of 3, 6, 12, 18, and 24 months. But the average maturity of the actual borrowing has been around 14 months.

2. Pocket Money offers very short-term (below one month) small loans, that range from 1,000–1,500 yuan apiece. Anyone inside or outside the company’s ecosystem can borrow or put spare cash to use. To comply with the government’s ban on lending to students, this product is off-limits to students. Otherwise, it is

68

Two Leaders: 51 Credit and Feidai (CredEx) similar payday loans in the U.S.

3. Let You Spend is a middle-of-the-road product with a maturity of up to 12 months and a ticket size of 2,000–10,000 yuan. It targets those without credit cards. 51 Credit says that it has a bad debt ratio of 3–5% (an unaudited figure). But this low ratio is questioned by a competing executive, although he acknowledged 51 Credit’s clear advantage in customer acquisition. The 3–5% ratio is extremely low by the industry standards, probably because of its history of being a credit card manager for consumers. It therefore knows these credit card users better than anyone. Apart from Alibaba’s Taobao and JD Finance, few other operators have the credit applicant’s transactional history as the foundation for underwriting purposes. Social media sites such as Weibo or LinkedIn have a huge number of users, but their users do not use these platforms for transactions (i.e., purchases). Therefore, it is hard to judge an individual’s ability to repay, even with all the information available on the sites. However, Li Bin, the founder and chief executive of Huaxia Finance, a leading operator in the online industry who used to work at Yirendai, thinks that transactional records are overrated in the underwriting of loans. He says that the creditworthiness of a borrower depends more on its willingness to repay and that the only way you can ascertain it is by lending to him. China Rapid Finance certainly agrees with this view. CRF purchases and analyses many data sources, both social and commercial. Its “Low and Grow” strategy is predicated on the theory that the best way to serve the

69

CHASING SUBPRIME CREDIT

people with unproven credit histories is by lending to them small sums for short terms and, then, once they gradually build up a credit history, offering them more money for longer maturity. One other advantage of 51 Credit is that it is right there when the borrowers look at their smartphones to review their installment loans, or the schedule of repayments. After all, is 51 Credit not the company in China that reminds you when to pay this much or that much to such-and-such a bank? This advantage is important because, out of many P2P lenders or even bank lenders, consumers have no special reason in remembering any names or their product features. No matter how much those lenders advertise on the side of a bus, or on a train station ad, you have no reason to remember them, especially when borrowing money is not on your mind at that particular moment. This is why customer acquisition costs are so high for online finance companies. While information is generally unavailable, it is estimated that, industrywide the average customer acquisition costs range from 100 to 200 yuan. China Rapid Finance revealed at its IPO prospectus that its cost in 2016 was around 17 US dollars (roughly 115 yuan), down from 20 US dollars in 2015. If the customer does not become a repeat customer, the lender stands to lose money on the customer. The same way the proliferation of smartphones in recent years enabled ride-sharing companies such as Uber and Lyft to take off, it also powered the growth of 51 Credit and other fintech firms such as Yirendai and China Rapid Finance. The shares of Yirendai and China Rapid Finance have been traded on the New York Stock Exchange

70

Two Leaders: 51 Credit and Feidai (CredEx) since December 2015 and April 2017, respectively. It is hard to operate a subprime business anywhere in the world, be it P2P or traditional non-bank secured lending. The banks have the full support of the state, and are regarded as rock-solid institutions, almost irrespective of their financial performance. They have never-ending and cheap deposits, which means that they can afford to charge their borrowers a very low rate. By definition, the banks primarily deal with prime customers as interest rates are much lower here. Borrowers approach P2P or other non-bank lenders only when they need the money very urgently or the banks deny them the access. That in itself is a source of credit risk for the non-bank lenders. The regulation of credit cards in China generally does not allow card users to take out cash. Card users can only use their cards to pay for consumption. For a credit card holder who cannot use his credit card for consumption, either he has maxed out on his cards, or he needs cash for a place where credit cards are not accepted. Where? Small eateries not yet linked with credit card companies, or gambling outlets in China.1 In the 2015 stock market frenzy in China, a big number of speculators took out debts from the P2P industry. Some P2P operators even encouraged and aided this practice. Many speculators were ruined when the lenders liquidated customer holdings in a sharply down market. Credit cards are a relatively new thing in China. As of the end 1.

Casinos in Macau are linked with most credit cards.

71

CHASING SUBPRIME CREDIT

of 2016, 465 million cards were in circulation, but only 38% were active, according to an industry consultancy report. The other 62% of the cards were ones that had been pushed by the banks to those “unconverted” in the market. Outstanding credit-card debts were 9,140 billion yuan as of the end of 2016, accounting for only 5.7% of the banking sector’s total assets. Many Chinese consumers have never thought about getting a card. When I was running Wansui Microcredit in Guangzhou from 2011 to 2012, I was told that my application for a credit card would be turned down because I did not have a fixed residence (Hukou), nor a steady income, let alone a tax-paying track record, or a social security number in Mainland China. But there are many prime-quality borrowers in this non-cardholding population. It is just that it has never occurred to them they should get a credit card. Now, they may never have to get a credit card as their needs are being discovered, stimulated and met by the likes of Qudian, 51 Credit, and, particularly, Tencent’s WeBank.

Avoiding the Bad Guys Like banks, these P2P lenders face two risks: frauds and honest defaults. The result is the same: your money is unlikely to come back to you. Some industry veterans say that this item is the biggest “expense” to worry about. When the online lending industry got started in China in around 2011 to 2013, credit data was scarce and analytical skills even scarcer. One pioneer in the industry told me that most operators

72

Two Leaders: 51 Credit and Feidai (CredEx) were “simply shooting in the dark,” putting all their faith in their lending model and the magic in their financial machine. One industry bigwig even argued that there was “a lot of pretense even today” (September 2017), maintaining that, in his test, there was little difference in the outcomes between his model-driven lending and a random shot in the dark. “Data is often a pile of garbage,” was a telling quote. But most industry executives disagreed with such an extreme assentation. Qudian’s public filing with the SEC in the United States was certainly a rebuttal. In just four to five years, the industry has gained much sophistication. Data providers such as Beijing-based Bairong and Hangzhou-based Tongdun do a job complementing the credit bureau of the People’s Bank of China. For a fee, P2P operators can access the data firms’ information and analysis on specific credit applicants. All of 51 Credit’s business is done via smartphones. As the telecom services providers, such as China Mobile or Unicom, have implemented a real-name identification system, credit applicants can download P2P operators’ apps to upload personal information. Once they authorize 51 Credit to verify their information against other sources such as their bank statements, their transactions on Taobao, and telecom records, a lending decision will be made quickly, often within 30 minutes. Its big ticket loans under the 51 Renping Loans category take no more than one day to approve. 51 Credit has an in-house team of debt collectors. But for debts that are overdue more than 30 days, it outsources the collection to specialist agencies as the probability of successful collection becomes

73

CHASING SUBPRIME CREDIT

slimmer. Like other high-traffic websites, 51 Credit channels visitors’ money to other lending platforms, such as Home Credit (PPF Jiexin) and Wolaidai (WeLab) based in Shenzhen, for a fee of typically 2% of the loans that are eventually transacted. In addition, 51 Credit acts as an agent for the banks’ credit card departments. Around 30% of the loans generated by 51 Credit belong to socalled joint loans, meaning those loans made in conjunction with the 30-odd partners’ banks. On credit card promotion, 51 Credit has a deal with around 20 partner banks (mostly mid-size banks; of the big five banks, only ICBC is a partner as of September 2017). If and when a person is successfully channeled to the banks and is granted a credit card, the card issuing-bank will pay 51 Credit for the service. This is indeed similar to what hundreds of agencies did offline in the 1990s and early 2000s (through retail stores or the distribution of pamphlets in the streets). Fearing frauds, the People’s Bank of China banned the practice in 2009, wiping out the whole cottage industry. That was overkill.

Feidai (CredEx) Is Constantly Disrupting Itself In 2016, payday loans suddenly became wildly popular and made some instant heroes. Was that a mirage, or just a bubble? I do not know. But Tang Xia, the founder and CEO of Feidai (CredEx), a wise man in Shenzhen, warned me that one must never confuse making quick bucks with a lender’s core competency. In

74

Two Leaders: 51 Credit and Feidai (CredEx) any case, he is not tempted by the ultra-high interest, short-term loans and he likens them to poison pills. These payday loans, he told me, have regulatory issues, moral issues, and sustainability issues all lumped together. His sentiment is echoed by Zane Wang, CEO of China Rapid Finance. Both see the 36% annualized interest-rate cap as sensible. In fact, both companies resist the siren song of quick bucks and charge much less than the cap. Both companies serve consumers as well as SMEs and both emphasize life-time value of customers. Maybe that is called “long-term greed”? Earlier in his career, Tang worked at the Construction Bank of China and Pingan. About a decade ago, he helped run Zhongan Xingye (中安興業), a respected traditional microcredit lender with branches in many cities. They helped the banks to lend, but took a subordinated position in each loan. The techniques were primitive in the whole cottage industry in those years. In 2012, Tang struck out to create ZTE Microcredit, with the seed money from ZTE, the telecoms equipment maker. In 2015, it was renamed Feidai (CredEx). Initially, his business model was oldschool; he had a microcredit license, and he opened branches in major cities to acquire customers and conduct due diligence. Within two years he found out that, with his 100 million yuan in paid-up capital plus retained profits, it would never go very far. In addition, the extensive branch networks and 3,000-plus employees were just too expensive. After all, there was just not enough sophistication in the business which everyone had piled into. Tang felt that he had to build a moat. In 2015, he finally shut down all his branches and kept only

75

CHASING SUBPRIME CREDIT

300 employees in the Shenzhen head office. He forced mobile digitization onto himself. His new way of lending emphasizes three things: 1.

Speed. With sophisticated knowledge and data, he insists that the firm must be able to make lending decisions within minutes, or even seconds.

2.

Customer experience. Borrowers must be given the flexibility to repay and re-borrow any time they like once a lending limit has been approved by the machine.

3.

Accuracy. Feidai has been around longer than most rivals and has built its long list of tainted borrowers (the black list of cheaters). It also taps extensive external data sources. That way, Feidai ensures that its funds and partner banks’ funds are very safe.

Still, you could call him grumpy, as he is never happy with his own company. His new pursuit is to be so strong technically that a big number of banks simply outsource their consumer credit business, and even SME business, to Feidai. Feidai’s track record has been very solid in the past few years, as its partner banks have incurred no loan losses. But the stateowned banks are, by nature, risk-averse. Feidai needs to convince, continuously, the partner banks’ compliance departments, riskcontrols, and asset allocation functions for the partnerships to work. And that is no easy task. The fact that the partner banks have stuck with them for so many years amid regulatory ebbs and flows is

76

Two Leaders: 51 Credit and Feidai (CredEx) proof that Feidai must have done something right. I have known Tang since 2011. When I was running Wansui Microcredit in Guangzhou, I visited him in Shenzhen quite a few times, as one of my colleagues joked, to show my “battle scars.” In the first half of 2017, we met three times to swap ideas. But my book idea only came about after I spoke with him the last time. Joe Zhang: Why are you constantly reshuffling your company? Tang Xia: No. I am not reshuffling my company. We aim high because that is what the borrowers want. If we are not good enough to meet their demand, then we should not stay in this business. I set the highest standards and then go out to find the toughest and smartest people who can meet those requirements. Luckily, we have added a lot of great talents to our original core team. You have met our chief data officer, and chief risk officer. They both joined us last year. Joe Zhang: You have stayed clear of P2P funds. Why? Tang Xia: P2P is a way of funding your credit business, and is a very different game from what we do. We want to focus on refining our credit analytical skills and we see P2P as a distraction to our pursuit. Joe Zhang: W hat makes Feidai different from the others in the industry? Tang Xia: We take pride in our analytical skills and long-term

77

CHASING SUBPRIME CREDIT

perspectives. At present, we are still a lending machine but we have set ourselves an ambitious target of eventual transition to a technology exporter. Currently, our lending is different from the fickle and dangerous payday loans you see in the marketplace. We cover both SMEs and consumers with an upper limit of 300,000 yuan per account — higher than the limits elsewhere. Within minutes of your registration by mobile phone, you will be given a credit score and a credit limit by our machine. You can use that limit for as long as you like on a revolving basis. The interest rates we charge you are lower than those prevailing in the marketplace. And the better your performance, the lower the interest rates you pay in the future. Joe Zhang: Unlike Qudian and 51 Credit, Feidai has no natural or exclusive playground to acquire borrowers, is that a disadvantage? Tang Xia: Maybe. But that makes us tougher and stronger. In the first year of launching our Feidai app, we have acquired over 5 million registered users. That is no small feat. How did they find us, as we have not done blanket advertising? The word of mouth and the ease of using Feidai have got us where we are. Joe Zhang: Is Feidai profitable? Tang Xia: You bet it is!

78

Two Leaders: 51 Credit and Feidai (CredEx) Joe Zhang: Are you getting better at your golf skills? Tang Xia: The last time I played golf was eight years ago!

79

Advertising by Shanghai Niwodai, a prominent P2P lender. “Timely Loans for Fruit-Stand Owners.”

Hangzhou-based Weidaiwang is a leader in the used car financing market. Around four-fifths of their loans are cash loans backed by used cars, and the other one-fifth is used car purchases loans.

80

51 Credit’s memorable outdoor advertising: “Let creditworthy people live better!”

Sun Haitao, the founder of 51 Credit. A deprecating Tesla driver, he is a serial entrepreneur. Having failed twice before, he got it right this time.

81

Zane Wang, the founder of China Rapid Finance. He is a scholar in the chaotic online lending sector. He is passionate about his four-wheel drive as well as compliance.

The elegant office tower of 51 Credit in Hangzhou. The company has a natural customer base.

82

China Rapid Finance charts a different strategy: Low and Grow. The interest rates they charge borrowers are considerably lower than the market. The company says it focuses on the life-time value of customers.

Zhi Zhengchun, the founder and Chairman of WeCash. A Beijing University genius (in physics and economics) who had worked for the Bank of China, and Jiufu (玖富). He has ambitions for his business in Brazil and Indonesia as well as China.

83

Shanghai-based Cuimi Collection Tech. “Forget your personal calls and WeChat messages. Focus on the work.” Debt collectors are not all masked men with tattooed arms.

Li Bin (李彬) Founder and chairman of Huaxia Finance, A graduate of U.C. Berkeley, he worked at Citibank, Deutsche Bank, and Home Credit Group before striking out. He predicts massive consolidation of the online credit sector, as well as some “good boys” eventually becoming limited-license banks.

84

An online/off-line lender’s calculation of repayments as shown below. A bit too exorbitant. There is no legal restriction on the interest rates you can charge borrowers, though there are guidelines. The government is striking a delicate balance between consumer protection and free enterprise. Enforcement of interest rate caps is very hard anyway.

Oscar Zhu (朱永敏), the founder of Cash Cards by Shanghai Qiancheng (淺橙). Another serial entrepreneur, he used to work at Tencent.

85

Mickey Li Yinghao, CEO of Mint Quantum based in Beijing. He used to work at Capital One and Citibank. He believes that a licensing requirement is both necessary and inevitable for China’s online lending industry.

Xia Ming, Chairman of Microcredit Association, Jiangxi province. An old school banker and microcredit lender, he is happy to be disrupted by the online lenders. Indeed, he is a facilitator of the process.

86

Meili Finance has staff stationed at 300+ used car dealerships in 30 provinces. Its speed of expansion and customer services have won accolades in the industry. Data and centralized risk control is key, according to management.

Howard Y. Liu, the founder and CEO of Meili Finance, a Warwick graduate, worked for Merrill Lynch and TPG for some years. But he finds used car financing more exciting. He thinks there will be 3 to 5 dominant used car financiers a few years down the road. Meili will be one of them, asserts Liu.

87

51 Credit threw a big party to celebrate its fifth anniversary in September 2017. CEO Sun Haitao chatting with a movie star Wu Xiubo.

Tang Xia, CEO of CredEx (Feidai). In 2015, he closed down all branches and embraced online lending. His new target is to make Feidai a credit technology exporter to the banks. The last time he played golf was eight years ago.

88

8

Chapter Qudian and Other Winners Will Not Take All

CHASING SUBPRIME CREDIT

On the one hand, the Chinese government must be very grateful that the guarantee companies, trust companies, online lenders, and the microcredit sector are shielding the banks from tidal waves of subprime credit. On the other hand, they are also downright hostile to the brave subprime institutions. This sentiment has led the Chinese government to ban the subprime credit sector from raising funds in the domestic stock market (starting about a decade ago), not even at the lowly Third Board Stock Market (the ban was more recent here). This has driven the online lenders and microcredit firms to the stock markets in the U.S. and Hong Kong. But the difficulties and procedures of converting a China-registered business into a foreign-registered business involves lots of tedious planning and expenses. Without tremendous amounts of drive and perseverance you would not want to go through the painful process. One regulatory official recently joked to me, “We used to have a market economy with Socialist characteristics. But in recent years, it has turned into a planned economy with some market characteristics.” In September 2017, Qudian filed publicly for an IPO on the New York Stock Exchange, sponsored by five investment banks (Morgan Stanley, CS, Citigroup, CICC, and UBS). Its prospectus sparked enormous interest in the China investment community and especially in the China online lending sector. I spoke with six senior executives in the industry. Two expressed skepticism about the figures and sustainability of the company’s fantastic sailing (on the grounds that it will soon get into

90

Qudian and Other Winners Will Not Take All direct competition with its backer and shareholder, Ant Financial). The other four expressed envy in different ways, especially since Qudian’s numbers were unbelievably good.

How High Is High? In its IPO prospectus (page 85), China Rapid Finance clearly states in an easy-to-read table the interest rates it charged all categories of borrowers in 2014, 2015, and 2016. It even offered a breakdown of interest rates, services fees, and transaction fees. But I failed to find similar details in Qudian’s prospectus. However, it did make the following confessions (page 36 of its prospectus): The annualized fee rates charged by us on a significant number of transactions facilitated were in excess of 36% historically. Among the number of transactions, we facilitated in 2016, 59.5% of their annualized fee rates exceeded 36%. Had all such credit drawdowns reduced their annualized fee rates to 36%, our revenue would have been reduced by approximately RMB307 million, representing 21% of our total revenue in 2016. In an effort to comply with potentially applicable laws and regulations, we adjusted the pricing of all our credit products in April 2017 to ensure that the annualized fee rates charged on all credit drawdowns do not exceed 36%. I tried to gauge Qudian’s actual fee rate (i.e., the comprehensive

91

CHASING SUBPRIME CREDIT

interest rate) in 2016. Since its total assets were RMB26.76 billion as of the end of 2015, and only in July 2016 did it announce a recapitalization (private round), I could assume a weighted average revenue-generating total asset of RMB3.1 billion in 2016, then it is easy to see that its average full-year interest rate was at least 41%! Even if I assumed a weighted average revenue-generating total asset of RMB3.3 billion for 2016, the average interest rate would have been at least 38.5%. These two estimates obviously understate the actual interest rates for two reasons. First, it assumed all the assets were constantly in the form of loans without an idle day. Second, as the management stated in the IPO luncheon in Hong Kong on 4 October which I attended, the loan losses were (in balance sheets terms) equivalent to about 3% of the total (Since the company turned over its balance sheet five to six times a year, the loan losses by vintage were below 0.5%). So the actual average interest rate was probably 40–44% in 2016. Note: its interest income (financing income) amounted to RMB1.27 billion in 2016. Despite Qudian’s cut in interest rate in April 2017, its interest income in the first half of 2017 was 21% of its end-2016 total assets, assuming all assets were revenue-generating. Remember this is only six months’ work, not the full year’s.

A Leader in the Industry For a company just three years old, Qudian is the undisputed leader in the sector, judging from data and remarks from industry consultants Oliver Wyman. Almost every metric of Qudian is

92

Qudian and Other Winners Will Not Take All outstanding: its registered users amount to 48 million, of which 18 million actually use its services; repeat borrowers are at 83%; and net profits amounted to 974 million yuan in the first half of 2017. The most striking figure of all is its 30-day overdue loans ratio: less than 0.5%! Qudian in its public filing says that, “Our M1+ Delinquency Rate by Vintage for transactions in 2016 and the first quarter in 2017 has remained at a level of 0.5% or less up to June 30, 2017. M1+ Delinquency Rate by Vintage is defined as the total balance of outstanding principal of a vintage for which any installment payment is over 30 calendar days past due as of a particular date (adjusted to reflect the total amount of recovered past due payments for principal and without taking into account charge-offs), divided by the total initial principal in such vintage.” This was not only unheard of in the online lending industry, but also far better than any Chinese bank’s credit card business! Its only match is WeBank run by Tencent (the owner of WeChat, QQ, and cool games), to which we will turn later. In an industry that is familiar with 10% and even 20% ratios of overdue loans and even losses, the 0.5% figure was simply too good to be true. Some executives expressed doubts about the figure, while others attributed it to Ant Financial’s investment in Qudian and the partnership. Qudian’s customers come mainly from Ant Financial. And Zhima Credit, a unit of Ant Financial, provides data and analytics for Qudian. One external source of funding came from Wangjinshe (網金社), an asset-trading platform controlled by Ant Financial, and Hengsheng Electronics (恆生電子, an A-share

93

CHASING SUBPRIME CREDIT

company controlled by Alibaba, Ant’s parent company). Qudian’s performance metrics should go a long way to please the sector’s bulls, but also increase the anxiety of many industry players. 1. Qudian in the past lent its own money to borrowers and transferred the rights to P2P platforms and other institutional asset managers. Is the lending on its own book not an industrywide violation of the regulations? Qudian says it has stopped doing so and instead now uses trust structures to lend, or lends through its two licensed online microcredit companies (Ganzhou and Fuzhou, both in Jiangxi Province), but many other players are still on their old models. Although the regulators have not officially punished any firm for violations so far, there is no guarantee that it will not happen in the future. The question in front of everyone is, should we expect further tightening of the regulations going forward now that the admission of wrongdoing by a firm is in the public domain? 2. Qudian says in its prospectus that its termination of business ties with the P2P platforms has to do with two factors: The P2P funds are too expensive (up to 12% on an annualized basis, it says), and there are regulatory concerns with respect to P2P platforms as a way of business. Some online lenders are understandably feeling the chill from this statement. 3. Qudian does not name the names of its external funding partners, except to say that they include trust companies, the banks, a licensed consumer finance company, and an asset

94

Qudian and Other Winners Will Not Take All trading platform. This secrecy is probably due to competitive reasons as much as client confidentiality. I suspect it also has the support from some asset management divisions of dealer-brokers (securities companies), and fund management companies. Qudian’s rivals should ask the question: Why have they not secured these types of cheaper and more stable funding? Some must have tried but have they tried hard enough? Many ordinary corporates (such as cash-rich grocery stores, industrial companies, or toll-road operators) make perfect partners for online lending platforms but, so far, few are known to have succeeded in winning their support. For startups, there are always a million things to do, as one executive confessed, and they should have hired senior executives dedicated just to this task (i.e., institutional funding). Now the scrambling should start. In Guangdong Province, one major online lender relies heavily on the banks’ funding but the regulator CBRC’s cautious stance since February 2017 has caused some serious headaches for the online lender when the banks withdrew funds abruptly. He even argued that P2P funding was more diverse and expensive but probably more reliable. But the truth is, he now admits, that there are even better sources of funding: the corporate world, asset managers, and the securities companies. One prominent executive in the industry read the prospectus and sent me his comments summarized below:

95

CHASING SUBPRIME CREDIT

1.

Qudian should probably be seen as the best capitalized microcredit company in the country. They were smart to shy away from the P2P funding model. At the very least, their experience shows that you do not have to be a P2P lender to be very successful. There is nothing wrong with a heavy-asset business model (relying on its own balance sheet). Qudian’s leverage was not very high, comparatively speaking. As of the end of June 2017, for example, its total assets were 11.4 billion yuan, and shareholders’ funds amounted to 3.5 billion yuan with the balance 7.9 billion yuan being debts. In the first half of 2017, Qudian’s total on-balance sheet transactions (credit drawdowns) were 35.4 billion yuan, almost half of them funded by its own capital. Despite its debt of 7.9 billion yuan being much bigger than its own capital of 3.5 billion yuan (In fact, its capital base was much smaller than 3.5 billion yuan at the beginning of the year), they performed a similar amount of credit drawdowns, reflecting its own money running faster (i.e., with shorter maturities or better efficiency as, when you use external funding, there are approval procedures to contend with). Qudian’s leverage is low by the standards of banking and non-bank financial sectors in China. In a way, Qudian debunked the myth that, to make money in subprime credit, you have to use high leverage. To fully utilize its analytical capability, Qudian recommended some borrowers to other lending platforms for a services fee (and guaranteed the safety of the funds). But this side business remains a side

96

Qudian and Other Winners Will Not Take All business; only 2.8 billion yuan of credit was transacted in the first half of 2017. 2.

Points two and three made by the executive were less flattering. He said that, in the past three years, Qudian made a killing through payday-loan-style loans with extremely high interest rates. But going forward it was not going to be as easy because, CBRC, the regulator, was intent on capping the rates at 36%. I personally am not that bearish as I believe that the government is unlikely to enforce the rate cap any time soon. In my view, the Supreme Court simply said that rates above 36% were not legally enforceable. But in the online small loans sector, who is counting on the court of law to enforce a contract?

3.

According to this executive, Qudian was too aggressive and had disregarded some regulations in the past as it admitted in its prospectus. It was ordered by the Jiangxi Provincial Finance Office to rectify its mistakes in its Fuzhou Microcredit company. More importantly, it had lent to borrowers with its own funds despite its not having a lending license, or not using a trust structure. These practices had stopped by the time of the public filing of the prospectus, but its management style could be gleaned from that past.

4.

Whatever the original sources of its customers (probably mainly from Ant Financial), it must have retained and built on the customer base. Compared to its rivals, this will represent a significant competitive advantage in the future.

5.

Qudian has two main products: cash-credit products with an average ticket size of 920 yuan and a maturity of two months, and

97

CHASING SUBPRIME CREDIT

merchandise-credit products with an average ticket size of 1,250 yuan and a maturity of eight months. This confirms that shorter maturity and smaller loans are the way to go in consumer finance in general, and subprime finance in particular. Qudian says that it “collaborates with more than 480 merchandise suppliers, including leading brands and their authorized distributors for our merchandise credit product business.” This is an advantage as it, apart from generating customer flows, creates new income sources for Qudian (in fees) and the loans granted here may be safer than take-out cash advances.

Other Market Leaders WeBank WeBank started operations in late 2014, around the same time as Qudian came along. According to one of its investors, Weilidai selected 70 million eligible borrowers of which 17 million had taken up the offer to borrow money as of the middle of 2017. Its loans were around 8,000 yuan apiece. As a licensed bank, it has a significant advantage compared to other non-bank financial institutions such as online lenders (including Qudian and 51 Credit). Using a comparable definition, its M1 overdue loans were 0.32% as of the end of 2016. Its borrowers pay interest of 0.025–0.05% per day (annualized at 9.125%–18.25%), and as interests on the loans accrue on a daily basis and the loans can be paid off any time, it gives borrowers more flexibility, and ends up being much cheaper

98

Qudian and Other Winners Will Not Take All than other consumer loans in the marketplace, and certainly cheaper than the banks’ credit card debts. As the Weilidai loans are granted within seconds of application through smartphones and repaid the same way, it is infinitely more convenient than consumer finance in the banking system. On the funding side, WeBank also has an edge. A bank status (plus Tencent’s clout) gives its prospective investors more confidence. As of mid-2017, it has signed up over 30 banks around the country. In a typical loan, the partner banks provide 80% of the funding while WeBank the other 20%. In the future, if the business grows above what WeBank’s capital base allows, it is conceivable that WeBank can reduce the 20% portion to much a lower amount given the very low delinquency rate. It is well below any bank’s own credit performance. It is worth noting that WeBank’s 20% portion in any loan is on par in seniority with its partners’ 80% (unlike Qudian’s subordination in its loan referral services). WeBank provides an attractive outlet for the big number of midsized and small banks. Their credit card operations and consumer finance business are well-suited for outsourcing to the likes of WeBank. In other words, WeBank’s credibility will someday make it an independent provider of credit underwriting services. WeBank in 2016 introduced a WeChedai in the WeChat ecosystem. By invitation, customers can take a car loan. This is of great interest to used car buyers as the prevailing interest rates in this segment of the market remain stubbornly high, above 25% per annum, although new car loans are cheaper, below 10% thanks to the banks’ and car-makers’ participation. In the credit market for

99

CHASING SUBPRIME CREDIT

used cars, however, the interest rates refused to fall mainly because of risks involved, creating a perfect condition for some disruption by the likes of WeBank that knows who you are and whether you are worthy of credit. There is speculation in the market as to whether WeBank will introduce WeMortgage in the WeChat system, targeting the home equity credit market (reverse mortgages), subprime loans, and nearprime mortgages. As these are secured loans, WeBank may have to team up with off-line operators with extensive branch networks across the country. Fortunately, some operators have already built such a network, including Fanhua Financial Services based in Guangzhou. We have a chapter to describe their business.

Ant Financial Qudian notes in its prospectus that Ant Financial, its principal shareholder and a business backer, may potentially become a competitor down the road. “Ant Financial operates consumer credit businesses, such as Ant Credit Pay, or Huabei, and Ant Cash Now, or Jiebei. Similar to a credit card, Huabei allows its users to purchase goods and services on credit and charges them no interest if full repayments are made before the first due dates. Jiebei offers cash credit products of various amounts, including those that are significantly larger than amounts offered under our credit products. As such, Ant Financial’s consumer credit businesses may target similar potential borrowers as ours and compete with us directly.” But, it further notes that it is actively exploring collaboration

100

Qudian and Other Winners Will Not Take All opportunities with Ant Financial’s Jiebei. As both companies are small in scale at this stage, direct competition is not material but when both grow, as do other online lending platforms, the potential for competition is likely to become an issue. Moreover, Qudian’s merchandise credit business may become competitive with Ant Financial’s Huabei, an online hire-purchase program where interest rates are much lower. Plus, there is an interest-free period.

Winners Will Not Take All It is amazing how slowly Qudian’s competitors have reacted to the emerging opportunities Qudian has discovered and benefited from. Can they replicate Qudian? If not in terms of customer acquisition channels but certainly in terms of funding sources. But funding sources alone will not lift online lenders’ returns of equity substantially. The table below classifies all online lenders into four categories. The best performers are WeBank, Ant Financial, JD.com, and Qudian. Their solid data and customer knowledge make their ratios of overdue loans almost negligible. Hangzhou-based 51 Credit is a close second. Industry leaders such as Yirendai, China Rapid Finance, and Beijing-based Quant Group, and WeCash marry their proprietary analytics with a wide range of data sources to make credit decisions but they do not yet have the type of firm grip on customers as Qudian and WeBank have.

101

CHASING SUBPRIME CREDIT

Table 8.1 Four types of delinquency rates Operators

% delinquency

WeBank, Ant Financial, JD.com, Qudian, etc.

Below 1% or low single-digits

51 Credit and those with a natural ecosystem

3-5%

Leaders without a natural ecosystem (YRD, CRF, etc.) 6-11% Others

Higher than 11%

Source: Author estimates, Company data.

The industry leaders such as WeBank, Ant Financial, JD.com, and Qudian clearly have an edge in three areas: 1.

Lower customer acquisition costs. These online lenders often do not have to advertise much. In 2016, WeBank discreetly selected 70 million pre-approved borrowers (i.e., the White List) and had a “weilidai” app installed in the select customers’ WeChat program. I felt hurt when I discovered in September 2017 that my smartphone had not been sent a “Weilidai” app. In the online lending industry, customer acquisition costs can amount to 100–200 per head and this often makes the difference of life or death, especially for small loans. Some online lenders discover that it takes 9–12 monthly loans for the interest income to cover the acquisition costs alone. Moreover, the natural “White List” borrowers are of higher credit quality than those you obtain through advertising. Advertising often attracts poor credit.

102

Qudian and Other Winners Will Not Take All 2.

Safer customers. Some detractors of the “captive customers” thesis argue that you only know if someone would repay your loans by lending to him, and that data on social media and even on online purchases does not matter much. However, the performance so far (despite only for a few short years) of WeBank, JD.com, and Qudian using data on online purchases and social activities makes a robust case for their advantage.

3.

Lower funding costs. Qudian benefits from lower funding costs due partly to its affiliation with Ant Financial and thus its much lower delinquency rates. Some of the 1,000-plus banks and huge numbers of cash-rich corporates may be willing to dip their toes into the online lending sector if they can be convinced of the limited risks and significant rewards of well-structured collaboration. It is possible that Qudian’s rivals have not persevered on getting the cheapest funding possible. Fintech companies’ executives are not the most tolerant of bureaucracy common at traditional institutions such as the banks, securities companies, or even corporates. But here are precisely where rich pickings hide.

Fragmented Forever Despite the considerable advantages of the leaders, their scales will never be big enough to squeeze out lesser players in the foreseeable future. In the credit market, unlike smartphones, search engines (Google), social media, or e-commerce sites (JD.com or Amazon), the credit market is always going to be fragmented because of one

103

CHASING SUBPRIME CREDIT

critical fact: There is no differentiation in the product (money) itself. The only difference will be the gap in the lenders’ profitability. Some will make a killing and others will make less. Still others will exit altogether because they have lost too much but there will always be new entrants. In the United States, for example, despite the shakeout in the past few decades, including the Savings & Loans crisis of the 1980s–1990s, and the subprime crisis of 2008, there are still over 6,000 banks across the country, and there are still new entrants, so consolidation in the industry will be long and drawnout.

104

9

Chapter Why Is Every Chinese Company Dabbling in Finance?

CHASING SUBPRIME CREDIT

Multinational companies such as Microsoft, Apple, and Intel all have huge cash-piles at home and abroad. The likes of Google, Amazon, and even Twitter have vast customer databases (think about supply-chain financing that is hot in China). And any of these companies can raise tons of cash any time they want, at extremely low costs. Why then do they not start a lending business and make a killing on the side? I often hear Chinese corporate executives ask these questions. On the other hand, these companies’ counterparts in China all have financial arms: lending, investing, and managing money for others. The only exception I can think of is Shenzhen-based Huawei. Why is finance so popular to the Chinese and so unpopular to the Western firms? There are cultural reasons for sure. Owning a bank, or something nearly a bank, has always carried gravitas and mystique in Chinese history, possibly because of biased literature. In a nation with a rich history of chaos and runaway inflation, the best business was naturally finance, second only to owning the tax offices and printing presses. Cultural factors aside, the Chinese fascination with finance owes a lot to the shortage of finance and thus, the high returns of the financial sector. As our data below shows, of the 3,000-plus companies listed on the domestic stock exchanges, the finance sector always accounted for more than half of the total net profits, and as high as 62% in 2015. So, finance is where the money is.

106

Why Is Every Chinese Company Dabbling in Finance? Table 9.1 Net profits of companies listed on domestic stock exchanges (Unit: billion yuan) Year

2013

2014

2015

2016

All listed companies

2,373

2,541

2,591

2,798

Listed financial sector companies

1,285

1,439

1,608

1,533

Finance as % of total

54.2

56.6

62.1

54.8

Source: Wind information.

But why is finance so much more profitable than other sectors in spite of the aggressive assault by the non-bank financial sectors? Is this because of institutionalized monopoly? Clearly not, as there are over 1,000 banking institutions across the country. A casual stroll in any street will convince you there are too many banks in China. Is it because of favorable regulation? A decade ago one could definitely make that argument. But that argument is losing some relevance as the lending rates have largely been liberalized in recent years, and the central bank’s control over deposit rates seems to have been also gradually weakened by “negotiated deposits” and money-market funds. On average, sadly enough, the banking sector’s cost of funding remains as low as around 2%, while they charge borrowers as much as 7–8%, although the prime lending rate is only 4–5%. So, the banks’ interest margin is still ridiculously high. And their return on equity is between 12–20%. No other sector can match it. But why is finance so much more profitable in a generally unprofitable China business environment? The high interest margin

107

CHASING SUBPRIME CREDIT

is the reason. But then why is the margin so high? The interest rates on deposits are tightly regulated. Alibaba’s Yu-E-Bao, while the biggest money-market fund in the country, and wildly popular, is still tiny. A brief comparison is telling: 1. Number of customers: Yu-E-Bao: 260 million retail customers, The banks: 800 retail, plus all corporate, non-profit and government entities 2. The “deposit” base (as of mid-September 2017): Yu-E-Bao: 1,432 billion yuan, The banks: 165,826 billion yuan 3. Net profit (2016): Yu-E-Bao (Tianhong Fund): Less than 2 billion yuan, The banks: 1,327 billion yuan The figures above show why regulated deposits are still dominant. It is regulated deposits that set the prices in the deposit market, rather than upstarts. So, the deposit rates are tightly regulated. But why did the liberalized lending rates not fall enough to squeeze the net interest margin? My hypothesis is as follows: 1.

The true inflation rate is higher than the State Statistics Bureau tells us. Therefore, the lending rates dictated by the invisible hand of the market are not high enough. The banking sector

108

Why Is Every Chinese Company Dabbling in Finance? is predominantly state-controlled, so for political and social reasons, the banks are not charging the full interest rates that they can get away with. They instead ration their always-limited available funds based on other yardsticks, such as borrowers’ shareholder background (political affiliation), prestige, and collateral. These lower-than-market-clearing interest rates have encouraged even higher demand for credit. 2.

Yu-E-Bao’s negotiated deposit rates at 4% or higher are consistent with the rates offered by other money-market funds, many corporates’ negotiated deposit rates at the banks, and thousands of wealth management products in the marketplace. So, it is probably fair to say that the below-2% average return the banks pay for deposits are well below the market rates and even below the true inflation rates. The State Statistics Bureau says that China’s inflation rates were 1.5%, 1.4%, and 3% in 2014, 2015, and 2016, respectively. Even against these official statistics, the rates on China’s bank deposits (with a maturity shorter than one year) were mostly negative in real terms. The banks pay only 0.35% for demand deposits (in 2016–17, for example), while Yu-E-Bao and many other money market funds that resemble the banks’ demand deposit pay 4% or much more. It is true that these money-market funds are not as safe as the bank deposits (and do carry interest-rate risks), but the money-market funds’ very good liquidity (they can be redeemed any day), and the existence of de facto blanket insurance means that the central bank has used its power to price deposits too cheaply.

109

CHASING SUBPRIME CREDIT

In 2017, Yu-E-Bao twice reduced the upper limit of each retail investor ’s deposits: from 1 million per account to 250,000 yuan and then to 100,000 yuan. It has also reduced the interest rates on the funds. This is strange. Why push customers away? Some observers argued that Yu-E-Bao just wanted to manage liquidity better. That does not make sense to me. When you have hundreds of millions of retail accounts, where is the liquidity management concern? My reading is that Yu-E-Bao did not want to upset the banks and the regulators too much. The central bank, the CBRC and the banks must have put political pressure on these money-market funds not to behave too aggressively. As a result of the pressure, the funds have always exercised self-restraint. 3.

Despite the very wide interest margins, the lending rates may not be high enough, representing a market failure of the invisible hand. The reason why there is a market failure is possibly because of self-restraint on the part of the banks; they do not want to charge fair rates (i.e., higher rates). After all, the lending rates were only liberalized in recent years, and there is a bit of inertia or stickiness in the adjustment. Maybe the credit market is not a proper market. It is a rigged game.

4.

In the past four decades, corporate China has been highly leveraged, reflecting a shortage of equity capital, and entrepreneurs’ hunger for higher returns. Call it greed or gambling if you like, but their insatiable demand for credit has constantly exerted upward pressure on the lending rates. Given their risk-taking, their appetite for credit can only be

110

Why Is Every Chinese Company Dabbling in Finance? met, at least partially, by the subprime market (i.e., the non.

bank financial sector). This two-tier credit market has propelled the rapid expansion of each part: the banking market for prime customers (mainly SOEs, bigger private-sector firms, well-connected entities, prime-quality consumer credit, and prime mortgages), while the subprime market serves SMEs, underdogs, and everyone else. The subprime market is also a place to fulfil the secret forbidden thrills of the regional and local governments, and privileged entities. For example, if the regional and local governments want to defy the central government’s wishes to indulge in the building of grand town halls, golf courses, and expensive hotels, and to defy the debt limits imposed upon them by Beijing, they have to use the creative debt structures at the subprime markets. Some of the 68 trust companies and PPP specialist firms (private-public partnerships) are very good at financial shenanigans and camouflage, every bit as innovative as the executives at Enron and Lehman Brothers. Indeed, it is their core competence, they often boast. When the regulators banned the banks from lending to property developers for land acquisitions (avoiding leverage upon leverage), the developers resorted to the subprime market: trust loans, wealth management products, and loans dressed up as equity (with repurchase agreements attached or side deals). When the government disliked steel mills, small cement producers, panel beaters, aluminum smelters, mining

111

CHASING SUBPRIME CREDIT

ventures, and heavy-polluting factories, or anything, it banned the banks from lending to them, forcing them onto the subprime market, also. The banks may very well stay in the game, but in a range of roundabout ways. In fact, the banks would stand to make considerably more money from these roundabout financing. For example, the banks may choose to finance these businesses in off-balance sheet products: wealth management vehicles. These vehicles are also handy when the regulator wants to see the banks report higher capital adequacy ratios or lower loan-to-deposit ratios.

Easy Come, Easy Go In a Starbucks Coffee shop in Shenzhen last in 2016, I sat with Steve, the eldest son of a real estate tycoon. He runs his family’s privateequity investment arm. Fresh from an American university with an MBA degree, he was in a hurry to prove himself. Within a year and a bit, he had pumped more than 1 billion yuan into two bike-sharing start-ups, an online insurance agency, and an after-sale services business for autos. He was in Shenzhen to do research on the Youth Co-Living Oasis Program. “You see, housing has gotten so expensive,” he said. “Young people cannot afford to buy their own apartments. They do not have time or the appetite to manage the nitty-gritty of the buying, mortgaging, and maintenance any way. In the meantime, lots of people have bought their apartments and left them idle for years.

112

Why Is Every Chinese Company Dabbling in Finance? This new start-up I am looking at will rent apartment blocks and renovate them for leasing. It is a light business model.” I briefly looked at the sector last year so I offered Steve a halfbaked view: “It is not exactly a light asset model. You see, the fixed rental cost is a heavy commitment. So are the renovation expenses. If you do not fill the units quickly and keep them filled, you are going to suffer a loss. I learned the lesson the hard way. In 2001, an outdoor billboard advertising company called Media Nation backed by Warburg Pincus went public on the Hong Kong Stock exchange. I enthusiastically wrote research notes on it, and recommended the stock to investors. But the stock kept going south. I doubled down and pushed harder. In the end, the business went belly up in my face. I was stupid not to notice that it was burdened by the fixed rental of advertising space and finance charge. In the meantime, the take-up on the ad space was lukewarm.” Steve assured me that “Demand for co-living space has got to be high. Millions of university graduates enter the labor force each year and do not want to live with their parents or have to live in a city different from their parents. This is the new trend.” He wanted to correct his father ’s “outdated” investment strategy. His father invested much of his gains from real estate in goldmines, and rare earth. That experience was not exactly memorable, as he was still litigating with his business partners. Steve’s new venture was to be funded by a 3-billion-yuan fund: two years (plus one year possible extension) in maturity. It has the customary junior-senior structure with him taking a 20% junior position. I wonder if his target company can succeed in getting

113

CHASING SUBPRIME CREDIT

new funding within the three years to pay him off. Despite the acceleration of IPOs in the domestic stock market since 2016, going public within three years is no sure bet. And there is now a tougher lock-up requirement even after the IPOs. A trade sale is not going to be much easier. But a lot of investments in the private market are done with this type of rosy underlying assumptions. I learned in September 2017 that some of Steve’s rapid-fire investments did not work out as planned. The family is still very wealthy but nevertheless, the wrong bets still hurt them. Perhaps following Premier Li Keqiang’s advice that “Everyone should become an innovator and entrepreneur,” China has stayed euphoric on creating start-ups. While the domestic stock market remains the most expensive in the world, the start-up universe is even more expensive. Everyone sets his eyes on the instant riches once his start-up gets listed. In late 2016, China Smartpay where I worked was invited to invest 20 million yuan seed money for a 10% stake in a supply-chain fintech company to be created by a PingAn banker, and two Tencent engineers, valuing the venture at 200 million yuan even before they had started. They had not yet officially resigned from their current jobs, and their glossy PowerPoint presentation file was still on a notebook (no printout). Having attentively listened to their presentation for 30 minutes, I asked if the 20 million yuan asked would be the only money they would have on day one. The answer was yes. I did not feel quite right and passed up the opportunity. However, they quickly got more funding from a company listed on the Shenzhen stock exchange.

114

Why Is Every Chinese Company Dabbling in Finance? Apart from the wealthy, large numbers of ordinary businesses have also piled into the private equity, venture capital, and even angel finance fields. Tens of thousands of ordinary Chinese citizens have joined them. Unlike most critics, I am supportive of this “social movement.” Is this not far better than the Cultural Revolution? Although a vast majority of new ventures will end up in flames, a small fraction will emerge triumphant, promoting competition, technologies, and better customer service standards along the way.

115

10

Chapter Tackling the Used Car Finance Market

CHASING SUBPRIME CREDIT

From 2014 to 2015, when tidal waves of new money flew into the subprime market (trust companies, wealth management products, and P2P), people suddenly realized that there seemed to be nothing to invest in. Or not enough anyway. Someone coined the popular term: zichanhuang (資產荒), meaning a shortage of quality assets. Not surprisingly, that was the time of tidal waves of non-performing assets, frauds, confusion, panic, and scrambling for assets. Many trust companies absorbed huge losses, so did the other private credit investors (the banks, funds, and the asset management divisions of securities companies). Many P2P were wiped out. I was surprised the term “triangular debts” did not make a comeback. It was during that period that people started to take a hard look at used car financing. For many years, buying a new car was a privilege of the wellto-do and, of course, the well-to-do did not need financing. Similar to buying a house some years back, new car buyers paid cash in full. That started to change around 2010 or 2011, when the concept of car mortgages became gradually accepted. Financing for new car purchases was, and is, the exclusive playground for the banks and automakers. The banks have the cheapest funding and automakers have a reason to boost car sales. For new car financing, there is no scope for subprime operators such as P2P, online lenders, or even specialist funds. But used cars are complicated and the banks still have not figured out a way to tackle the financing of used car inventories or purchases, except through dipping their toes into financing for the bigger and better specialist financiers of used cars.

118

Tackling the Used Car Finance Market This was the time when Howard Liu Yannan entered the scene. In 2012, he and two partners started Yooli.com, a P2P firm in Beijing. Liu graduated from Warwick University and worked for Merrill Lynch and TPG for a few years before feeling itchy about starting his own thing. In China’s P2P space, Yooli.com was one of the top five players from 2012 to 2015, attracting eyeballs, investments, and deal flows. But, two things drove Liu away: the strategic and managerial discord within Yooli.com’s top brass, and his views about mounting challenges of a P2P business model. Liu was concerned about a liquidity crunch that was a constant threat. In his eyes, anything could threaten the model: regulatory changes, fickle public opinions, and non-performing assets. In 2015, the three partners parted ways and Liu started to experiment with new ideas. He wanted stable funding rather than fickle retail funding from P2P sites. He settled his eyes on two consumer sectors: used cars and mobile handsets. His new firm, Meili Finance, quickly attracted private equity investors. But, initially Meili continued to source funding from its own P2P site. However, in July 2016 he shut down that funding source (paying off some 110,000 retail investors) and leaned entirely on institutional funding as it was cheaper, of longer terms, and more reliable. Back at Yooli.com, Liu relied on microcredit firms to lend money to final consumers, taking the credit risks of the middlemen. Now, he wanted to lend directly to the end consumer.

119

CHASING SUBPRIME CREDIT

Internet Greats Have A Hard Time China is one of the biggest car markets in the world. In 2017, the China Automobile Association predicted a car sales total of almost 30 million units. The used car market is also active and huge. In the first half of 2017, for example, a total of 5.8 million used cars changed hands (22% more than the same time of 2016), amounting to 390 billion yuan, according to the China Automobile Circulation Association. At least three factors underpin the growth of the used car market. First, new car sales still grew at 4–5% in the first eight months of 2017, compared to the same time of 2016, according to the China Automobile Association. Second, the population is still young and mobile. Young people move around in search of better opportunities, and that boosts used car sales. Third, more and more consumers want to save money and yet enjoy different driving experiences, as housing, education, and travel all compete for a bigger slice of the disposal incomes. Major e-commerce companies and internet greats have tried to tackle the used car market, either in the trade of used cars, the data distribution, the intermediation of trades, or the financing of buyers or inventory. But, they have reached a consensus. Two factors stand in the way of their fast domination of the market even if they are willing to burn lots of cash: the low-frequency purchasing behavior and the fact that every used car is different.

120

Tackling the Used Car Finance Market This is a fragmented market. The bigger car dealerships handle about one-fifth of all the used car trades while the other four-fifths are handled by about 1,100 used car markets. Meili Finance gets its funding from eight partner banks at around 7% annualized rates. Its 2,100 sales representatives stationed in over 300 used car markets generate two-thirds of its business. With loans ranging from 5,000 to 70,000 yuan apiece, and cars pledged to Meili but owned and driven by the borrowers, the quality of risk controls is crucial to the survival of the lender. There are two types of used car financing. One type is conducted by the likes of Weidaiwang (微貸網) based in Hangzhou. You have a car but suddenly need cash for whatever purpose. You pledge your car to Weidaiwang for a cash advance. Call it car-backed cash loans (車抵貸). The second type involves no cash going out and is conducted by the likes of Meili Finance. You want to buy a used car but cannot afford the full price. With a down payment (or sometimes no down payment), Meili will finance the balance. You own the car, but your car is pledged to Meili. Call it car purchases financing. (About one-fifth of Weidaiwang’s business is car purchases financing.) This technical difference is very important, because car purchases financing has a specific purpose and involves a specific transaction, and is generally safer than car-backed cash-out financing. In the case of cash-out financing, some consumers quickly discover that they cannot afford to repay the loans after their cash is used for, well, a coffee here and a meal there. Repossessing the pledged car can be a huge headache and may involve arm-twisting, literally, or worse.

121

CHASING SUBPRIME CREDIT

Great Expectations: A Walmart Fan I met with Meili CEO Howard Liu three times in the past six months. Our most recent meeting is summarized as follows. Joe Zhang: Why are you so bullish on the used car market? Howard Liu: L ook, the used car market is already huge: over 8 million trades a year and growing at doubledigit rates, much faster than new car sales growth. Used car financing is a 200-billion-yuan market today, and in a few years, it will likely be five times bigger. Fortunately for us, neither the banks nor the Internet giants have preordained advantages over ordinary operators like us. The Internet giants have a lot of money, and can engage in sweeping and bombardment advertising. But, at the end of the day, the buyers still must test drive and feel the car which is not parked in the cloud but in physical car markets. At best, what the Internet giants can do is create “leads generation.” Even that I have doubts about. For most used car buyers, the best thing to do is go to the market and take a look for themselves. We often see car buyers come to the market with their friends and relatives. They discuss and make a joint decision. So, advertising has a limited effect on the used car buyers. You spend a lot of money on advertising only to benefit the used car dealers and the site operators,

122

Tackling the Used Car Finance Market used car inventory financiers, and the consumer financiers. We offer used car inventory financing and consumer purchases financing. In the future, we will extend our reach to used car trading. That will enhance our efficiency and improve quality controls. Joe Zhang: Does size matter in the used car market? Howard Liu: T he used car market does not seem to exhibit e c o n o m i e s o f s c a l e a n d m a y v e ry w e ll s ho w diseconomies of scale. Concentrated advertising cannot create demand for credit, let alone customer loyalty. For a low-frequency purchase such as buying a used car once every three or four years, there is no customer lifetime value to speak of. You still have to deal with one used car at a time, on the spot. That is a hurdle the internet giants find hard to overcome. For us, it is also a challenge: How do we balance centralized risk controls and localized decision-making? How do we achieve scalability? Joe Zhang: You said that you believe there will be only 3 to 5 major players in used car financing in several years. How is that going to happen if there are diseconomies of scale in the sector? Howard Liu: That is a tough challenge for us. We have an earlymover advantage and have demonstrated our capability to balance various things. As the Walmart

123

CHASING SUBPRIME CREDIT

founder used to say, the best way to run a huge chain-store company well is to run every store well. Of course, this is not the thinking logic of some internet people. Having said that, I must add that our critical, centralized function is to gather and analyze intelligence on the market and prospects. We tap the Credit Bureau of the central bank and dozens of market databases to aid our work. To grow really fast, we need cheap and reliable funding. We are fortunate that the eight banks and NBFIs have become our funding partners. We have also launched two ABS programs (asset-backed securities). We will continue to explore other funding avenues. That is a big vote of confidence. I hope they become more confident of our risk controls over time.

124

11

Chapter Home Equity Loans for New Urbanites

CHASING SUBPRIME CREDIT

Just before the 2017 Lunar New Year Festival in China, someone posted a table on the web which immediately went viral. It read something like this: Top 10 Career or Investment Moves in the Past Decade: 1.

Buy property in Beijing

2.

Buy property in Shenzhen

3.

Buy property in Shanghai

4.

Buy property in Guangzhou

5.

Buy property in Nanjing

…and I think that you get the idea where that list was going. Top 10 Career or Investment Mistakes in the Past Decade: 1.

Sell property to launch a start-up

2.

Sell property to buy stocks

3.

Sell property to fund overseas education

4.

Sell property to...

…and I think you get that joke too. Property developers are both surprised (just like everyone else) and happy for the public to stay swept-up in the euphoria and frenzy for as long as possible. In the meantime, the detractors have all been humbled. In the top 30 cities, real estate prices must

126

Home Equity Loans for New Urbanites have risen 5- to 10-fold in the past 15 years. The idea that real estate prices can go only one way is entrenched. Robert J. Shiller’s famous book, Irrational Exuberance has been translated into Chinese, but it is not selling very well because, according to many, his analysis only applies to the U.S. market, not the China market. What about the 20-year gloom in the Japanese real estate market? “That is because of the population decline in Japan,” one might say. “But China is a different case altogether.” As Deutsche Bank analysts estimated in September 2017, abound 500 billion yuan of so-called consumer loans have found their way into down payments for home purchases so far in the year. Risks are real for a tidal wave of defaults and hardships when, and if, property prices were to fall, or mortgage servicing were to become too much of a burden as a result of job losses or stagnant incomes.

Easy Life of a Banker As a Chinese banker, life is still beautiful, although not quite a simple 9-to-5-existence. Mortgage bankers do brisk business without having to try too hard. If there is a new residential project for sale, it is usually sold really fast, and that has been mostly true in the past 15 years anyway. The only thing mortgage bankers have to do is lend to the big numbers of borrowers in a short space of time. Eager executives at property development companies will help organize the logistics. This looks more like a wholesale business rather than a retail business.

127

CHASING SUBPRIME CREDIT

For the mortgage bankers, this is a lot of fun compared to waiting in the office for odd customers to come in. As there is so much easy business to do with the purchases of new homes, mortgage bankers have not had to give much thought to home credit business, i.e., those who tap the equity value of their homes to get some cash for a trip to Thailand and Singapore, or to stock up for their restaurant business. Some even get cash for a punt on the latest hot stock tip they heard while in a nail shop or a grocery store. To be sure, competition is coming, particularly from mid-sized and small banks. So, the mortgage bankers have to venture beyond the low-hanging fruit. They generally dress up their home credit loans as “renovation loans” — in the full knowledge that the cash taken out may be used for God-knows-what purposes. The regulator, CBRC, is always concerned about the banks’ consumer credit or subprime credit in the online lending sector being turned into down payments for home buying. While data is hard to come by, there is anecdotal evidence that this is happening. But dealing with a bank can be extremely tedious. Many consumers (particularly migrants from the rural areas or those who have not have much education) are not familiar with the banks’ procedures and find them intimidating. This has created an opening for the nimble small lenders, though they charge far higher interest rates for the loans. In addition, many consumers work in the gray economy, and are self-employed or “undocumented.” They have trouble getting a loan from the banks because they do not have an official resident status in the city they reside in, or there is no taxpaying record or social security history, or they have a bad mark on their credit history.

128

Home Equity Loans for New Urbanites

Fanhua Targets New Urbanites with a Business Enter Fanhua Financial, a Guangzhou-based alternative lender. It was founded around 2010 by the U.S. fund house Cathay Capital Group (33% stake), Nasdaq-listed insurance agency Fanhua Inc (20%), and the balance is held by the management team and some private investors. In the earlier years, Fanhua Financial focused on bridge loans for mortgagors who wanted to sell their houses (贖樓貸). In China, banks have a strange attitude towards mortgagors: the latter must clear all their mortgages before selling their house. In some cases, a guarantee from a qualified entity may also work. Fanhua Financial provides loans to pay off the banks and then gets repaid once a new mortgage is obtained by the buyer of the house. It also provides some customers a guarantee to facilitate the selling of a mortgaged house. This process is usually weeks but can be as long as months. While the old business has stayed with Fanhua, the company has moved on to much greater things. In recent years, its breadand-butter business has been lending to new urbanites with a small business. In the past two decades, over 300 million people have migrated from the countryside to cities. That is Fanhua’s customer base. Currently, Fanhua operates in the 30-plus biggest cities with a payroll of over 4,000 people. Through a decade of retained earnings, its net asset value has risen to about 1.5 billion yuan. It does not have a lending license in all the 30-plus cities so it partners with

129

CHASING SUBPRIME CREDIT

several trust companies to tap their funds, as well as uses their lending licenses. Fanhua lends at roughly 24% annualized rates and pays 10% or so to the trust companies, while retaining a junior tranche of the loans on its own book. Its total loan portfolio just passed 15 billion yuan in September 2017. That gives a so-called leverage ratio of about 10 times. Its net profit is likely to reach 450, or even 500 million yuan in 2017. I have known Fanhua’s team for six years and have kept in close contact. Just before the 2017 National Holiday, I sat down with the Chairman and CEO Zhai Bin (翟斌) to discuss his strategy and challenges. Joe Zhang: Who are your typical customers? Zhai Bin: We target new urbanites who need money for their small businesses, such as restaurants, florist shops, nail shops, and so on. The average size of our loans is 600,000 yuan for two years, typically. Unlike many of our rivals, we emphasize monthly equal repayments. In other words, the principal of our loans is amortized reasonably quickly. That way, we reduce our risks. If your house is worth, say, 1 million yuan and we lend to you less than 70% of that value. After a few months, our exposure will be less than 70%. So, we feel quite safe. Joe Zhang: Why do the banks not compete with you? Zhai Bin: Of course, some banks do. They add “renovation loans”

130

Home Equity Loans for New Urbanites on top of their mortgages. The money can be used for whatever purposes. We all know that. But combing the neighborhood to find customers and make loans one at a time is hard work. Why would the banks do too much of that? In fact, the banks are often subject to their internal lending limits. So, they refer good customers to us, as do realty agencies, insurance agents, lawyers, e-commerce companies. We also market to prospects directly through seminars, WeChat messages, and cold calls. But referrals are the major source of our customer acquisition. Joe Zhang: Do you provide second-lien mortgages? Zhai Bin: Yes we do. We actually quite like this business. The banks keep the property title and we add 20% loans on top of the bank’s remaining 40%, for example. We are quite comfortable. Defaulting on a bank loan is a big deal. Black marks on the Credit Bureau (of the central bank) are a serious matter. Normally, the consumer does not want to even consider doing so, if there is another solution at all. Our loans are far more expensive than the bank’s, so the borrower has an incentive to pay us off more quickly. Joe Zhang: How easy is it to repossess a property? Zhai Bin: It is complicated, as always, whether the house is the borrower ’s principal residence or an investment

131

CHASING SUBPRIME CREDIT

property. So, the critical thing for us is lending according to the principle of what seems “fit and proper,” and by similar standards. We do not speculate. We do not harbor wishful thinking schemes. Just plain old, common sense wisdom. Joe Zhang: What’s your delinquency rate? Zhai Bin: Around 1%. We achieved this by controlling the size of each loan, the loan-to-value ratios and we stay disciplined; you must always be willing to make fewer loans. Joe Zhang: What is the biggest risk in your business? Zhai Bin: We know the property price has risen sharply in recent years. To reduce risks, we are religious about lending less than 70% of the assessed value. When, and if, one of our staff members colludes with a borrower to inflate the assessed value, we will take on undue risks. So, internal checks and balances are key. We are careful to examine the borrower’s other metrics such as his career history, family background, and social media activities. Joe Zhang: Is your 10 times leverage too high? Zhai Bin: No. We can actually lend more. Our partners have full confidence in our risk control systems after years of cooperation. When we have more capital, we take a bigger junior tranche in the loans. When we have less

132

Home Equity Loans for New Urbanites money, we put in less. Our junior portion gives our partners extra comfort in the deals, but, strictly speaking it is not always necessary. Joe Zhang: Any big plans going forward? Zhai Bin: The net growth of our loan portfolio is about 1 billion yuan per month. We are doing brisk business. But, we cannot afford to make big mistakes. However, we must strengthen our data analytics. How? We do not want to reinvent the wheel. We are negotiating with specialist data providers and analytical firms to set up joint ventures to align our interests. We have a full plate. You see, we need more data and better data analysts. Our cost of funding is too high. If we can get bank funding, our net profit can also double in 2018. The math is simple: bank funding is probably 7% a year, compared to trust companies’ 10.5%.

133

12

Chapter Too Many LimitedLicense Banks?

CHASING SUBPRIME CREDIT

I interviewed Li Bin, founder and Chairman of Huaxia Finance, a leading P2P company based in Shanghai. Li graduated from the University of California, Berkeley, in 1992 and worked at Citigroup and Deutsche Bank before joining CreditEase (宜信), the parent company of Yirendai. In 2015, he upstarted Huaxia Finance in Shanghai with an investment from Cathay Funds of the United States and Guangu (冠福) listed on the stock exchange of Shenzhen. Our discussion went roughly as follows: Joe Zhang: How do you see P2P sector regulation today? Li Bin: For a long time, the government did not really want to regulate the sector at all. Neither the central nor the regional governments were sure whose responsibility it was to regulate it, anyway. After all, it was a new type of business and seemed harmless initially. But the collapse of E-Zubao, and a few other fly-by-night merchants, forced the government’s hand, because there were a lot of protests by ordinary citizens who were defrauded many billions of dollars. So, it was only in late 2015 that the government suddenly realized that the sector had grown so enormous and that it could no longer play ostrich. But what to do? The government could not possibly shut everyone down after so many years of silent approval, or even encouragement in many cases. After all, P2P was seen as innovative and the government did not want to be seen as possibly trying to hurt innovation. There

136

Too Many Limited-License Banks? was also probably the realization that shutting down the sector would immediately exacerbate the precarious situation because a panic in the industry would cause a run by investors, pushing thousands of operators over the edge. Handling it properly could unleash the positive energy of the sector, many officials argued. Regulating this new industry required a lot of expertise which the government did not have in 2015. So, a typical Chinese solution was to issue a lot of temporary measures, guiding industry players to behave. This was a form of moral persuasion. We are still where we have been for the past two years as far as regulations are concerned. But a lot of good boys have shaped up and tidied up. Now, all players are required to clean up our mess (rectification 整改) in order to complete the registration process (備案) with the local government’s finance offices. Joe Zhang: What should we look out for? Li Bin: The regulatory landscape is becoming clearer. The bank regulator, CBRC, will take the lead in the regulation of the online lending sector, including P2P lending. I am surprised the government did not choose the securities regulator [CSRC] instead. In the U.S., for example, the Securities and Exchange Commission (SEC) is the regulator. Secondly, the regulators have had a lot of time to listen and learn and think. I am confident that

137

CHASING SUBPRIME CREDIT

a detailed set of regulations will be in place reasonably soon. These regulations would cover registration vetting, IT systems, privacy, funds custodian arrangements, customer selection, and dispute resolution. To be sure, demand for online lending is growing fast. But I think the rising costs of compliance, operations, and back offices will weigh on the weaker players. I reiterate my old forecast that there will be less than 100 players once consolidation takes effect. Maybe a few years down the road. Joe Zhang: W hat do you think of the lending arms of Baidu, Alibaba, and Tencent? Li Bin: I do not see their advantages in lending as considerable and sustainable. Someone’s social media data, and even the data on shopping behavior, has little bearing on his or her creditworthiness. You only know if he is going to repay your loans or not by lending to him. Really. Joe Zhang: When do you think the current registration process will end? Li Bin: I do not know. But I think this registration process is like a licensing process. Those qualified online lenders will become limited-license banks. That’s good news for the good players.

138

Too Many Limited-License Banks?

Are Internet Microcredit Licenses Decorations? At the peak in 2012, China’s local governments approved as many as 15,000 microcredit companies across the country. Many had not even officially opened for business before the sentiment turned sour. Almost everyone had dreamed of eventually upgrading themselves to village and township banks (村鎮銀行). That common aspiration lasted only a couple of years. Then the tidal wave of bad debts quickly dampened these aspirations. But not everyone had given up. Some microcredit companies were still beautifying their books by refusing to write off bad debts for fear of jeopardizing their chances of upgrading to village and township banks. But news came two years later that many village and township banks were suffering badly also: bad debts and diseconomies of scale. The whole industry entered a gloom-and-doom phase in 2015, and then a new hope sprang up: the possibility of applying for an internet microcredit company license! That was seen as the salvation for a crippled industry. But three years later, unfortunately, many have merely been “upgraded” to an internet microcredit company as far as licenses are concerned, but their business remains unchanged. Their DNA was not really meant for internet-based, small loans. Their forte was old-school stuff: big collateralized loans. I interviewed Xia Ming, the head of the microcredit companies’ association in Jiangxi Province. His association’s membership is over 200 firms. In the early part of his career, he was at the Agriculture

139

CHASING SUBPRIME CREDIT

Bank of China. Eight years earlier, he quit his SOE job for the rough and tumble life of the microcredit sector. His excitement eventually gave way to one of regulatory burdens, confusion, and bad debts. From 2011 to 2012, I visited him often, trying to team-up with him to acquire a group of microcredit companies in his province and get them listed in Hong Kong. But the regulatory hurdles were too high and so, we gave up. Some in other provinces managed to achieve the listing status in Hong Kong, such as Hanhua (瀚 華 3903.HK) in Chongqing and Huirong (1290.HK) in Jiangsu, but their valuations were very low thanks to their bad debts, tight regulations, and somewhat inflexible business models. Here are the highlights of my recent conversation with Xia Ming. Joe Zhang: How do you see the internet microcredit companies? Xia Ming: There are probably up to 100 such companies across the country. But, sadly, most of the real champions in the online lending industry — I mean those with solid analytical technologies — are being left out. Qudian has two such licensed companies in Jiangxi. That is a good sign. But many more deserve a license. Let a thousand flowers bloom and compete. Joe Zhang: Yes, it is ironic. With a few exceptions, the good ones have no licenses and those holding licenses are mostly old fixtures. Should we not encourage mergers and acquisitions? Xia Ming: Yes. Of course. But M&A rules are also too stringent.

140

Too Many Limited-License Banks? Joe Zhang: What about the likely regulatory changes for the sector? Xia Ming: The internet microcredit companies are regulated exactly like their old cousins. That is a shame. For example, a maximum of 2x leverage (4x in Chongqing), and the expected frequent reporting requirements. The benefits are that you can lend to anyone in the country, free of geographical restrictions. You are encouraged to make small loans. Otherwise, you would go belly up quickly. One other benefit is that you can borrow from your shareholders to increase your fire-power if the banks do not lend to you. You can also sell asset-backed securities (ABS) to recycle your money. Joe Zhang: It seems that the new licenses would be of little use to the biggest online lending companies because the capital requirements are too onerous. Why then are they all chasing these licenses? Xia Ming: Someone joked to me the other day, “These licenses are useful decorations in this uncertain regulatory environment. You get them and hang them on your wall. But you do not have to use them, and in fact you cannot really operate them on a daily basis. They are too regulated in the old way. But that joke is far too cynical and we encourage the license-holders to work with the regulators and the associations to find solutions.”

141

13

Chapter The Tidal Waves of Subprime Credit

CHASING SUBPRIME CREDIT

It is a cliché that China’s household sector is underleveraged compared to that of developed countries. It was certainly true when China had just emerged from the Cultural Revolution, and true even just a decade ago. But, is it still true after a decade of rapid growth of housing mortgages and consumer finance? Did Korea not suddenly wake up in 2003 to discover that it had tumbled from a frugal consumption culture into one with a credit card crisis? Note that this was just six short years after the country suffered the Asian Financial crisis and accepted a humiliating bail-out package from the IMF. In Taiwan, the consumer culture was the same as in China. After all, the age-old preaching of frugality was from the same Confucius textbook. However, around 2005, a credit card crisis rocked the island and it left a scar that lasts even today. Until even the late 1990s, credit cards were not very common in Taiwan. As of 2000, there were only 18 million credit cards in issue, according to the Bank of Taiwan. But with a few years of hard pushing by the banks, the number of credit cards in circulation surged to more than 45 million as of January 2016, compared to a total population of a mere 23 million! According to Huaxia Jinweiwang (華夏經緯網), “the surge in consumer debt led to nervous banks, anxious consumers, and widespread social ills.” Today, at least 600,000 people have stayed on rolling consumer debt in Taiwan, with little hope of ever getting out of the debt trap. This contributes to the chronic weakness of the economy. Our first table below shows that China’s household sector is still somewhat underleveraged but the growth rate of consumer debts

144

The Tidal Waves of Subprime Credit is very high and deserves attention. In the statistics of the People’s Bank of China, there are no data series for consumer loans but, instead, the two relevant data series are short-term household loans and long-term household loans, both include small business loans taken out by the households (or guaranteed by the family members). Since most households lump their consumption with their family businesses, I have chosen to do the following: 1. Use short-term household loans as a proxy for consumption loans; and 2. Use long-term household loans as a proxy for mortgage loans. There will be some overstatement of consumer indebtedness in this approach. But the overstatement should be more than offset by the household debts in the unofficial market, including the online lending market. So, on balance, the table below should be seen as an understatement of the overall household debts. In any case, the trend of the loans’ growth should be consistent with true underlying data. Table 12.1 China: Consumer loans and mortgages (Unit: billion yuan) 2011

2014

2017 (as of Aug.)

Consumer loans (excl. mortgages)

1,360.7

3,257.0

10,842.7

Mortgage loans (incl. small business loans)

9,226.7

1,5071.4

27,539.4

Year

145

CHASING SUBPRIME CREDIT

(Cont’d) 2011

2014

2017 (as of Aug.)

69,796.5

108,570.2

172,056.4

Consumer loans as % of total assets of financial sector

1.9

3.0

6.3

Mortgages as % of total assets of financial sector

13.2

13.9

16.0

Household debts as % of total assets of financial sector

15.2

16.9

22.3

Year Total assets of the financial sector

Source: PBC.

I understand that it is often problematic to compare one country’s consumer debt level with that of another country because there are other important factors to consider: 1.

Definitional differences;

2.

Social security (retirement benefits, jobless benefits, and medical care);

3.

Interest rates; and

4.

Rules on tax deductions.

With these factors in mind, we have compared the household debt level in China with that in the U.S. We can see that China’s 16% does not seem high compared to the 29.6% in the U.S., but caution is warranted for two reasons: 1.

146

China’s bank asset is 80% bigger than the U.S.’s, reflecting

The Tidal Waves of Subprime Credit an overall bloated and highly-leveraged economy in China. Therefore, the inflated denominator in China understated the extent of the consumer leverage. If, as I expect, the economy continues to slow in the next few years, while the consumer debts continue to outgrow the overall economy, the ratio will loom much bigger. 2.

Much of China’s consumer debts are concentrated in the 20odd big cities. So, while the national average ratio of consumer debts may not seem alarming, they are alarming in the big cities in general, and for the low-income groups in the big cities in particular.

True, there are many subprime borrowers in the United States. But, using the tidal waves of subprime borrowers in China as an indicator, I feel that China is rapidly approaching a consumer debt saturation, if not a crisis. There is little room to be sanguine about the trend. Table 12.2 United States: Consumer credit (Unit: billion US dollars) Year

2011

2014

2017 (July)

Consumer credit

2,757

3,317.4

3,753.9

Bank credit

9,663

10,883

1,2676

Consumer credit of % of bank credit

28.5

30.5

29.6

Source: The Federal Reserve System.

147

CHASING SUBPRIME CREDIT

Four Decades of Rapid Credit Growth With the exception of barely two years, China has implemented only two types of monetary policy in the last four decades: expansionary and very expansionary. The only exception was in 1995–1996 when, amid runaway inflation and a real estate bubble in Guangdong and Hainan (海南) provinces, then-Central Bank Governor Zhu Rongji (朱鎔基) tightened credit abruptly, which quickly led to the collapse of the Hainan Development Bank. That was the only bank failure in the history of Communist China, and it took a full decade to work out the large number of abandoned real estate projects that the credit boom had been responsible for. Unfortunately, that episode taught policy-makers the wrong lesson. Since then, the People’s Bank of China, as well as the Ministry of Finance, has become ever more accommodating to the country’s construction binge, all in the name of financial stability. In the past 20 years, the compound growth rate of China’s money supply has stayed as high as 16 per cent. In May 2017, the growth of money supply moderated to 9.6%, marking the first time the reading had dipped below 10 per cent in 22 years. In August, the growth rate fell further to 8.9 percent over the same month in 2016. Most observers now take this as a sign that further tightening is in the making. However, I see it as only a continuation of the extremely rapid expansion of credit in a sluggish economy. Growth rates year-on-year are often misleading because they mask the ever-

148

The Tidal Waves of Subprime Credit higher base. China’s gross domestic product is 40 per cent smaller than that of the United States, but its money supply is 80 per cent bigger — and still growing almost three times faster.

The perverse thing is this: The faster the credit growth, the

higher the new demand for credit. Higher credit leads to still higher demand for credit. Journalists call this an addiction. No. That is not accurate. The truth is this: 1.

The fact that credit has been growing so fast for so long is proof that credit demand has been pushed up artificially by the interest rates being too low, or even negative in inflationadjusted terms. Therefore, credit is subsidized by the ultimate lenders (i.e., the savers). The strange feeling among some businessmen is that, if they do not borrow as much as possible (even to their eyeballs), they would be ripped off. They just do not feel right!

2.

If credit growth is too fast, it will likely cause inflation. In the past four decades, inflation has been high in China. In recent years, it has come down and stayed low at 2–3%. However, asset prices (stocks and real estate) have gotten out of control, but they are not part of the inflation basket. With inflation, more credit is needed to facilitate the same amount of economic activities.

149

CHASING SUBPRIME CREDIT

China Has Defied the Gravity of Debt In 2013, I was part of a chorus of analysts who predicted that a wave of privatization would soon sweep through China. Our sense was that the pressure of official debt, already then reaching a scarily high level by global and Chinese historical standards, would force local governments to sell off interests in commercial ventures. Simply too much had been borrowed at interest rates of more than 7% to build roads, bridges, office towers, and sports stadiums which were not generating enough cash flow to pay back trust companies and other creditors. We were all wrong. Although debt levels have almost doubled again since 2013, there is no sign that the government is about to unload its vast array of state-owned enterprises. In fact, the state is still building up its portfolio both at home and abroad. Hardly a day passes without a private entrepreneur succumbing to enticements from the state sector. What is going on? The economics we have learned cannot tell us just how much debt is too much, or how economic theory will work in reality under different sets of political institutions. Over the past four decades, China has aggressively pursued inflationary fiscal and monetary policy. This is despite a painful history of hyperinflation, a key factor in the fall of the government of the Kuomintang, or Nationalist Party, to Communist forces in 1949. Today, off an extremely high base, China’s money supply is still growing faster than 10% a year. Despite high inflation over the past four decades, both the government and the public are strangely adamant that a reasonable

150

The Tidal Waves of Subprime Credit rate of inflation is not only necessary but also desirable, though no one can define what “reasonable” is. While governments in a number of developed nations are striving to produce even a bit of inflation, China and most developing countries have only sad histories to relate about inflation so more wariness might be expected. In theory, persistently high inflation should lead to the weakening of the Chinese currency. But over the last two decades, the yuan has been one of the strongest currencies in the world, offsetting much of the depreciation seen in the two decades prior. This suggests enormous erosion in the purchasing power of other major currencies over this time-frame and robust Chinese productivity growth. A crucial question economists have neglected to address is whether China has grown its economy despite high inflation, or at least partly because of it.

Questioning Independence For decades, China’s policymakers have talked about the independent central banks of the West with great admiration, although Beijing has never wanted to give any independence to its own central bank. To Chinese policy-makers, independence would mean inconvenience. After the U.S. subprime crisis of 2008, the twists and turns of American monetary policy, plus extended Congressional debates about official debt ceilings, have left Chinese central planners

151

CHASING SUBPRIME CREDIT

feeling vindicated. Some are now loudly voicing doubts about the very idea of independent monetary policy in the West, never mind independent fiscal policy. Four years ago, when debt servicing started to bother China’s regional and local governments, Beijing promptly opened two new fundraising avenues for them. One was public-private partnerships, which effectively shifted state debt to the private sector and to future generations. The other was to allow regional governments to raise new debt in the public market. As a result of these new channels, even the most heavily indebted regional governments have not had to offload commercial assets. Inflation has made inequality much worse in China, but as long as the economy is still growing at a good pace, any social crisis explosion will be delayed. All over the world, a popular movement is challenging the accepted wisdom of austerity and fiscal responsibility. For China’s policy-makers, a united front coming from the West is amusing though somewhat humbling. Western economic governance has long been held up as a role model for China. But in areas such as the independence of monetary and fiscal policy, China suddenly finds the West converging with its own backward model. A part of this chapter is based on my essays at Nikkei Asia Review, 14 July 2017, and SCMP, 27 July 2017.

152

14

Chapter Cleaning Up the Mess

CHASING SUBPRIME CREDIT

The online lending boom since 2015 has been nothing if not spectacular. Like all wild parties, there are consequences. The first is millions of defrauded investors and borrowers. The second is mountains of bad debts. To see how a mid-sized online and offline lender — Let’s call it Dadong — cheats borrowers, see the example of their major product. In this case, it’s an 18-month lending program. On the dinner table, its CFO wrote on a piece of scratch paper how they charged its offline customers: Dadong lends 1.8 million yuan to an offline borrower with collateral (his street-level floral shop) for 18 months. The real purpose of the loan is anyone’s guess. The officially-stated interest rate in the contract is 40% annualized, but look at the calculation as follows: 1. The borrower has to repay the principal in 18 equal instalments. So, each month the borrower has to repay 100,000 yuan. Burdensome for almost anyone. 2. Plus monthly interest payments: 1.8 million yuan * 40% / 12 = 60,000 yuan. The borrower has to repay 160,000 yuan each month! As the interest is collected each month and the principal is amortized each month, the effective interest rate of this loan is exorbitant. Admittedly, this is an extreme case. It is no surprise the lender is on the verge of collapse and its ratio of bad debts is 30-odd percent.

154

Cleaning Up the Mess Its online operations are also guided by the same philosophy: using high interest rates to cover high delinquency rates. Many online and offline lenders charge upfront account management fees, services fees, plus this penalty and that penalty. The thinking behind the practice is the same. While the regulators, the media, and the consumer protection groups condemn ultra-high effective interest rates, China remains the most free society in the world, at least on this front. Call it the Wild East. There is a 36% cap on interest rates, which the Supreme Court decreed, and that only becomes an issue when it is taken to the legal realm. But few cases go to the court. Dadong may have little hope of getting clearance with the local government’s finance office to continue its operation in the current round of its “rectifying process,” but it just may. As they say “Ultra high interest rates? Everyone does it.” On the protection of retail investors, hundreds of thousands get burned every year when the “wealth managers” run away with their money, or suddenly shut down shop. But, apart from some protests in front of the government offices and the lenders’ offices, few cases go to the court of law. As the vast majority of investments are small sums, investors generally nurse their wounds and move on. Many continue to put their money and faith in other online wealth management sites. Their experience of being cheated in the stock market and in grocery stores has somehow numbed their nerves. Greed (and fear of lagging behind inflation) continues to drive them to unscrupulous outlets.

155

CHASING SUBPRIME CREDIT

Debt Collectors on a Tear Almost all online lenders and off-line investment companies keep an in-house “asset management division,” or “asset protection unit,” which is just a euphemism for bad debt collection. For loans that are overdue by just a few weeks, online lenders tend to send messages to, or call, borrowers to remind them of their obligations. But, as the overdue loans age into months, online lenders tend to send the loans off to specialist collectors. Unlike the four big bad-loan work-out agencies such as Cinda, Orient, Great Wall, and Huarong, that only work on big parcels of bad loans from the banks, a huge number of small debt-collectors have come into being in recent years to meet the needs of the smalltime subprime sector. They typically collect loans with an average size of from just a few thousand to a few million yuan. They also work on much bigger tickets of unpaid corporate debts. It is estimated that there are about 3,000 registered debt collection agencies around China, with a total of 300,000 employees. But, at this stage, the collection is not much more than making repeated telephone calls, and sending text reminders. It is not costeffective to make house calls to chase small unpaid loans. What has changed of late is that some collectors have started to put pressure on debtors by sending messages to the debtors’ relatives and friends. There is a lot of backlash to this approach, but it can be quite effective. With the fashionable “online everything” trend in China, some institutions (including the likes of Oriental Asset Management and

156

Cleaning Up the Mess Merchants Bank) have put a small number of their bad debts in Alibaba’s Taobao for sale. Maybe the thinking behind the move is that grandmas can order a few pieces of bad debts after they order their grocery deliveries online? In any case, there is no harm in experimenting. Shandong Financial Assets Exchange, a state-affiliated marketplace, where I am a member of the board of directors, launched online sales of bad credit in 2016. In the first nine months of 2017, it listed over 20 billion yuan of unpaid credit. In the debt collection industry, the dirty little secret is various layers of institutions and persons (fixers as well as introducers) will take a cut. Nothing terribly unfair perhaps, as long as you can really demonstrate your value-added. But it makes the whole process opaque. The efforts of the Shandong Exchange are to make debt collection and disposal more transparent in order to avoid corruption and maximize the value for the creditors. Some of the listed bad credit on the Shandong Exchange had been pre-negotiated between sellers and prospective buyers. But the public listing and the mandatory waiting period (the cool-off) provides legitimacy and a fair amount of time for other potential bidders. This allowed the sellers to discharge their fiduciary duties. Some other loans did not attract indications of interest before listing, but received favorable bidding upon listings. On the whole, the success rate of the Shandong Exchange was unusually high (over 80%) in 2017. Regrettably, Shandong has so far not attracted online lenders to list their bad debts, probably because the online lenders wish to

157

CHASING SUBPRIME CREDIT

retain some secrecy, and/or they are skeptical of the usefulness of the public exchanges. The Shandong Exchange was founded by the provincial government some years back, and in 2015 it introduced some external investors including Hanhua Finance (3903.HK) and Cinda. The fee model in the small-credit collection industry is either profit-sharing or a combination of profit-sharing and fixed retainer. The debt collection industry has a negative image, partly because of the old movies portraying debt collectors as masked men with tattoos on their arms wielding sharp knives. That is incredibly unfair. It is true that a minority of debt collectors use aggressive tactics and caused harm, and even deaths, but the vast majority of debt collectors use civilized approaches. They are no different from credit officers, accountants, or construction workers. The most notable players in the small-loans collection industry apart from sophisticated data crunchers (Tongdun 同盾, Juxinli 聚信力) are public platforms such as Dachui Asset (大錘資產) and Ziyitong (資易通). The biggest third-party collectors include Yongxiong (永雄) and Yinuoyinhua (一諾銀華). There is money to be made and the industry’s stigma is evaporating, as some real professionals are entering the industry. Lü Weiting (呂衛亭), who holds a PhD in telecommunications from Indiana University and who has worked at Capital One and then McKinsey, started a third-party collection agency, Cuimi Technology (催米科技公司), in Shanghai. Apart from traditional call centers, Lü is experimenting with digital ways of debt collection and finding answers in big data.

158

15

Chapter Valuations, and Not-So-Cynical Conclusions

CHASING SUBPRIME CREDIT

1. Banks prevail. Banks should be valued the most highly among lenders. They are safer and regarded by the public as such. They have constant streams of new and cheap (and even subsidized) deposits to keep them afloat. Some say the banks everywhere in the world are legalized Ponzi schemes. There is probably some element of truth to that idea as sometimes they dip into negative equity territory, but you will never know about it. When they claw back to positive equity, you probably will not know about that either. In any case, they weather the business-cycles better than any other type of financial institutions. As parts of societal infrastructure, the banks have the printing press firmly attached to them. Please do not say that this is just a Chinese phenomenon as the recent experiences in the U.S. and EU are proof. The biggest U.S. banks have emerged the biggest winners in the past decade, although they became mostly insolvent or near that in 2008 and 2009, and almost brought down the global financial system. 2. Long live the fintech sector. Instead of disrupting the banking sector, the activities of the fintech sector are revolutionizing the subprime credit sector. The fintech entrepreneurs make good noise, speak fancy buzzwords, stimulate credit activities, and experiment with all sorts of structured schemes. The outcome? Apart from making a killing for themselves — some of them anyway; they work so hard that they deserve every penny they have — they are making the banks safer, and more profitable. How is that happening? The fintech sector is sucking almost all the subprime borrowers firmly into its orbit, leaving the banks with

160

Valuations, and Not-So-Cynical Conclusions a clean group of prime-quality customers, the state, and the privileged SOEs. 3. The banks are also adaptive. The Chinese banks are adapting to the fintech challenges (at least their verbal assault) and will eventually be even bigger winners. They are working (albeit reluctantly so far) with the fintech sector, and more enthusiastically with the traditional subprime credit providers such as the guarantee companies, microcredit firms, and trust companies. If you look closely at the cooperative arrangements between the banks and the non-bank financial institutions (NBFIs), you will have no doubt who has the upper hand. The rule of engagement has determined that, in turbulence, the NBFIs will be crippled and wiped out. They have been wiped out in the past several waves, and will be wiped out again in the next waves of turbulence. In the past two waves (in the 1990s and 2011 to 2013), the guarantee companies, trust & investment companies, and the microcredit sector have served the banks extremely well through their episodes of self-destruction. 4. Marriages made in Heaven. Of the banks, the likes of WeBank run by Tencent clearly have an edge. They make huge numbers of tiny loans based on their intimate knowledge of their customers. They stay nimble as they do not want everyone’s business. Given time, many mid-sized and small banks across the country will likely outsource their consumer credit business to the likes of WeBank. The other leading online lenders such as Qudian and 51 Credit, also have the same potential but without a banking license, they are less convincing than WeBank, at least

161

CHASING SUBPRIME CREDIT

for now. They may aim to obtain banking licenses or acquire some of the existing banks. The condescending regulators today do not feel comfortable about giving banking licenses to these “Wild Heroes from the Bush.” But when the convergence between the small and mid-sized banks and the fintech sector becomes so compelling, and when the small banks get seriously wounded by economic turbulence, the regulators will feel that their merger (or their rescue by the fintech heroes) is nothing but a marriage made in Heaven. 5. The Chinese regulators have, for decades, deliberately depressed the interest rates on bank deposits. Proof is in the money-market funds and wealth management products. Low interest rates on bank deposits have stimulated the NBFIs and subsidized those who can borrow from the banks. The whole paradigm has encouraged credit growth. But how did China avoid a banking crisis so far, against all the odds? Look at the selfless work by the NBFIs. 6. Leasing companies, finance companies, and factoring businesses borrow money from the banks. So, the cost of their input (funding) is the banks’ cost of output (loans). By definition, they operate in a subprime, or near-prime, sector. They should be valued cheaper than the banks. 7. P2P companies should be priced on their earnings but consideration should be given to their growth and the sources of their customers: how do they acquire customers? In a captive environment, or in the competitive open market where frauds are more common?

162

Valuations, and Not-So-Cynical Conclusions 8. Data companies should be priced much higher than even the banks but the trouble is that their earnings are often too small in absolute terms. Bad debt collection agencies should be priced on earnings multiples and deserve a premium once they achieve a scale. In the foreseeable future, their growth is likely to be high. 9. Credit-related software companies are safer than the banks. But, the question is: how many lenders trust outside firms’ analytical models and risk-control models? Marketing capability is crucial. Maybe many of them should become an in-house unit of a big lender? 10. Reverse mortgage loans (home equity loans) and used car lending are best done by the banks because their cost of funding is low and this sector offers mouth-watering possibilities of profitability. But, the banks are too bureaucratic to get their hands dirty. A good solution is for the banks to outsource the tedious legwork and risk controls to the hungry firms established by PSDs such as Meili, Weidaiwang, and Fanhua Financial. These firms usually take a junior tranche in all the loans to protect the banks. 11. Finally, the so-called asset platforms boast a wonderful concept: they take on no credit risks and not even residual risks. They simply sell other people’s financial products such as funds, packaged loans, ABS, or bonds. In other words, they act as a supermarket for financial assets. But, after some years of hard work, some of these operators realized that their revenue was patchy and competition fierce (and getting fiercer). Without some sort of guarantees, you just cannot convince

163

CHASING SUBPRIME CREDIT

the Chinese retail investors to have too much faith in your recommendations. You find out that you need skin in the game. Many platform companies are either aggressively getting into lending (such as Wacai and Shuishouji), or feel very itchy about it. The enviable exceptions are Ant Financial and the early movers such as Dongfang Caifu (300059.SH) that traded in September 2017 on almost 80 times its 2016 earnings.

164

Afterword Fintech Is Doing God’s Work China’s history in the past four decades has been one of creditinduced inflation. They came in two big waves: consumer price inflation (CPI) and asset price inflation (real estate and stocks). No one knows how to stop the train, let alone reverse it, but not for lack of trying. Credit explosion and inflation reinforce each other. The music is still playing. This credit-inflation nexus is due, in part, to financial depression: interest rates on bank deposits have been too tightly regulated and have been too low for too long. That constantly stimulates the demand for credit. This process is not without its benefits as the method has monetized a command economy, and a largely agricultural economy, quite quickly. But, it has caused massive inequality: savers have subsidized borrowers, rural residents subsidized city residents, ordinary citizens subsidized the rich, and so on. Your access to big quantities of credit (and subsidized credit) is often the crucial factor in your financial success. In these four decades, inflation has reduced the yuan’s intrinsic value considerably, although the reduction has been partially offset by the tremendous (accumulated) growth in labor productivity. In the long term, there will be more downside to the yuan’s

165

Afterword

exchange rates. But the government is resisting it through tight controls on the exchange rates. Sadly, the control itself has become another source of inequality; only the privileged class has the means to offset their exposure to the yuan (and are subsidized to do so by ordinary citizens). China’s regulation on the online credit sector is very lax. But that is not because the government or the public are philosophically pro-innovation or pro-competition. Not at all. The real reason is that the regulatory toolkit has always been empty, unlike in the West. Four decades ago China emerged from a backward command economy, and did not inherit a well-structured regulatory regime. That turned out to be good news for the new economy, including for online lending, and the fintech sector, eventually. A thousand flowers are blossoming. The frantic activities of the online credit sector have caused harm to many retail investors and subprime borrowers alike. But, they have produced a vibrant fintech sector. Fintech would be meaningless if it failed to make subprime credit available cheaply (enough), safely, and cost-effectively. For a long time, China’s subprime sector has been the sewage pipe of the banking sector, taking a subordinated tranche in huge numbers of credit transactions. Fintech promises to make the banks even safer and more profitable.

Appendix A Personal History of Subprime Credit 1. One bank. Until 1984, the People’s Bank of China was also the only bank in China. It did all the lending to the state and to businesses. Bad loans were covered by the printing press.

2. Creating the banks. In 1984, the Industrial and Commercial Bank was spun off from the central bank, though the real separation took many more years to occur. Agriculture Bank was turned into a separate bank. Ditto for China Construction Bank where I interned in 1982. It was the Ministry of Finance’s infrastructure credit rationing tool. In the years that followed, China created many more banks such as Bank of Communications, Merchants Bank, Citic Bank, Everbright Bank, etc.

3. “Triangular debts,” and illegal fundraising. From 1986–1989, I was a junior officer (主任科員) at the People’s Bank of China head office. I was often sent to various places to investigate “triangular debts” and illegal fundraising. I went to Wenzhou and Ningbo in Zhejiang Province, for example. Punishment for illegal fundraising was swift and harsh.

4. Trust companies collapsed in droves. In the 1980s and 1990s, the government created many trust and investment companies to bypass its own regulation that the banks must not make equity investments. All of these trust and investment companies

167

Appendix

were SOEs, and they went bust swiftly, and understandably.

5. Rural credit unions fell systematically. In the 1980s and 1990s, the rural credit cooperatives systematically collapsed, only to be bailed out by the central bank and by inflation. They had a business license and continued streams of deposits

allowed them to stay afloat. Rising tides lifted all boats. They eventually rose to viability and may plunge back to insolvency, and back again. The common practice at the time was to make loans without collateral: very few borrowers had any collateral anyway. Many borrowers even borrowed money without any equity down. Few borrowers had any equity to begin with. I would not be surprised if Grameen Bank founded by Muhammad Yunus in Bangladesh would eventually suffer very high delinquency rates. It is a matter of when, not if.

6. Urban credit cooperatives also fell in big numbers. Many urban credit cooperatives were created in the 1980s and 1990s. Many did well and some did badly. My brother, Hualiang, ran such a company, Golden Shrimp Credit Union in Jingmen City, Hubei Province, for some years but it did not survive. Who took over their liabilities to the depositors? The state arranged a bank to swallow them.

7. Trust problem again. After waves of failures in the trust and investment sector (most notably the one in Guangdong that shook the capital markets in Hong Kong), the government in the late 1990s regrouped the surviving ones into 68 “trust companies,” deleting the word “investment.” But their venture since then has been just as risky, if not more so. They are highlyleveraged lenders. They sell wealth management products to

168

Appendix

invest in subprime deals (e.g., forbidden land acquisitions, mining, and infrastructure). They do not legally stand behind the performance of these debt instruments. But in practice, they have to. Their real leverage is much higher than the banks’ — but without the banks’ constant streams of deposits and without the banks’ privileged protection by the central bank. A failure of several major deals in a trust company is enough to cripple the lender — or make it illiquid — as the industry people like to say.

8. Guaranteed failures. For decades, the guarantee companies have existed to serve subprime borrowers (SMEs). They are the writers of CDSs (credit default swaps). For a tiny fee of 2–3%, they guarantee their customers’ bank loans. CDSs brought AIG to its knees in 2008, and have also killed a huge number of Chinese guarantee companies.

9. Mass murders of microcredit lenders. For the government, it was always an uphill battle to control illegal fundraising. So, from 2005 to 2008, the state started to license microcredit companies. Once the floodgates opened, the local governments authorized as many as 15,000 such entities. Some borrowers took out loans from multiple lenders, making a mockery of the lenders’ analytical models. Unfortunately, the subprime lenders did not have a shared database to know that in advance. Bad debts, daring managers, and rigid regulations quickly wiped out at least one third of the industry.

10. P2P came along. In 2012, P2P firms sprang up to bypass many of the hurdles faced by microcredit firms (overbearing regulations, heavy taxes, and geographical restrictions). They

169

Appendix

also learned other lessons from the microcredit firms: •• Small loans are safer than big loans. •• Consumer loans are safer than SME credit. •• A loan to fund part of a purchasing is safer than a cash loan. But these lessons were not enough to save the P2P industry. Several thousand closed down, and most surviving firms were languishing. Only a few dozen did well.

11. Smartphones and data came to the rescue. But a big number of P2P firms still collapsed because of mass frauds, natural defaults, and the high costs of operations. Since about 2015, smartphones helped lenders to know their prospective borrowers better, and allowed lenders to reach the social contacts of their borrowers. So, in the event of a default, some lenders have the option of gently contacting the delinquent borrower ’s social circles to exert pressure. Tongdun and Bairong, and the data industry, have also helped improve the anti-fraud skills of the lenders.

12. Targeted lending works better. In 2014 and 2015 some specialist firms started to plow the fields of used car financing, facial treatment, and wellness-related financing, wedding loans, and holiday financing. A few years earlier, PPF (Home Credit Group) pioneered lending finance for mobile phone buying. Baiqian and Meili Finance joined the efforts and have made the sector more competitive and intelligent. Good borrowers from the handset purchases were later offered cash loans.

170

Select Bibliography Cuadros, Alex. Brazillionaires: The Godfathers of Modern Brazil.����� ���� London: Profile Books, 2016. Greenberg, Alan C. The Rise and Fall of Bear Stearns. New York:���� Si��� mon & Schuster Paperbacks, 2011. Linyi Research Institute 零壹研究院. Zhongguo P2P jiedai fuwu hangye baipishu 2015 中國P2P借貸服務行業白皮書2015 [China P2P Credit Services Industry White Paper 2015]. Beijing: The Oriental Press, 2015. McLean, Bethany. Shaky Ground: The Strange Saga of the US Mortgage Giants. New York: Columbia Global Reports, 2015. Prasad, Eswar S. The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance. Princeton: Princeton University Press, 2014.

The People’s Bank of China. The official website, http://www.pbc. gov.cn. Wangdaizhijia 網貸之家. The official website, http://www.wdzj. com.

171

Acknowledgments I owe many people for my half-merchant / half-academic lifestyle. I especially thank the following people for their generous time and guidance as I wrote this book. 1. Li Bin, Chairman and CEO of Huaxia Finance, Shanghai 2. Sun Haitao (Chairman), and Kenny Zhao (CFO) of 51 Credit, Hangzhou 3. Joseph Wang, Chief Strategy Officer at China Rapid Finance, Shanghai 4. Zhi Zhengchun, Chairman of WeCash, Beijing 5. Mickey Li Yinghao, CEO of Mint Quantum, Beijing 6. Oscar Zhu, Chairman of Shanghai Qiancheng Cash Card 7. Yan Dinggui, Chairman of Liwodai, Shanghai 8. Charles Yuan, Partner at Greenwood Asset Management 9. Xia Ming, Chairman of the Microcredit Association, Jiangxi Province 10. Zhai Bin, CEO, Fanhua Financial Services, Guangzhou 11. Howard Y. Liu, CEO, Meili Finance, Beijing 12. Tang Xia, Chairman, Feidai, Shenzhen 13. Xia Zhen (Chairman) and Zoe Chen (Partner) at Pailie Technology (eCreditPal), Hangzhou 14. Elvis He, MD at China Merchant Securities, Hong Kong 15. Wang Pengfei, EVP, Weidaiwang, Hangzhou

173

Acknowledgments

16. Vicky Chen (CFO) and Y.C. Wu (CSO) at WeCash, Beijing 17. Lü Weiting, Chairman of Cuimi Technology, Shanghai Glenn Griffith and Barbara Cao have edited this book and my two other books (Inside China’s Shadow Banking: The Next Subprime Crisis?, and Party Man, Company Man: Is China’s State Capitalism Doomed?). Glenn was also the editor of three dozens of my op-eds at Financial Times, New York Times, Bloomberg, Reuters Breaking Views, Nikkei Asia Review, and SCMP. I am extremely grateful.

174

Chasing Subprime Credit: How China’s Fintech Sector Is Thriving In China, credit is booming, so is subprime credit. Instead of disrupting the banks, fintech is energizing the subprime credit sector while helping the banks. It is a chaotic scene, causing headaches to the government and much harm to investors and borrowers alike. The regulatory stance is full of intrigue. But things are not all negative. If fintech can enable all subprime borrowers to access credit cheaply, safely, and cost-effectively, all the chaos and trouble will have been worthwhile. For decades, China’s subprime sector has been the plumber for the banks. Fintech is now adding some sharp tools. If the two can work together well, the banks will be much safer, and more profitable. This book explains how the major players are doing it, and why there are risks and rewards for us all.

AUTHOR

Joe Zhang is the Chairman of China Smartpay. He sits on the boards of directors of a number of other firms including Fosun (656.HK), China Rapid Finance (CRF NYSE), and Logan Real Estate (3380.HK). He worked 11 years at UBS Investment Bank. In the 1980s, he worked at the People’s Bank of China. His many essays have appeared at Financial Times, The New York Times, The South China Morning Post, Nikkei Asia Review, The Asian Wall Street Journal, Reuters, and Bloomberg.