On 15 September 2008, addressing the White House briefing room, Hank Paulson spoke of "drawing a line in the sand" with respect to Lehman Brothers which had just filed for bankruptcy.

While the US treasury secretary and his other comrades claimed the moral high ground in letting Lehman go to the dogs, blaming their culture of excesses, in reality, it was more to do with their failure of restructuring Lehman through a private sector solution, given the state had already exhausted all its options during the earlier bailout of Fannie Mae and Freddie Mac.

Outside America, Barclays’ regulators in the United Kingdom had left Paulson stranded, being disapproving of a potential deal where Barclays would have taken over Lehman minus the subprime assets.

Nevertheless, the fallout had implications for the credit markets worldwide. Not just Wall Street, but healthy companies as far as the West Coast were facing troubles financing their everyday operations. Put simply, the entire credit markets of the West were in a deadlock for a few days, leaving the best of businesses gasping for breath before TARP happened.

History often finds a way of repeating itself. Almost 13 years later, Evergrande Group emerged as the next Lehman, this time in the real estate sector. China’s real estate investment model was similar to the housing crisis of the United States in 2008. Both countries had placed their bets on housing demand and prices going up, eternally and exponentially, and had thus made provisions for cheap credit.

The only difference was the motivation. In America, banks were using subprime loans to create financial products, mainly credit default swaps, to investors, and making a fortune out of it. In China, cheap credit was ensured for developers, by both state-backed financial institutions and offshore private investors, to fuel the Chinese growth story, for real estate was the nucleus for almost one-fourth of the Chinese gross domestic product (GDP).

In 2008, Paulson, as the treasury secretary, was assuring China that their markets were in a healthy condition and could contain the fallout. In 2021, Chinese officials gave a similar assurance to Jerome Powell, chairman of the US Federal Reserve.

As the falling stock price was a testament to the imminent fate of Lehman, the missing coupon payments from Evergrande confirmed that all was not well for China’s biggest real estate developer.

The first close escape came around 22 October when Evergrande transferred $83.5 million worth of interest payments to Citibank, a day before the month-long grace period got over.

On 28 December 2021, it has an interest payment of $255.2 million due, another $117.5 million due on 22 January 2022, $235 million on 24 January 2022, $2.1 million on 14 February 2022, and principal payments due worth $2.1 billion on 23 March 2022 and $1.5 billion on 11 April 2022. In totality, Evergrande has $8.1 billion in principal and interest payments before the end of 2022 on its offshore bonds alone with liabilities exceeding $330 billion.

However, the music stopped earlier this month when Evergrande missed a coupon payment worth $82.5 million. Fitch became the first rating agency to declare Evergrande as a defaulter, though the Chinese government did not confirm the development immediately. However, a management committee was later installed with a majority of members from the state-owned enterprises, consequently the Chinese government, thus confirming the silent Chinese takeover of Evergrande, and the beginning of a restructuring process. Evergrande, as it turns out, was not going the Lehman way.

While the exact details of the restructuring are currently unknown, the objective would be to protect the Chinese homebuyers before the offshore bond holders. Almost two million in number, the restructuring process will ensure that the existing buyers do not lose out on their homes, most of them unbuilt as of today, and will factor the need to keep the company’s other real estate projects going.

The offshore bond holders, however, will have to prepare for a haircut or a prolonged payment process, and perhaps may have to settle for as much as 20 cents on a dollar.

What complicates their case further is the workaround Chinese companies have been employing for almost a decade now, also known as the Keepwell obligations. Just as is the case with the variable interest entity (VIE) structures with the stock market listings in the United States, the bond market equivalent is the Keepwell obligation, which is nothing but a word of promise from the borrower.

For offshore borrowing through bonds, a Chinese company’s offshore subsidiary raises money from foreign investors with the parent company in mainland China, otherwise not allowed to directly borrow from foreign investors, guarantees the financial backing and payment on the bonds issued. Therefore, there is no formal guarantee from the parent company in mainland China on the bond, and in case of defaults, as is the case with Evergrande, there is no formal avenue or recourse available. It boils down to a good word. That’s about it.

For China, there is a greater incentive in containing the fallout of Evergrande, given more than a quarter of its economy relies on real estate related sectors like construction, raw materials, etc. Also, unlike America, where the US Treasury and Federal Reserve had to run through the White House and the Congress before they could contain the fallout of Lehman, the politics in China is quite straightforward. The state is the judge, jury, and executioner, and in the case of Evergrande, a potential saviour.

The restructuring also sends out a message to the foreign investors, betting on China’s growth in this decade, that the state will intervene as and when required.

While many stakeholders and commentators, citing the same cooked up story of moral high ground and lines in the stand from 2008, expected Evergrande to go the Lehman way, the Chinese government was not going to risk its entire real estate sector to make a morality point about reckless borrowing. Finances over philosophy, and rightfully so.

Evergrande, for now, will live to fight another day. The restructuring comes with a hope that the ongoing real estate projects will churn some revenue, and even if it takes a few years, the company will find some of its health going forward.

Quite like Evergrande, where other real estate developers fail, the Chinese government will engineer a bailout or ease credit access, as it did earlier this month by pumping $200 billion into the markets by having banks lower their reserve requirements. Private sector solutions and collaborations, as was the case with Wall Street banks in 2008, would also be the option going forward.

Unlike the US government that was caught napping as Lehman and AIG failed, the Chinese government knows what it is dealing with, and for the love of the global economy, one hopes they play their cards right. Paulson knew he had made a mistake in letting Lehman fall. Thirteen years later, Chinese are not repeating the same folly.

Hank Paulson

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