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China: Re-Hypothecated Steel Vaporizes?

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    September 20, 2012

    In the wake of a global crash on the the price of steel, led by falling demand, banks in China have gone to warehouses to seize assets of companies in default. However, commodities pledged as assets for loans, simply are not there.

    Please consider Ghost warehouse stocks haunt China’s steel sector
     Chinese banks and companies looking to seize steel pledged as collateral by firms that have defaulted on loans are making an uncomfortable discovery: the metal was never in the warehouses in the first place.

    China’s demand has faltered with the slowing economy, pushing steel prices to a three-year low and making it tough for mills and traders to keep up with payments on the $400 billion of debt they racked up during years of double-digit growth.

    As defaults have risen in the world’s largest steel consumer, lenders have found that warehouse receipts for metal pledged as collateral do not always lead them to stacks of stored metal. Chinese authorities are investigating a number of cases in which steel documented in receipts was either not there, belonged to another company or had been pledged as collateral to multiple lenders, industry sources said.

    Ghost inventories are exacerbating the wider ailments of the sector in China, which produces around 45 percent of the world’s steel and has over 200 million metric tons (220.5 million tons) of excess production capacity. Steel is another drag on a financial system struggling with bad loans from the property sector and local governments.

    “What we have seen so far is just the tip of the iceberg,” said a trader from a steel firm in Shanghai who declined to be identified as he was not authorized to speak to the media. “The situation will get worse as poor demand, slumping prices and tight credit from banks create a domino effect on the industry.”

    Miracle GDP or Sham Accounting?

    ZeroHedge had some choice comments today about the impact on GDP and China’s miracle growth …

     And just like that the Chinese growth “miracle” goes poof… as does its steel first, and soon all other commodities (coughcoppercough) that served as the basis of “secured” liability creation.

    If the above makes readers queasy, it should: after all rehypothecation of questionable assets is precisely what serves as the backbone of that critical component of the shadow banking system: the repo market, where anything goes, and where those who want, can create money virtually out of thin air with impunity as long as nobody checks if the assets used for liability creation are actually in the system.

    We will soon discover that all other assets: stocks, bonds, commodities (including gold and silver) and finally cash (think deposits) have been comparably rehypothecated and criminally commingled.

    I fully expect stockpiles of copper to be missing as well. I am not aware of gold and silver being pledged as assets for loans.

    For certain, at least in the US, stocks and bonds are under different rules than commodities. Furthermore, while I do not know what every US equity and bonds brokerage house does, many institutions require 100% full cash collateral on securities they lend out.

    Is cash collateral widespread in China? I highly doubt it. So at least in terms of China, a discovery that multiple asset classes were criminally commingled to a significant degree would not be surprising at all.

    The big question is not whether it happened, but to what degree. Let’s just no go overboard thinking rehypothecation is a widespread practice in every asset class around the globe, even if it’s likely this is the tip of the iceberg in China.

    Mike “Mish” Shedlock
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    Images: Flickr (licence attribution)

    About The Author

    Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management. Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.  Visit Sitka Pacific’s Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

    You are currently viewing my global economics blog which typically has commentary every day of the week. I am also a contributing “professor” on Minyanville, a community site focused on economic and financial education.  Every Thursday I do a podcast on HoweStreet and on an ad hoc basis contribute to many other sites.

    When not writing about stocks or the economy I spend a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com.