Why Ant Financial's IPO was pulled

It's Lehman all over again

Disclaimer: I did this back-of-the-envelope research in a couple of hours purely for fun, and it’s not meant to replace an actual deep-dive. Please feel free to point out any unforced errors.

I came across this interesting article about the possible reasons behind Ant Financial’s recent debacle, which had its celebrity IPO metaphorically defenestrated: https://www.nakedcapitalism.com/2020/11/china-takes-step-against-securitization-consumer-borrowing-with-suspension-of-ant-ipo.html

So word-on-the-street is that China’s regulators scuppered the American Idol equivalent of 2020’s IPO because their relatively flamboyant founder Jack Ma made some comments in the public sphere about existing banking regulations being the equivalent of “pawnshops” - as they encouraged maintaining high levels of collateral. This was seen as a direct retort to Chinese regulators, who have been struggling to reign in the hangover effects of China’s 300% debt-to-GDP ratio (govt + corporate).

But why did China’s regulators respond with such fiery intensity to an off-the-cuff comment that the politically agnostic Ma was wont to make? They could have just ignored it and nobody would have remembered it by the end of the week - and Ant’s blockbuster IPO would have given markets something to cheer about, especially in China where confidence is much needed. The aforementioned article appears to put 2+2 together.

It’s not a very long article and you should read it yourself, but for the acutely indolent among you, here’s a summary:

1. Ant’s lending arm is in the business of extending short-term, high interest microloans for small-ticket discretionary purchases to predominantly younger borrowers with lower credit quality (e.g. freshly graduated professionals). It is basically a glorified fintech credit card.

2. It then packages these loans into asset-backed securities (ABS) and sells them to investors, who hold them as collateral to fund “joint loans” under Ant’s brand. The loans are “joint” because unlike vanilla ABS exercises used to fund bank loans, the credit risk almost entirely remains with the loan partners instead of Ant. Ant merely holds a miniscule subordinated debt tranche consisting of roughly 2% of the loan principal.

3. This means that Ant only needs to front a ridiculously small amount of capital in order to extend a loan. Some sources say it’s between 1%-5%, while new draft rules suggest this could increase to as much as 30%.

I’m sure you can see where this is going. These are exactly the kind of credit conditions which eventually lead to the 2008 US subprime mortgage crisis. As microlenders like Ant practically do not bear any credit risk, they have every incentive to be aggressive in their lending standards. There are actually news reports which suggest they already have been in the past.

Of course, the counter to this argument is that Ant’s loans have had pretty decent historical delinquency rates thus far, about 1.5% prior to 2020. In the onset of coronavirus, delinquency rates have doubled YTD, but most simply attribute it to a black swan credit environment. However, it does say something about Ant’s borrowers that they can’t or choose not to be timely about repaying a small 12-month loan used to finance an iPhone. Even at 12%-15% interest rates, nobody on a middle-class salary should have any trouble fulfilling those monthly installments even during a recession.

Anyway, I digress. The point that the article above was trying to make is that microlenders like Ant could potentially pose a systemic risk to the banking system when they securitize their “credit card” loans and sell it to the bigger fool. Even if those conditions don’t exist today, they certainly make it easy for them to exist tomorrow. Anyone interested in NINJA loans (literally) for students to replace their old iPhones during Single’s Day? I’ve got an Ant-backed ABS to sell you.

Now that you’ve got some context, let’s slap some meat on those bones. As some guy probably said during the gold rush, it’s prospect-ing time.

p. 307 - Net current assets

First, we have to find those pesky ABS’s. If you take a look at p.307 of Ant’s IPO prospectus, the company held only RMB 36b of loan receivables as of end-June 2020 (or about USD 5b). In a vacuum we can’t tell whether that’s a little or a lot, but that amount doesn’t really sound like much for a company with a dominant share of China’s USD 14 Trillion economy. So let’s try to find out how much of those loan receivables have been bundled off-balance sheet as ABS’s.

p. 166 - ABS

p. 309 - Loan receivables

Going by the stated amounts in p.166 and p.309 above, we get RMB 36b of loan receivables & RMB 1,732b of total consumer credit balance. Which implies ~2% loan retention (36/1732 = 2%), and which ties with their own admission that 98% of the total credit balance were likely sold off as ABS’s.

RMB 1.7T… or USD 260b. Sounds much more like a big bank’s loan portfolio than USD 5b, doesn’t it? Or perhaps more precisely, a credit card portfolio?

p.I-158 - Transferred financial assets that are not derecognised in their entirety

So how much of this RMB1.7T was bundled off as ABS’s, and might henceforth pose a systemic risk to the wider Chinese economy? Well p. I-158 suggests that these loans are bundled into “asset management plans” (more colloquially known as wealth management plans, or WMPs) with carrying amounts of RMB 170.8b, of which Ant only retains RMB 3.154b in credit loss exposure, or ~2% (3/171 = ~2%).

On the surface, this doesn’t seem too bad when compared to China’s RMB 250 Trillion credit economy. But wait, didn’t we see earlier that Ant’s total consumer credit balance was RMB 1.7T? What’s up with that 10x gap?

p.I-159 unconsolidated structured entities

We can see in p. I-158 and p. I-159 that Ant utilizes Unconsolidated structured entities for… basically anything. And it also has discretion on whether or not to consolidate these structured entities. And these unconsolidated structured entities (USE) had carrying amounts of RMB 2.073T as of June 2020. So if I had to guess, this is where all the RMB 1.7T of ABS’s that were bundled off-balance sheet were deposited.

So for a RMB 4.334b investment in these USEs (its effective cash outlay for the loans), Ant gets to make RMB 2.073T in loans through its platform. Which means its LDR ratio is somewhere north of 40,000%. And I’m conservatively guessing that it gets to keep at least 10% of the interest on the loans, by virtue of being the middleman? Which, again conservatively assuming a 10% interest rate, results in an effective ROI of 400% (40,000% x 10% x 10% = 400%). Wow, I can sort of see now how Ma might have maintained that sliver of possibility that kicking the sleeping dog could yield a positive risk:reward.

In summary, this just looks like Lehman all over again. If you recall, the 2008 US subprime mortgage crisis started because the lack of credit risk assumed by the loan originators incentivized them to extend loans to borrowers of increasingly lower credit quality - because they were just going to sell them off to Fannie Mae anyway. And then when they ran out of legitimate subprime borrowers, the enticing profits incentivized them to switch to outright fraud in order to keep the printing press flowing. Add in a credit environment which encourages moral hazard (i.e. government bails out the failures), and you get a situation where - in the words of the effervescent Bruno Mars - I’ll catch a grenade for ya’.

So if someone put a smoking gun to my head and forced me to speculate why China’s regulators were so harsh on Ant’s IPO, I'd say it would be the culmination of all the above plus a clearly belligerent Jack Ma that had every intention of exacerbating the collapsing house of cards that is China’s credit situation.

Add in the fact that China will soon become a net importer due to their ever-increasing oil imports, and the fact that they’re running out of foreign reserves owing to the trade war - which means they can’t print RMB willy-nilly anymore to equitize the titanic debt - and you can see why Xi Jinping might be breathing down the regulators’ sweaty necks and ordering a huge dose of cAN’T.

edit: I previously drew a comparison to not just Lehman, but Enron as well. However, someone pointed out how that comparison was incorrect, so I took out the Enron analogy. Apologies for the unintended head fake.