In The Headlines

Bad Loans Threaten China’s Banking System

Predictions of a Chinese banking system bailout are getting more numerous and coming from more mainstream sources. What was once the fringe view of market bears and short sellers is now increasingly being adopted by economists at some of the world’s biggest banks and brokerages. Nine of 15 respondents in a recent survey of financial institutions predicted a government-funded recapitalization will take place within two years. Among those who provided estimates of the cost, a majority said it will exceed $500 billion.

While a bailout of that size would be a far cry from the $10 trillion forecast of U.S. hedge fund manager Kyle Bass in February, the responses reflect widespread concern that Chinese lenders will struggle to cope as bad loans surge. Even as some analysts said a state recapitalization would put the banking system on a stronger footing, 80% of respondents predicted news of a rescue would weigh on Chinese markets, dragging down bank stocks and the yuan while pushing up government borrowing costs and credit risk. “A recapitalization will happen after the Chinese government comes clean with the true nonperforming loan figure,” said Kevin Lai, the Hong Kong-based chief economist for Asia ex-Japan at Daiwa Capital Markets. “That will require a lot of money creation.”

At Commonwealth Bank of Australia (CBA) in Sydney, analyst Li Wei said the survey (conducted by Bloomberg) was the first time he had estimated the timing and cost of a recapitalization. The topic became more prominent after an article calling for the nation to tackle leverage and bad debt appeared in the People’s Daily, the primary newspaper of China’s ruling Communist Party, in May. That same month, Societe Generale SA issued a 48-page report outlining restructuring options for China’s state-owned enterprises and banks.

Chinese lenders are grappling with a growing mountain of bad debt after flooding the financial system with cheap credit for years to prop up economic growth. Non-performing loans (NPLs) jumped by more than 40% in the 12 months ending March 2016 to 1.4 trillion yuan ($210 billion), or 1.75% of the total according to government data. The figures are widely believed to understate the true scale of the problem, with CLSA Ltd., estimating NPLs were probably closer to 11.4 trillion yuan at the end of last year. The People’s Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC) did not comment on these estimates. Chinese banks will be able to maintain relatively high capital levels even if they are hit by severe shocks, the central bank said in its 2016 financial stability report last month. A stress test of 31 large- and mid-sized Chinese banks showed their aggregate capital-adequacy ratio falling to 10.97% from 13.32% in a worst-case scenario, the PBOC said. China will require systemically-important banks to have a ratio of 11.5% by the end of 2018.

Some economists are less sanguine, predicting that Chinese banks will need state help as loan losses erode capital buffers. A majority of the survey respondents said policy makers will use a mix of foreign reserves, state assets sales, sovereign bond issuance, or money printed by the central bank to fund a recapitalization. Most of the economists who estimated a tab for a bailout said it will cost at least $500 billion, with forecasters from CBA and Hamagin Research Institute saying it could climb to as much as $3 trillion.

It would not be the first time China’s government has stepped in to support its banks, most of which are still majority-owned by the state. When the country’s NPL ratio climbed to as high as 40% in the late 1990s, policy makers sold special bonds to recapitalize the four biggest lenders and set up state-run bad banks to buy 1.4 trillion yuan of soured loans at face value. The effort was largely a success, setting the stage for more than a decade of breakneck growth that turned China into the world’s second-largest economy and helped many of its biggest companies tap into global capital markets.

A government bailout “will help write off bad debt and help banks clean up their balance sheets,” said Ding Shuang, the head of Greater China economic research at Standard Chartered in Hong Kong. “It’s a positive thing if it really happens.” Of course, some analysts argue that a bailout by the government will not be necessary. Iris Pang of Natixis SA says lenders can replenish their capital by selling bonds and equity. Others foresee more extreme scenarios. Bass, the Dallas-based founder of Hayman Capital Management, says a large devaluation of the Chinese currency will be the centerpiece of a government response that may also include cutting interest rates to zero. The yuan will fall in excess of 30% against the dollar, Bass predicts, helping to boost export competitiveness and “reset” the economy. “China will save its banks, and the renminbi (yuan) will be the valve for normalization,” Bass told investors in a February letter.

In a May report called “Restructuring China Inc.,” Societe Generale analysts said losses in the banking system could reach $1.2 trillion. They advised avoiding shares of lenders until after a debt restructuring in coming years, and said if government bond sales surged as part of funding a recapitalization, sovereign borrowing costs could rise by 100 basis points or more across all maturities. Chinese markets are already signaling anxiety over losses in the banking system. The nation’s four biggest lenders trade at an average 32% discount to net assets in Hong Kong, suggesting investors are braced for big write-downs, a recapitalization that dilutes their equity stakes or some combination of both.

The yuan just capped its biggest quarterly decline since China unified the official and market rates in 1994, while market perceptions of the nation’s default risk have almost doubled since late 2014. “The government appears to still be in the process of working out how to restructure,” Yao Wei, China economist at Societe Generale, said in the report. “This is the root of the uneasiness—the excruciating time spent waiting before the government takes action.”

Citations

1. http://bloom.bg/29mKKtP – Bloomberg
2. http://econ.st/1UCmwfZ – The Economist

Is Recreational Marijuana the Next California Gold Rush?

How do you create business infrastructure in an industry that is not legal yet? California may be about to find out. There is no guarantee California will vote to legalize recreational marijuana in November, but political operative and father of four, Daniel Conway, has already staked his future on it. Conway left his job as chief of staff to Sacramento’s celebrity mayor, former Phoenix Suns NBA basketball star Kevin Johnson, to help start the marijuana investment company, Truth Enterprises. He is one of hundreds in the most populous U.S. state already pushing ahead with plans to enter a market experts say will be worth $4 billion by 2020.

“I’m someone of an age and of a demographic that sees the legalization and normalization of marijuana as inevitable,” said Conway, 35. “This was a chance not just to build companies, but to build an industry.” With a population of nearly 40 million people, and a thriving medical marijuana trade legalized 20 years ago, California already has the largest legal marijuana market in the United States. Legalization of recreational pot would generate an estimated $1 billion in additional taxes per year. In November, if voters approve a measure to legalize and tax marijuana that qualified recently for the ballot, California would be the fifth U.S. state—and by far the largest—to allow marijuana for recreational use, joining Colorado, Washington, Oregon, and Alaska, as well as the District of Columbia.

A similar ballot initiative failed in California in 2010, but recent polls show strong support for legalization. The latest effort is backed by mainstream leaders including Lieutenant Governor Gavin Newsom, who helped negotiate the regulations and taxes the law would impose. Eight other states, including Nevada and Maine, also have recreational or medical marijuana proposals headed for their 2016 ballots.

California’s sheer size as the world’s sixth largest economy means a decision by its voters to legalize marijuana could accelerate the trend elsewhere. “I don’t believe there will be any precedent in the United States that can compare to it except for maybe the Gold Rush,” said Leslie Bocskor, whose Nevada-based private equity firm, Electrum Partners, advises and invests in marijuana-related businesses. The lure of wealth in an uncharted industry is so great that thousands of people are jostling for position, said Bocskor.

Since January, 115 new California companies have joined the National Cannabis Industry Association, bringing total membership in the state to 330, said Deputy Director Taylor West. New companies include cultivators, dispensaries, laboratories, law partnerships, accountants, software developers, insurers and more, she said. Their challenge is to set up an infrastructure for a business that is not yet legal. Conway and his business partner, General Hydroponics CEO Ross Haley, for example, recently purchased farmland in Northern California that they hope to use to grow marijuana, but would not say where before the measure is passed.

Newport Beach-based Terra Tech is trying to prepare for recreational sales while building a legal business within the state’s medical marijuana marketplace, which has annual sales of $2.7 billion. The company spent more than $800,000 designing and remodeling its Oakland dispensary to look more like a high-end lounge than a drab medical clinic, said CEO Derek Peterson. It also developed colorful packaging for its marijuana instead of dispensing it in prescription bottles.

Despite such optimism, passage of the California measure is not certain. It is opposed by many of the same law enforcement and health care groups who helped defeat the 2010 initiative. But this time backers have the deep pockets of former Facebook president Sean Parker, support from Newsom—a Democrat expected to run for governor in 2018—and a switch in attitude among voters who saw legalization come to pass in other states.

The measure would allow adults age 21 and older to possess up to one ounce of marijuana, cultivate up to six plants, and sets rules for the manufacture and sale from commercial cultivation. It includes rules aimed at keeping cannabis products from children, preventing impaired driving, and requiring licenses for sellers. Newsom said he is backing it as a way to responsibly manage legalization, which he views as inevitable, but also needing careful handling in the transition and beyond. “As a guy with four kids who doesn’t like the drug, doesn’t like the smell, doesn’t want my kids to think it’s normalized, this is my number one concern,” Newsom said.

Citations

1. http://for.tn/29pimZJ – Fortune
2. http://cnnmon.ie/29tLCdU – CNN

The Good News Is . . .

• U.S. consumer spending rose for a second straight month in May on increased demand for automobiles and other goods. The Commerce Department reported that consumer spending, which accounts for more than two-thirds of U.S. economic activity, increased 0.4% last month in May, pointing to acceleration in economic growth in the second quarter. Consumer spending in April was revised upward to show it advancing 1.1% instead of the previously reported 1.0% increase.

• FedEx, Corp., a leading logistics, transportation, and package delivery service reported earnings of $3.30 per share, an increase of 24.1% over year-earlier earnings of $2.66 per share. The firm’s earnings topped the consensus estimate of analysts by $0.02. The company reported revenues of $13.0 billion, an increase of 7.1%. Management attributed the company’s results to profit improvement program initiatives at FedEx Express, e-commerce growth, and the positive net impact of lower fuel costs.

• The movie studio Lionsgate has agreed to buy Starz, the premium cable channel home to hit shows like “Outlander,” for about $4.4 billion in the latest round of media consolidation. Lionsgate, the studio behind “The Hunger Games” movie franchise and “Mad Men,” had long been considered as a likely buyer. Adding a cable channel could help provide scale, while providing stability for a sometimes volatile movie business at a time when other studios have been swallowed up by bigger entertainment giants. The terms of the Lionsgate-Starz deal are complex. Lionsgate will first split its stock with each share splitting into half of a voting share and half of a nonvoting share, and then, owners of Starz A shares will receive $18 a share in cash and 0.6784 of a nonvoting Lionsgate share. Holders of Starz B shares will receive $7.26 in cash and both 0.6321 of a share of Lionsgate voting stock and 0.6321 of a share of Lionsgate nonvoting stock. The offer values Starz A shares at $32.21 each.

Citations

1. http://reut.rs/2901geW – Reuters
2. http://cnb.cx/1gct3xa – CNBC
3. http://bit.ly/299YcNz – FedEx, Corp.
4. http://nyti.ms/29cb5M5 – NY Times Dealbook

Planning Tips

Tips for Financially Assisting Aging Parents

Baby Boomers are increasingly tasked with caring for, or providing for, aging parents. In fact, according to the Pew Research Center, nearly 15% of middle-aged adults are contributing financially to aging parents. In addition, 75% of adult children agree that they have a responsibility to provide financial assistance to an aging parent. This can represent a significant financial burden on families. Below are some ways in which you can financially assist elderly parents. Be sure to consult your financial advisor to determine if these strategies are suitable for your situation.

Tax advantages – A child may claim an exemption on his or her tax return for the care of aging parents provided several requirements are met. For example, the parent must not file a joint return unless only to claim a refund, they must be a U.S. citizen, and the parents’ gross income cannot be greater than the personal exemption amount of $3,950. Since some Social Security payments may be included in this figure, many seniors with modest incomes from pension, interest, or investments may be excluded. In order to claim a parent as a dependent, a child must furnish more than one-half of the support during the year. In addition to food, medicine, and other support items, if the parent lives in the caregiver’s home, the fair market rental value of the lodging can count towards part of the support provided. One of the advantages of this provision is that the parent does not have to live with you. If the parent resides in their own home, in an assisted living facility, or a nursing home, the costs paid for this type of support at those locations is counted towards meeting the IRS requirement.

Medical expense deduction – Once the parent(s) meet the IRS dependency test rules, any medical expenses that are paid for by the caretaker child can be used towards this itemized deduction. Since the medical costs need to exceed a certain percentage of the caretaker’s adjusted gross income before they can be claimed (10% if the caretaker is under 65 years of age, 7.5% if the caretaker is over 65), a parent’s expenses may help meet the requirements. These costs include the premiums for supplemental Medicare coverage or long-term care insurance. Assuming all the requirements are met, a family (particularly with parents, grandparents and dependent children all in the same household), could benefit from pooling all of the medical expenses together in order to qualify for the medical deduction. In addition, if the parent requires continual care so that the caretaker may continue to work, adult children caretakers may be able to qualify for either the dependent care credit or an employer-sponsored flexible spending account. The dependent care credit allows for a tax credit of up to $1,050 based upon the amount spent on dependent care and the gross income of the caregiver.

Annual gifting – If financially feasible, children can gift their parents up to $14,000 per year—$28,000 for both parents. If multiple siblings participate, this can pay directly for a parent’s medical expenses, including skilled in-home care. This gifting can also help pay long term care policy premiums which covers both home health and skilled nursing care.

Home improvements – Certain improvements made to accommodate a home for a taxpayers’ disabled condition or that of a spouse or dependents that reside in the home—improvements that do not increase the value of the home nor are done for architectural or aesthetic purposes—can be deducted in full as medical expenses. Examples of this type of renovation would be exit or entrance ramps, widening doorways, hallways or interior doorways, installing railings or support bars, modifying kitchen cabinets, adding handrails or grab bars (either inside or outside of a bathroom), and modifying hardware on doors. The deduction is limited to the excess of the actual cost of the improvements over the increase in the fair market value of the home, if any.

Reverse mortgage – A reverse mortgage may be a way for a parent to remain in their home and pay for their own expenses and remain independent (albeit it may be an expensive move due to fees up front). A reverse mortgage is a type of loan that enables senior homeowners to convert part of the equity in their homes into income without having to sell the home, give up title, or take on new monthly mortgage payments (as in a refinance). Reverse mortgages are available to individuals age 62 or older who own their own homes. Funds obtained from a reverse mortgage are income tax free and do not affect the receipt of Social Security or Medicare benefits. Borrowers can choose to receive the funds as a lump sum, monthly income, or as a line of credit. The funds can be used in any way they wish. The loan becomes due when the borrower sells the property, permanently leaves the home (to go to a nursing facility) or passes away. The debt the borrower or their heirs owe equals the entire loan advances taken plus interest.

Citations

1. http://bit.ly/1kE4I4a – US News & World Report
2. http://on.mktw.net/1GhNbCB – MarketWatch.com
3. http://bit.ly/29aaZPZ – Investopedia
4. http://bit.ly/29dgHBt – Forbes
5. http://bit.ly/29cq6ZC – SmartAsset.com