December 07, 2012

By Derek On December 7, 2012 Under December

I landed in this country with $2.50 in cash and $1 mn in hopes, and those hopes never left me.”
Charles Ponzi, describing his arrival to America


Clawed by Fraud

The US and China are headed straight for confrontation regarding a three-year investigation of accounting practices in China. Monday, this week, the SEC brought an enforcement action against five big accounting firms for refusing to hand over requested documents and allow PCAOB inspections. The first deadline for inspections, according to China accounting expert, Beijing-based Dr. Paul Gillis, was 2009. This deadline was extended for three years and now the exasperated SEC has given up the idea of any more negotiation with China.

Under the US Sarbanes-Oxley Act, foreign audit firms must comply with SEC document requests and allow PCAOB (Public Company Accounting Oversight Board) inspection regarding US-listed companies. Congress has made the law that black and white. However, China views auditing documents as “state secrets” and it is against Chinese law to send them overseas – probably due to the fear that like newly enriched Chinese officials, they won’t come back. Ernst & Young (which is neither), PWC, Deloitte and KPMG all have subsidiaries in China, which audit US-listed Chinese companies. If they comply with the SEC requests, their people in China will go right to jail. China won’t hesitate to do that. If they do not comply, they face punitive fines and more in the US. While my sympathies for global accounting firms are anything but deep, I can see they are blameless in this situation and are just victims of a major diplomatic impasse.

Welcome to the “Audit Cliff”

The conflict was in the works for some time but the accounting profession had been quietly hoping that a compromise would be reached. Apparently, No, it was not reached and with this week’s SEC action, the “audit cliff” has now been reached.

It is speculated the PCAOB, created by the Sarbanes-Oxley Act to protect investors, will now revoke the registration of the affected China subsidiaries of the Big Four. Without US-licensed auditors, the companies will not be allowed to trade on US exchanges. This would then lead to wholesale delisting of all US-listed China stocks – the worst case scenario. Many of these stocks, such as BIDU, EDU and CTRP were off 6-10% when the news broke.

Red Collar Crime

The reason for all the noise is, of course, the fraud that has occurred in the sector, or what Forbes Magazine is now calling “red collar crime.” The Chinese are learning you can’t keep three sets of books in the US and the US is learning the Chinese can tell great, compelling stories.

Also on Monday, Canada announced it had fined SinoForest auditor, Ernst & Young $118 mn – the largest fine of an auditor in Canadian history for “not being skeptical enough.” You may remember deceptive, delisted and now deceased SinoForest met its doom by claiming more trees than it had (can’t see the forest for the trees fact it isn’t even there). John Paulson certainly remembers; he lost $720 mn due to the fraud perpetuated by the company..

Many of the US-listed Chinese companies are the result of a back alley birth in the form of perverse reverse listings, which reached a high of $1.34 bn in value in 2008 when such whelping was occurring in force. According to data, US IPOs by Chinese issuers has fallen by more than 2/3 since then. Investment banks acting as midwife, cheerleader and snake oil salesman of these unholy conceptions, such as Roth Capital Partners, Rodman & Renshaw and Piper Jaffray have all been halted in their tracks. With the SEC now looking at the “gatekeepers” of such deals, this became risky business.

According to a recent report in the WSJ, Roth Capital raised more than $3.1 bn for Chinese companies – and just closed its five-year old China office. Rodman & Renshaw not only shut down its China research arm and canceled its China investment conference but also changed its name (to Direct Markets Holdings Corp).

According to BBG data, there are around 400 Chinese companies trading on US exchanges and over a quarter of these have been audited by the domestic subsidiaries of the Big Four accounting firms. Formerly a hot sector for US-based investors to get exposure to China, the group has lost 61% in value since the beginning of 2011. The SEC has already deregistered

the securities of almost 50 companies, filed fraud cases against more than 40 and is still investigating another nine unnamed US-listed Chinese entities.

The Next Step

What happens next? Now we wait to see if the PCAOB deregisters any of the Chinese accounting firms it cannot inspect, which by law they are mandated to do. According to Dr. Paul Gillis,
“That is likely to be a lengthy process, starting with a rule-making action, followed by public comment, and concluding with SEC approval. The judge has 300 days to rule in the SEC case. A PCAOB action probably takes a year.”

Chairman James Doty of the PCAOB also says the White House or Congress could intervene in the process. But I think for now they are rather busy dealing with the fiscal cliff.

The accounting firms all have large Hong Kong operations. However, they will not be able to transfer work to them from China either as China will not allow them to comply with SEC demands. As a result, those entities will also likely be deregistered in the US. A lot of money is at stake here and this is becoming a target rich environment for lawyers and lobbyists

A Punch in the Testes for AmCham

While the immediate impact of driving off the “audit cliff” will be felt in the equity market, punishing the good companies along with the bad, longer term this raises serious questions for any MNC active in China, many of which are audited by one of the Big Four. If auditors can’t complete an audit in China because their China subsidiary has been deregistered, how will they sign off on consolidated accounts for the entire entity? I would expect the American and EU Chambers of Commerce in China to lobby hard for a compromise and it is likely some sort of compromise may be reached. But that will take time.

They Won’t Go to Hong Kong

Many, if not most, of these companies will privatize and delist from the US exchanges. Last year 16 US-listed Chinese companies did just that. This year 25 Chinese companies have announced similar plans. Will they move to Canada? No. Some believe they will resurface and list in Hong Kong. I wouldn’t bet on that. In an earlier issue of EMI where we explored the convoluted structure of VIEs, we also noted that unlike the US, Hong Kong does not allow unequal voting structures. If these companies have shareholders with, for example, 10% ownership but who control 50% of the votes, they will not be able to list in HK with that structure. So, they just restructure, right? My question is: will they want to give up that control for a HK listing? Doubtful.

Big questions are being raised here and no one yet has any answers. Sadly, I expect the sell-off in US-listed China shares to continue. The street has been very bullish on some of these names as evident from the most recent recommendations:

Stock Buys Sells
Baidu 79% 6%
New Oriental 75% 0%
Sina 67% 13%

I would expect suspension of coverage or downgrades will follow – usually unhelpful to positive share price performance. Even if an eventual diplomatic compromise is found, this is just more tar and feathers for the sector and its demise, whether by administrative enforcement, or lack of investor interest is now destined. My view: It is time to sell the US-listed China stocks.


Ragamuffins and Tatterdemalions

Two weeks ago in EMI we looked at Jeremy Grantham’s depressing 3Q investment letter, “On the Road to Zero Growth,” (here) where Grantham makes the prediction the US has stopped growing and we have nothing to look forward to due to major quantitative headwinds. Those of you who are pessimistic by nature may also find interesting research published in September, which obviously influenced Grantham’s thinking. In the Centre for Economic Policy Research Policy Insight No. 63 (an organization so confident of its “insights” that it numbers them), Northwestern University Professor Robert J. Gordon wrote, “Is US economic growth over? Faltering innovation confronts the six headwinds,” (here). (By my count, that is at least six insights). Both authors argue that we should not look forward to permanent growth, particularly in the US. In other words, the good times are over, our children will become ragamuffins and tatterdemalions, get used to it.

Professor Gordon is in the middle of writing a book and this research paper is a condensation of his thesis. He is able to take a broad historical view and identifies three industrial revolutions:

IR 1: (1750-1830) Invention of steam engines, cotton spinning and railroads
IR 2: (1870-1900) Invention of electricity, internal combustion engine and indoor plumbing
IR 3: (1960-1990s) The computer and internet revolution

IR 2 was the most important and the positive impact of it on economic growth played out for 100 years. His main view is that productivity has declined since and we can’t look forward to any more breakthroughs or to Industrial Revolution 4. These were one-offs, much like the demographic dividend of women entering the workforce in the last century. It won’t be repeated so the future is shite. Gordon cites the Boeing 707 as an example. Since it began flying in the 1950s (my father used to fly them in the 1960s and 70s) the speed of air travel has not increased and there has been no improvement to productivity in aviation since then.

My Dad Says No

A pilot for 56 years, my Dad would disagree. Airplanes are quieter, safer and far more resource efficient now. Commercial aviation in the form of private company Space X, which has been ferrying cargo to the international space station would have been unimaginable in 1950. Space X now has the aim of colonizing Mars and will put people on the red planet before any government.

I think Gordon and Grantham are “off-piste” here and (without causing them to become “piste-off” with me) I believe they get mired in the mud of statistics without climbing out and looking at the situation from a higher, non-numerical vantage point. First, aside from making public predictions on stock prices with a date attached, the surest way to be wrong is to claim nothing new is ahead of us. Just a few years ago when I was working for another brokerage with a “C” handle, we spent a lot of money hiring experts to talk to clients about “peak oil.” I laughed at the idea at the time but curiously, many people seriously believed one day, oil was just going to run out and at $5,000 a barrel the global economy would lurch to its final stop. Then all of a sudden, WTF: What the Frack? Fracking comes along and now natural gas in the US sells for $2 a MBtu, or the oil-equivalent of $13 a barrel.

The real impact of the previous industrial revolutions, while they may be played out in the US and a few parts of Europe, the show is continuing in the developing world. Women are entering the cash workforce in ever greater numbers in countries such as India, China and throughout Africa. Mobile phones are just now becoming ubiquitous in far-flung forgotten foreign frontiers, as any visit to Tsim Sha Tsui’s “Chungking Mansions” with all its African phone buyers evident will tell you.

I stayed in one of those cheap guesthouses at Chungking Mansions while backpacking around Asia 20 years ago. I remember it well.
Me: Thank you for showing me the room. I’ll take it for three nights. Would you like me to pay you now or later?
Chinese Landlady: YU PEI NAO!

While the US will continue to re-invent itself and its productive landscape, the country will find it difficult, if not impossible, to break above the trend growth line of around 2% for any length of time. The real growth where huge gains in productivity are being realized, such as engine power replacing animal, women learning to read and write, electric lights and cooking gas and indoor plumbing are all happening now in emerging markets.

Laurence B. Siegel
wrote an interesting and elegant rebuttal to Grantham’s tomb of gloom here. He also believes the future is unknowable and not only is it is rather meaningless to assume there will be no more big ideas, he points out, “In the 1890s, the idea was circulated that everything worth inventing had already been invented.”

I myself have also at times fallen victim to this intellectual cul-de-sac. Right after the most welcome death of disco music, I said to anyone who would listen, “There will never be music invented again that was as bad as this.” And then, bang! Rap music hit the scene.

Bill Gross Weighs In

This week, famed stamp collector (and global fixed income manager) Bill Gross of Pimco, has published his latest investment letter, “Strawberry Fields – Forever?” (here). Unlike Grantham’s quarterly, which I reviewed last week, Bill believes that while we need to tone down expectations, growth is not dead, nor is it banished from the scene. He correctly, in my view, points out that the deleveraging of private debt will continue for some time and remain an impediment to growth, the “New Normal” as they refer to it around the Pimco’s golden water cooler. This is a necessary recovery process, not the end of the world.

Gross cites Reinhart and Rogoff, whose research paper, “Growth in a Time of Debt” (here) concludes that at least for the last 200 years when a country’s debt exceeded 90% of GDP, economic growth plummets for on average a decade. Using a dataset of over 3,700 annual observations, Reinhart and Rogoff found the following:

1) The relationship between gov’t debt and real GDP growth is weak for debt/GDP ratios below 90%
2) Emerging markets face lower thresholds for external debt as the debt is usually denominated in foreign currency. EM economies see annual growth decline by 2% when external debt/GDP ratios reach 60%.
3) There is a link between higher debt levels and inflation; but only for emerging market economies – and the United States…!

Table 1. Real GDP Growth as the Level of Government Debt Varies: Selected Advanced Economies, 1790-2009
(annual percent change)

Notes: An n.a. denotes no observations were recorded for that particular debt range. There are missing observations, most notably during World War I and II years; further details are provided in the data appendices to Reinhart and Rogoff (2009) and are available from the authors. Minimum and maximum values for each debt range are shown in bolded italics.

Sources: There are many sources, among the more prominent are: International Monetary Fund, World Economic Outlook, OECD, World Bank, Global Development Finance. Extensive other sources are cited Reinhart and Rogoff (2009).

Gross concludes that we may need “at least a decade for the healing” and the predictable policy response in developed economies (especially the US) will be reflation and inflation. Unlike Grantham’s rasping view from the crypt, Gross cheerily points out, “How many gloomsters could have forecast the internet?” or, I would add, fire, the wheel, animal domestication, gunpowder, penicillin or bipolar junction transistors? Let us not lose sight of history here; the future ahead is still bright. But we first have to pay some bills that are coming due. Investment conclusion after digesting the above? One of Pimco’s top picks are non-dollar emerging market stocks.


We are seeing capitulation in China as the last bulls give up and head to the glue factory. Reportedly, tight credit in the system is causing large shareholders to be forced sellers at these levels. Some investors are asking, “Does the Shanghai market even matter?” The HSI is up 18% this year and Shanghai is down 10%, and falling. However, there are signs, weak and feeble though they may be that things are turning.

China’s manufacturing PMI continues to improve, even at a tepid pace. Headline PMI has risen three months in a row. Andrew Liveris, Chairman of Dow Chemical, a $35 bn market cap company and the second largest chemical company in the world said this week that China’s manufacturing supply chain is coming back to life. Previously bearish in outlook, Liveris is quoted in the WSJ talking about China’s small and medium-sized businesses: “They are starting to buy goods again, which means they are getting finance.”

Those who like playing with their technical will be interested in what Tom DeMark, creator of the market turning indicator that bears his name is saying about the Shanghai equity market. According to DeMark, the SHCOMP will rally 48% within 9 months after its decline below 1,960. The market closed at 1,959 on Monday. DeMark says his trusty software tells him the index will rally to 2,900 from here. Should we listen? Nah. But this is interesting noise.


In an earlier issue of EMI I highlighted what I believe will be the next big threat to China: the implosion of “shadow finance.” From almost nothing, informal off-balance sheet lending is on fire now in China and rivals the formal banking system in size. Estimates of the size of the sector range from 25% to 50% of China’s GDP.

Even Xiao Gang, the Chairman of the Bank of China, in a recent opinion piece in the People’s Daily, is calling it a “Ponzi scheme”. His concern centers on duration mismatch. Investors can buy wealth management products (WMP) over the counter at a bank or even online which earns a higher yield than available elsewhere and with duration of only a month. Market returns on current 3-month WMP is around 4.35%, or 175 bps higher than the 3-month benchmark deposit rate of 2.6%. The banks dump this short term money into a big wok, fry it up by adding some longer term funds and then pour it on the plate of sketchy property developers or local government infrastructure pools to fund long term projects. Much like the “music” and “dancing” that was going on in the US which helped cause the financial crisis, this works fine as long as more short term money comes in to replace the earlier maturing short term funds, thereby matching the classic definition of “Ponzi scheme.” New money must replace old before it all collapses like a cheap soufflé.

From the ever entertaining People’s Daily with the following caption:
“A girl shows her banknote dress she received as a birthday present from her sugar daddy”

Would like to see a photo when the borrowed money she is wearing has to be paid back. Please…

The other scary red flag comes from the regulator who says, “Mei shi” – everything is hunky dory. Soon to retire central banker Zhou Xiaochuan has this response to the issue,

“Shadow banking exists in China, just like it exists in many other countries. Most of the non-bank related financial activities are under supervision in China.”
Words, I am afraid, he may will live to eat.

Who was Charles Ponzi?
Born in 1882 near Ravenna, Italy, Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi (“Charles” to his friends) arrived in America in 1903 on the SS Vancouver, a penniless 21-year old immigrant. Just look at that face below:

He learned English quickly and got a job as a dishwasher in a restaurant in Boston and worked his way up to become a waiter – but was fired for shortchanging the customers. This was just a hint of things to come.
Ponzi moved to Montreal, which had a growing Italian population and was arrested for fraud and thrown in prison for three years there. He couldn’t let “Mama” back in Italy know his predicament so he sent her letters from prison claiming he had found a job as a “special assistant” to the warden!

Upon his release, Ponzi returned to Boston and got married to an Italian girl from a good family (of course). Funnily enough, “Mama” in Italy was no fool and actually wrote a letter to his bride-to- be warning her of Ponzi’s dubious past and told her to dump him.

One day, Ponzi discovered an arbitrage trade in postal international reply coupons. These coupons were issued in one country at the local rate and could be redeemed in another country. Redeeming them in the US allowed the capture of exchange rate differences and made the arb very profitable. Ponzi’s next get rich quick scheme was born.

He called his new company ironically, the “SEC,” or the “Securities Exchange Company.” Ponzi then advertised 50% returns on money invested through his company in 45 days, or 100% returns in 90 days. As people started to invest and actually reap those returns (money paid, of course, from the funds of new investors) word spread like wildfire and soon Ponzi had people lining up outside his door to give him their life savings.

He was so busy raising money he made no effort to invest it and make any legitimate profits. Within a year, the penniless Italian immigrant Ponzi was raking in profits of $250,000 a day, or $2.7 mn in today’s money. This couldn’t last and it didn’t. The authorities grew suspicious and wanted to examine his books. Ponzi, of course didn’t have any but he deflected their investigation by promising to stop taking in funds.

Meanwhile, Clarence Barron, founder of the financial newspaper that bears his name and the recognized father of financial journalism, was contracted by the Boston Post to investigate Ponzi. Barron published the results of his analysis, which demonstrated that 160 mn postal reply coupons would have had to be in circulation for Ponzi to make the returns he was claiming when, in fact, only around 28,000 had ever been issued.

“The jig is up, the news is out, they’ve finally found me….”

His company collapsed and brought down five Boston banks with it. Investors lost around $225 mn in today’s money, Ponzi was charged with 86 counts of mail fraud and spent 5 years in federal prison. As soon as he was released, Ponzi headed to straight to Florida and set up a business selling swampland to gullible investors by promising them 200% returns in two months. This guy was irrepressible. He was caught, busted and spent a total of another 9 years in jail before being deported – Ponzi had never bothered to become an American citizen.

Charles Ponzi eventually washed up in Brazil, dying as penniless as he was born in a Rio de Janeiro hospital. Just before he expired, in his final interview he gave us this quote about his legacy in the US,

“I gave them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth 15 million bucks to watch me put the thing over.”

Beijing of Two Minds

Regarding “shadow finance,” Beijing seems to be of two minds here. First, they rightly perceive the risk over indebted property companies pose to the banks and are not budging on loan caps to that and other risky sectors. Yet, given China’s investment-driven growth model, they realize the economy needs massive amounts of credit to grow and are therefore turning the proverbial blind eye toward informal lending and marketing of WMP schemes to the public.

Analyst Stanley Li writes in his new regular product, “Money Market Monitor” (here) that China’s “economy needs ever more gasoline in its tank to run at the same speed.” He notes trust industry assets rose 51% y-y to almost Rmb 6 tn in 3Q12. Local government project financing has replaced real estate (although in many cases it could be the same thing) as the most popular project model, up 54% ytd.
Stanley estimates that the total WMP balance is over Rmb 9 tn, or already 10% of China’s deposit base.

With NPLs in China’s banking system near record lows and the level of “outstanding overdue loans” soaring and one of the world’s biggest Ponzi schemes sucking in billions of dollars a day, there is only one way this story ends.

A Mafia godfather finds out that his bookkeeper has cheated him out of $10 million bucks. His bookkeeper is deaf. That was the reason he got the job in the first place. It was assumed that a deaf bookkeeper would not hear anything that he might have to testify about in court.

When the godfather goes to confront the bookkeeper about his missing $10 million, he brings along his attorney, who knows sign language.

The godfather tells the lawyer, “Ask him where the $10 million bucks he embezzled from me is.”

The attorney, using sign language, asks the bookkeeper where the money is. The bookkeeper signs back, “I don’t know what you are talking about.”

The attorney tells the godfather, “He says he doesn’t know what you’re talking about.”

The godfather pulls out a pistol, puts it to the bookkeeper’s temple and says, “Ask him again!”

The attorney signs to the bookkeeper, “He’ll kill you if you don’t tell him!”

The bookkeeper signs back, “OK! OK! You win! The money is in a brown briefcase, buried behind the shed in my cousin Enzo’s backyard in Queens !”

The godfather asks the attorney: “Well, what’d he say?”

The attorney replies, “He says you don’t have the guts to pull the trigger.”


Derek Hillen, CAIA

Mirae Asset Securities


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