Everything Is Falling - The Evergrande Crisis Explained

What's up, Graham? It's Guys here. So, I had another video that was scheduled to post today, but that could wait because we have to talk about what's happening throughout the entire markets and the severity of the Evergrande fallout. Not only in terms of how this impacts you, but also the entire financial system around the world, as one of the largest property developers defaults on 300 billion dollars worth of debt. Yes, you heard me correctly, that is a B, as in "be."

Be sure to keep watching. I think most people don't fully understand the severity of what's begun to unfold or how this is allowed to carry on to such an extreme level before getting to the point of no return. So here's everything you need to know summarized in the next eight minutes, and then we'll talk about the potential impact this could have on all of us over the next few days, weeks, and months.

And of course, if you appreciate all this information being condensed down to just the facts, it does help me out a lot if you hit the like button for the YouTube algorithm. Also, if you're brand new here, feel free to subscribe; it's totally free to do, and I post a new video every single Monday, Wednesday, and Friday about investing, personal finance, and anything else related to your money.

All right, so all of this starts with the massive Chinese real estate company Evergrande. They were originally founded in 1996 and since then they've become China's second largest property developer specializing in residential construction, hotel operations, finance, and the health industry. Their core business is buying up empty plots of land and then transforming those into large residential structures.

Although over time, the company also diversified their business across bottled water, electric vehicles, theme parks, a streaming service, and even—wait for it—a soccer team. Obviously, that's a big operation that needs a lot of moving parts, and as a result, Forbes noted that they had more than 125,000 employees around the world.

But there was also a growing problem, and that would be debt. In order to pay for the cost of building these residential skyscrapers, they have to borrow money. Most of that is generated from large banks, institutional investors, bondholders, or even home buyers who agreed to loan the money in exchange for a down payment or a modest interest rate for a few years until eventually the project is complete.

Now, in a normal market, Evergrande could sell the newly built properties for a profit; paying off their debt wouldn't be a problem. Although, unfortunately, the real estate market in China began to see a sudden shift that would lead to the perfect storm, causing everything to come crumbling down.

Throughout 2018 and 2019, China experienced what many people would call a real estate housing bubble boom as citizens preferred to invest their money in housing as a safety net. This caused the real estate market to increase double digits year over year. On top of that, the urbanization of rural China, combined with the societal pressure to own a home, caused a massive relocation to cities that promised greater earning potential and more opportunities, thereby further driving up the market.

In fact, China was building five times as many homes as both America and Europe combined, and still, the supply was so low that some cities resorted to a lottery system that would decide who gets to buy a home, some with the chance of being picked as low as one in sixty.

But there was also another problem: people believed the housing market was such a good investment that individuals would buy anything they could. Because even if they never lived there or kept it empty, they could always sell it for more in the future for a profit. It didn't matter how much it would cost either; some individuals would pay as high as 23 times their annual income to buy a home, with their mortgage payment taking up more than half of their gross take-home pay.

That led to a 22% vacancy rate throughout China as home buyers bought second properties for an investment, just outside limits without property restrictions, right as the government stepped in to buy surplus inventory to keep the market stable.

In addition to that, the increased building demand meant that there was less oversight over construction quality, leading to substantial building problems as developers cut corners to save costs to maximize profits. The Chinese government tried to step in and calm things down. According to The Economist, non-residents who are single are banned from buying property in certain locations; a married couple is welcome to buy, but only so long as they have paid local taxes for two years and make nearly a third of the purchase in cash.

However, just north of that, in Shenyang, anyone could buy a home; everyone is welcome. And as a result, their property prices have risen considerably faster than anywhere else, making property developers a lot of money in the process.

So, in short, there's societal pressure to use homeownership as a sign of prosperity, combined with very few other places to invest your money, which led to rampant speculation across real estate values. That can only go on for so long until eventually this happens.

As I'm about to explain, Evergrande took on 300 billion dollars worth of debt to continue building real estate, and this worked as long as they were able to roll that over to the next project. But when the Coronavirus lockdown hit, everything was stalled. Supply chains were backed up, material costs went through the roof, labor was hard to come by, and as a result, their operations slowed down massively.

But you know what does not slow down? Their loan payments. Investors, lenders, and bondholders don't care if properties are half-finished or that materials have gone up in price; they just care about their interest payments being on time as agreed.

But in June of 2021, Evergrande warned investors that they might not be able to make their next payment and that they were aggressively working to restructure debts to stay afloat. At the same time, China issued a statement saying that banks should stress test their exposure to Evergrande, meaning they need to make sure they're not overexposed in the event something were to happen.

But the entire time, Evergrande also said that they were operating as normal, that there was nothing to worry about, and that it was business as usual, except as we later found out, it wasn't.

On September 16th, China warned that Evergrande wouldn't pay their interest the following week, and instead, they would be negotiating the terms to give them more runway to operate and eventually sell off some of the buildings to pay their debts. But that presented another problem: Evergrande was at a complete standstill. No one wanted to take over a half-built project for fear that values would continue to drop.

Evergrande's stock has fallen more than 90%, and the company has done its obligations to more than 70,000 investors. In addition to that, more than one million buyers of unfinished projects are in limbo, having already submitted a down payment that could already be worthless.

And today, Evergrande was supposed to make an 80 million interest payment, but they simply couldn't afford it. Reports even show that leading up until now, Evergrande gave their employees an ultimatum: either loan the company money, or they lose their bonus. The New York Times even reported that some workers tapped their friends and family for money to lend to the company. Others borrowed from the bank.

Then this month, Evergrande suddenly stopped paying back the loans, which have been packaged as high-interest investments. Since then, Evergrande is in the ultimate bind: the 300 billion dollars in debts, they have tens of thousands of unfinished units across China, and they risk collapsing not only the entire real estate market in China, but also the investors, banks, lenders, and index funds who buy those loans and then repackage them for everyday investors like you and I.

So now that you know the severity of what's going on, here's a few potential outcomes. Right now, China reportedly has 78% of their wealth tied up in real estate. 20% of their GDP is also tied to real estate-related activities. And the question now becomes: Is Evergrande too big to fail?

The problem was that Evergrande was running what some people would call a Ponzi scheme. They collected money from the pre-sale of apartments, used that to fund the down payments of other properties, using more cash from that to buy even more. Now, this shifting of money can work as long as those buildings sell, but as soon as things slow down, it all begins to fail.

The first scenario is the Chinese government could simply not get involved. They could let things unwind to prove a point. And if that happens, it could be disastrous. Most likely, Evergrande won't be able to sell their unfinished buildings because no investor wants to take on a half-completed project that could fall in value. Investors and banks who bought their loans will likely see all that money gone if the company defaults.

The suppliers who provided building materials would likely be on the hook for footing those bills that are not already reimbursed. Banks and lenders would also be inclined to sell other assets to raise capital, putting downward pressure on the market, like what we're kind of seeing today.

This could also completely collapse China's real estate market, along with every other sector associated with it, causing job losses across hundreds of thousands of people and putting a big dent in their GDP. Now, obviously, we can't yet project the full consequences if this were to happen, but needless to say, things could get a lot worse if this happens.

The second scenario is that Evergrande is able to negotiate the terms with their lenders and banks long enough to give them time to complete some of the projects. Now, I would say this is probably the least likely scenario to happen because at this point they've been having financial trouble since the beginning of the year. They've had months to reorganize their debt, and if this were possible, I have a feeling it would have happened by now.

But regardless, there's a chance that investors, lenders, and home buyers take a small hit in the short term. Evergrande may take slightly longer to repay back their debts, and then we can hope for the best.

Third, China could step in, negotiate a bailout for Evergrande, and try to minimize the impact. Now, obviously, this would soften the blow across the market, and they could use this as an opportunity to take over Evergrande at a fraction of the price. Or the Chinese government could get involved in another capacity to keep things afloat.

But at the same time, Evergrande was recklessly overextending themselves, and a move like this could signal that China endorses and supports this kind of behavior, which goes against their current policies. So either way, things are not looking good. If they bail them out, Evergrande becomes too big to fail, and they get away with it. But if they don't, then the entire Chinese economy could fall apart.

Anything beyond this is really just pure speculation, but in terms of how this might impact you, here's what you need to know. Now, even though it's easy to think, "Oh, that's just the Chinese real estate market; that's not gonna affect me; I'm safe over here," that's not exactly true. As Evergrande raised capital, they did so by selling off those loans to institutions like Vanguard, BlackRock, HSBC, and Goldman Sachs, who took those loans and then packaged them up to everyday investors.

Now, it's important to mention that even though these companies have hundreds of millions of dollars tied up in Evergrande, that's still just a drop in the bucket compared to their overall portfolio worth. And when you consider that a company like BlackRock has nine trillion dollars under management, suddenly a 400 million dollar exposure to Evergrande is the exact same as someone else with a hundred dollars losing one half of one cent.

Regardless, Chinese companies do hold exposure to the US market, and when they need money, it would make sense that they sell off assets to raise capital, and that would put downward pressure on the market, like what we're seeing today.

But the real impact to everyone in the United States isn't so much a policy change or a quick drop in the market, but instead the investor perception that things could get a lot worse before they get better. Or in other words, it's just fear. All of this is coming at the exact same time that economists worry about record high valuations, changing illness variants, and the possibility that our economy could begin slowing down. Not to mention JP Morgan recently shared that they saw a growing risk of a 20% correction in the S&P 500.

And given the fact that we have not seen a 10% pullback in more than 380 days, which is the longest stretch in more than three years, it's beginning to worry people in terms of how this might set a new trajectory for the market.

Now, in terms of the details, if we look back at the previous corrections, we could see that since 1920, the S&P 500 has on average seen a 5% pullback three times a year, and on average, a 10% correction happens every 16 months, with an average loss of just over 15%.

All right, so now that you know exactly what's happening with Evergrande and a few of the potential ways this could play out, I just want to say this: even though your portfolio may have dropped a significant amount—and I think at the peak today I was down about 175,000—honestly, it's not a time to panic. Instead, I would use this as an opportunity to continue buying into the markets as normal, except now you get a slight discount on all of your favorite stocks.

Plus, in the big picture, the S&P 500 was back to the same level it was a month ago. Now, that is not to say that things can't get worse, and if JPMorgan is correct, we could see a 10% to 20% drop from here. But even if it does, rest assured, it's most likely not going to be anywhere close to as bad as it was back in March of 2020. Every drop is temporary. Load up on all the stocks that you meant to buy when things were a lot cheaper, and then you just got to do that consistently.

That's it. Now, I know that's the boring advice that I say all the time, but you know what? It's the truth. This is not a time to sit out of the market to try to wait for things to get a lot worse. And who knows, maybe it does. But consistently timing the market is pretty much impossible long-term. So don't hold off; continue buying as usual, and no matter what, continue smashing the like button for the YouTube algorithm.

So with that said, you guys, thank you so much for watching. I really appreciate it. As always, make sure to subscribe and hit the notification bell. Also, feel free to add me on Instagram; I post pretty much daily. So if you want to be a part of it there, feel free to add me there, as on my second channel, The Graham Stephan Show, I post there every single day I'm not posting here. So if you want to see a brand new video from me every single day, make sure to add yourself to that.

And lastly, since the entire cryptocurrency market also fell alongside the stock market, I bought up more Bitcoin earlier today, and then I transferred it over to BlockFi because they at least pay me a bit of an interest rate on my money. So if you're interested in also signing up for BlockFi, where you could get up to $250 with a free Bitcoin, use the link down below in the description. Let me know what you think. Thank you so much for watching, and until next time.