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Bank of America Corp (BAC), Goldman Sachs Group, Inc. (GS): A Major Threat to China’s Banks

China’s authorities are growing increasingly worried about major risks to the nation’s economy and financial system.

Of particular concern is Chinese banks’ exposure to wealth management products, or WMPs — short-term investments that account for a significant portion of banks’ balance sheets and may carry hidden risks far greater than previously thought.

Let’s take a closer look at these financial products, the major risks they pose to China’s banks, and what China’s authorities are doing to stem these risks.

Bank of America Corp (NYSE:BAC)

A primer on China’s wealth management products
WMPs are essentially short-term investments sold by Chinese banks that serve as an attractive alternative to bank deposits. In recent years, their issuance has skyrocketed. According to China’s banking regulator, the China Banking Regulatory Commission (CBRC), 7.1 trillion yuan worth of WMPs were outstanding as of year-end 2012, equivalent to 7.4% of bank deposits.

WMPs have been the most obvious and commonly sought after solution for Chinese savers in search of higher returns. On average, they yield roughly 2% higher than bank deposits, yet are marketed as low-risk investments. Several sources have identified WMPs’ structure — which involves pooling investor funds together and using that pool to invest in a variety of assets, some highly risky and some less so — as a major cause for concern.

Major risks associated with WMPs
WMPs tend to have short maturities, generally less than a year. But in many cases, the funds pooled together from WMP sales have been invested in much longer-term projects, usually related to property and infrastructure, which creates what’s known as a maturity mismatch issue.

In order to subdue this inherent problem, banks are forced to keep issuing new WMPs to replace expiring ones. If that doesn’t smack of Ponzi finance, I don’t know what does.

Another major issue related to WMPs is their lack of transparency. Because they involve the pooling of several investor funds, which are then invested in a wide range of projects that traverse the risk spectrum, it is extremely difficult to estimate the risk of any single WMP.

Remember collateralized debt obligations (CDOs) from a few years ago? Like WMPs, one of the key issues with these complex, asset-backed securities was their lack of transparency. Because they had multiple “tranches” that offered varying risk-return profiles, and because many of them invested primarily in other CDOs, they proved extremely difficult to value.

Failure to appropriately gauge their risk even brought down insurance giant American International Group Inc (NYSE:AIG), which had insured $62.1 billion in CDOs when it was bailed out by the U.S. government in 2008. The CDOs it insured were underwritten by some of the world’s premier financial institutions, including Merrill Lynch & Co., now part of Bank of America Corp (NYSE:BAC), which underwrote $13.2 billion, Deutsche Bank AG (USA) (NYSE:DB), responsible for $9.5 billion, and Goldman Sachs Group, Inc. (NYSE:GS), which underwrote $17.2 billion worth of CDOs insured by American International Group Inc (NYSE:AIG) — more than any other financial institution.

As with CDOs, Chinese investors and banks alike may have grossly underestimated the hidden risks associated with WMPs.

The last major issue related to WMPs is their connection to riskier assets and rates, including stocks, bonds, exchange rates, and — perhaps most worryingly — trust products. According to Nomura Global Economics, more than a third of WMPs are linked to trusts. Given that trust products have been characterized by Nomura and others as “the weakest link in the financial leverage chain,” it will be interesting to see how WMPs fare if default rates in the trust sector accelerate.