One month ago, when describing the bizarre, not to mention systemically dangerous practice of dozens of small and mid-cap Chinese companies and executives offering to backstop losses on their employees’ purchases of company shares, we couldn’t quite explain it, although it seemed to revolve around a simple, and fraudulent, ponzi scheme: the same executives who were making the “make whole guarantee” had themselves taken out substantial loans collateralized by a pledge on their own stock. Naturally, the lower the stock dropped, the closer the moment when the dreaded margin call would come in demanding loan repayment, and since the value of the stock used as collateral was below the value of the loan, defaults would inevitably follow. As such, the “offer” to backstop losses was nothing more than a last ditch effort to find the greatest fool of all: an employee who believed that the sinking ship known as his or her employer would bail them out, when in reality it was the other way round. Oh, and good luck, trying to collect on your “guarantee”, when both the company and the executive were in bankruptcy court, or worse.
We bring it up because in a report overnight, Bloomberg has uncovered that while the practice of backstopping corporate stock purchases may – for now – be limited to a subset of potentially fraudulent companies (our advice is to create a short basket of all the companies that engaged in this practice listed here and watch them sink), pledging shares is not. In fact quite the opposite: as it turns out, one of China’s most acquisitive companies, HNA Group which Bloomberg dubbed “China’s boldest dealmaker” which “supercharged its transformation from an obscure Chinese airline operator to a juggernaut capable of amassing multibillion-dollar stakes in globally recognized brands, including Hilton Worldwide Holdings Inc. and Deutsche Bank ” had pledged billions of its own shares as a source of funding for these purchases.
And herein lies the rub: as we said one month ago, “fundamentally a ponzi scheme, this works without a glitch during rising markets but falling prices especially among small and mid-cap companies, have eroded the value of that collateral, raising the specter of forced liquidation – where lenders, often Chinese brokerages, make borrowers sell the pledged shares. Selling the stock adds more pressures on share prices, triggering a downward spiral.”

This post was published at Zero Hedge on Jul 13, 2017.