What happened
Shares of massive Chinese property developer China Evergrande Group(OTC: EGRN.F) had rocketed 61% higher as of 1:30 p.m. ET Monday.
The saga of Evergrande's blowup and potential bankruptcy has been going on since last summer, when Chinese authorities were making efforts to tighten up loose credit and rein in the speculators driving that country's property bubble. With over $300 billion in liabilities, Evergrande defaulted on its loans back in December, and trading of its shares in China was suspended. Since then, government authorities and relevant parties have been working on a restructuring.
Then late last week, Evergrande's CEO and CFO resigned at the request of the company's board after an investigation revealed the misappropriation of funds in a subsidiary. Shawn Siu, the chair of Evergrande's electric car subsidiary -- yes, Evergrande had for some reason expanded into building electric cars -- has taken over as CEO.
Yet on Monday, it was reported that China's State Council had announced a bailout fund for certain property developers. While the bailout funds may not make their way to the equity holders, the plan did increase the chance of those shares having some residual value. Given that Evergrande's equity had traded down to penny stock status, reflecting the high odds that it could go to zero, the news sent the equity "stub" soaring.
So what
On Monday, financial news outlet REDD reported China's State Council had passed a $44.4 billion bailout plan aimed at certain Chinese property developers.
What caused China to decide on a large bailout, as opposed to allowing those companies to go through bankruptcy and restructuring? Well, in China, it was a common practice for property buyers, both institutional and individual, to pay for properties while they are still under construction in order to receive a discount. This is part of the way Evergrande got into trouble in the first place -- by taking proceeds from uncompleted projects and reinvesting the revenue before the projects were done.
With several property developers under financial strain, some had stopped building projects due to a lack of funds. In response, many buyers of uncompleted projects and apartments have recently threatened to stop paying their mortgages. If that were to happen, it could spark greater contagion in the nation's banking system. This explains why the Chinese government may be reluctantly bailing out developers, at least as far as completing in-progress construction.
Now what
While this news sent China Evergrande's stock skyrocketing, investors may want to cool their enthusiasm, as it's unclear if the bailout will rescue its equity holders.
To be fair, one unnamed source did say some of the funds could be used to buy bonds or even take equity stakes in developers. That would certainly be a positive, but if the Chinese government gets involved in rescuing these companies, what kind of concessions will current equity holders have to make? Even if projects are brought to completion, they are unlikely to make any profits, given the declines in property values. Therefore, any government-backed bank stepping in is bound to demand a lot in return.
So even if Evergrande avoids a technical bankruptcy, it's possible the current equity may be so diluted that it wouldn't matter. It's just hard to say.
In any case, while moves like Monday's surge may tempt investors, an investment in Evergrande is really a gamble on the whims of Chinese government officials. Unless you're quite familiar with the machinations of local Chinese politics and that nation's obtuse banking system, I'd recommend steering clear, especially given that so many healthier companies are also trading at discounts after this year's sell-off. While Evergrande can have strongly positive days, its stock still may well wind up dropping to zero.
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Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
