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There's a new ticking time bomb building inside China's economy

People are starting to talk about a new danger in the Chinese financial system: asset-backed securities (ABS).

An ABS is basically bond that might be collateralized by a number of things like loans, credit card debt, or a company’s receivables. Many experts blamed a boom in ABS for helping inflate the credit bubble as it quickly turned liabilities into cash, while offering investors what appeared to be high yield at relatively low risk.

China’s trust companies have started buying ABS at a stunning rate, and with the same vigor with which they once bought infamously dangerous wealth management products (WMP), which are now on the decline.

One recent Chinese Reserve Report (CRR) projects that financial firms could issue $US127 billion in ABS this year, up from $US44 billion worth last year.

“Showing a flexibility to reinvent themselves that a pre-2008 Wall Street investment bank would be impressed by, the trust companies that drove the now fading WMP boom are now becoming packagers of ABS,” wrote CLSA analyst Christoper Wood in a recent note.

As China has sought to clean up its banking sector, WMP’s have fallen out of fashion, and for good reason. Years ago investors were told that these products offered risk-free returns of 2% and higher. That was often not the case, and angry investors would sometimes take to the streets to express their frustration.

But that doesn’t mean investors stop chasing yield, of course.

Wood continued: “As for what loans go into the ABS, a CRR analysis of 60 ABS products issued in 2014 found that most of them were focused on corporate loans… with the average yield 5.7% and the average maturity of the product 22 months. Meanwhile, an investor in an ABS does not have to wait until the product matures to get paid in the sense that he can sell it at any time, traded as ABS now are in the interbank market.”

That corporate debt part is where things get really worrisome. Corporate loans make up almost 92% of what goes into these ABS, but analysts have long argued that China’s biggest debt problems lie in its corporate sector. They are the country’s biggest borrowers, and unfortunately right now they’re also under intense pressure.

As the Chinese economy moves from one based on investment to one based on consumption, corporate margins have thinned. China’s producer price index is at its lowest level since October 2009.

Already this year we’ve seen massive Chinese property developer, Kaisa, default on bond payments.

Now it looks like that debt is being repackaged and shipped around to investors at the worst time possible.

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