china bubbleInvestors knew something was amiss when on November 26th, the wealth management product (WMP) they had bought from Huaxia Bank that promised 11% returns, simply didn't pay out.

A few days later, dozens took to the streets of Shanghai in protest, China's Sina reports.

Wealth management products have become increasingly popular to Chinese investors searching for high yield. Banks, like Huaxia, usually act as third parties (in this case for Zhongding Wealth Investment Centre) selling them with promises of returns of up to 13%. Fitch estimates that $1.95 billion (12 trillion yuan) of these investment vehicles have been sold as of the first half of this year.

More importantly, experts say that these investments are funneled into China's massive underground banking system to fund housing loans as well as high interest loans for small to medium sized businesses. Fitch's research indicates that these investment vehicles have continued to grow in popularity through Q3.

In Huaxia's case, dozens of investors (some in their 70s) invested millions of yuan in a WMP sold by an employee named Pu Tingting. The bank claims that she was not authorized to make these sales. Her husband, and clients, insist that she was.

According to Reuters, Pu has been arrested. In the meantime, Huaxia customers want the bank to take responsibility for their losses. They want answers. The bank, however, says it is not liable for paying customers... at least not yet.

From Reuters:

Hua Xia reiterated its stance on Wednesday, saying the bank had no direct relations with the product.

"Hua Xia has never been a distributor of the scheme," the bank, partly owned by Deutsche Bank, said in a statement to Reuters.

"The scheme is a suspected crime and the public security bureau has stepped in to investigate," it said, adding the bank will fully cooperate with the investigation and will communicate with investors.

Huaxia's WMP problems may only be getting attention, not because they're the first of their kind, but because the protests occurred in a large city like Shanghai. As the FT points out, Chinese reports suggest that a WMP has already left investors high and dry in Henan.

From the FT:

How do we know that a default in a city less exposed to international scrutiny would likely have been ignored? Because the same management company that offered this wealth product had defaulted in October 2011 on at least 430 million RMB in investor capital when its guarantee company went bust. Only this default was in Henan, and it didn’t make the papers. It seems that the wealth management product had been issued in the first place, with the apparent concurrence of Henan regulators, as part of a plan to settle claims from investors seeking to redeem their funds in Henan.

What's worse is that these investments are moved on and off balance sheets at banks' convenience and are most often issues by smaller banks.

From Charlene Chu at Fitch (via FT):

WMPs are vehicles that can borrow/lend, and banks engage in transactions with their own and each other’s WMPs. This makes the pools of assets and liabilities tied to WMPs in effect second balance sheets, but with nothing but on-balance-sheet liquidity, reserves, and capital to meet payouts and absorb losses. These hidden balance sheets are beginning to undermine the integrity of banks’ published balance sheets.

So what we're talking about is billions of dollars of investor money floating on and off (mostly) small Chinese bank balance sheets and flowing through China's under regulated, underground banking system.

The big Chinese banks have voiced their concern. The Bank of China's chairman called WMPs a Ponzi scheme right out.

So here's how Chinese regulators plan to solve the problem, according to Reuters. If the WMPs are guaranteed, they will be forced onto bank balance sheets instead of being included in government estimates of the shadow banking system.

If the WMPs are not guaranteed, they will not be included on bank balance sheets or in estimates of the shadow banking system.

They'll just disappear.