On Monday, I discussed the major bubble crisis in China. I’ve mentioned the term Shadow Banking. This new banking term caught my attention – is shadow banking legal? What is Shadow Banking anyways? And most importantly, how can Shadow Banking affect your portfolio?

With a name like this, it’s hard to think shadow banking is good for the economy. From my understanding, shadow banking is like steroids; it boosts your performance and exacts a toll to pay later at a critical price for your excesses.

Shadow Banking and the 2008 Crisis

The term “shadow bank” was coined by economist Paul McCulley in a 2007 speech at the annual financial symposium hosted by the Kansas City Federal Reserve Bank in Jackson Hole, Wyoming (source IMF.ORG).

A short explanation would be a parallel banking system that doesn’t follow traditional bank regulations. This is how banks were able to literally package their mortgages into commercial paper backed securities and sell them in the shadow banking system in 2008. Those high risks mortgages were then taken off the banks’ balance sheets to be sold on the market.  You know how this story ended… with blood on the street.

Imagine that: something similar and probably bigger is happening in China right now…

How Shadow Banking works in China

This is a very well designed system where Chinese banks pretty much ignore any classic banking rules. In a classic model, here’s what is happening with your money:

As the process continues, there is less and less money available to lend from the Bank. This is normal as Gov’t laws force banks to keep a specific minimum of cash in their institution to cover for bad loans or to fund any withdrawals from its clients.

But right now, the bank is not directly lending money. Through Wealth Management Products (WMP), it can invest 100% of the deposits into these “funds” that are held and managed by an outside trust. The Wealth Management Product Trust usually fund riskier projects to make a higher yield. So the cycle looks like this:

The system looks awesome as it injects more liquidity into the economy and the WMPs offer higher yield than banks. For example, a WMP can offer as high as 10% return while a normal investment within the bank will generate 3%. This sounds a lot like skipping the money market fund to invest in commercial paper backed by securities with a higher rate of return…

And the problem is similar too: since the money is managed by a trust that is owned by the bank, you can’t have access to what is inside and how risky investments are. This is where we start walking through the fog. Some say it represents 45% of the Chinese banking system, some say it is as big as $1,785B USD…

As was the case with commercial paper, as long as the wheel is turning, it’s all good. But when the wheel hits bumpy roads where buildings are built without tenants, the high yield promised by the WMP is not delivered. This happened in January when the biggest bank in China, the Commercial Bank of China (ICBC), promised a 10% return on an investment in a product called Credit Equals Gold #1 to 700 clients. The money was invested in a coal producer which went bankrupt. There was no way the bank could pay the 10% return. But since we don’t live in a capitalist country, a “mysterious” investor came at last minute and injected enough money to cover for the mess.

The Chinese Gov’t Will Cover Everything… Will They?

There are some people who aren’t too worried about the situation. They claim China has the largest money reserve in the world (estimated at $3,821B USD). This represents twice the Chinese shadow banking system. We can then hope China will cover all the mess.

But I don’t agree that China will always cover for hundreds of buildings left abandoned in these ghost cities. Money isn’t free, even for the Chinese. The fact we don’t know exactly what is going on and that we can’t get clear answers is the proof that something is wrong. It reminds me too much of the 2008 crisis when nobody could tell us where the money had gone. But one thing is for sure…. It WAS GONE.

There is something going on at the other end of the planet…

You know me; I’m not the guy who predicts the next market crash on a quarterly basis. And this time, I’m very worried about China. I don’t know yet how hard it will hit our country, but one thing is for sure; China’s bubble is going to burst and hit the stock market like a rock. Since 2008, the market has gone up every year (besides 2011 in Canada). 2013 was an amazing year for dividend investors where my US stock picks did 37.06%. Since then, I’m looking everywhere for the next bubble. I’m a pretty optimistic guy, but there are now two things that really bug me. The first one being the Canadian housing situation which seems to be falling into the most optimistic scenario for now with a smooth slowdown. The second thing that bugs me is China and how they escaped the 2008 recession. This bubble is about to burst…

China is the Second Economy in the World

China is not the manufacturer for the world anymore; it has become a very important economic player. Due to its impressive reserve of US dollars, it even had the “guts” to comment on how the US government was handling the 2008 credit crisis. China’s economy has been growing in the double digits since the early 90s. It has slowed down to 7.5%-9% recently but it is still a higher growth than industrialized countries.

China was among the few countries which weren’t affected much by the 2008 recession. In fact, the BRIC kind of lifted the whole world out of the recession. The result was impressive, but the solution China found back in 2008 to avoid the recession may very well blow up in our faces today.

How China Skipped the 2008 Recession… and How it Will Cause Their Biggest Headache

After seeing its “book of orders” melt in 2008, China realized it was impossible for them to maintain their growth level by simply exporting their goods. Their biggest clients (the USA & Europe) were cutting down on their expenses and this was leaving many workers unemployed. Instead of leaving the cold hearted capitalism work its magic by wiping out companies, the Chinese gov’t decided to react: Beijing started the most impressive infrastructure program ever built. They built entire new cities looking like London, Paris and New York. From 2008 to 2013, they built so many skyscrapers that Manhattan looks like a small Lego cities package. The plan worked: China’s growth kept rolling and the economy was saved….until they realized that all these skyscrapers are STILL EMPTY.

They blindly thought: “build it and they will come”, but no one has showed up yet. Some cities have been built for 500,000 citizens and yet, only a few thousand have bought one of those rich villas. There are dozens of ghost cities in China and this is becoming a real problem that can’t be hidden.

So far, it hasn’t been an issue since the Communist Gov’t had backed any company in financial trouble… until recently. They actually decided to let Real Estate Promoter Zhejiang Xingrun Real Estate Co go down with their debts (567M$). You want my guess? This was their Bear Stearns story. This is the first company to go down, but many others will follow. It is simply impossible to keep huge buildings alive without tenants. A few weeks before this event, Chaori Solar Energy Science & Technology announced their first default on debt payment. Once against, the real estate bubble will burst.

The whole financing system is also very hard to explain as it includes complex “shadow banking”. I’m not talking about some sort of evil force of nature with super powers here, I’m talking about a parallel financing system that doesn’t appear on Chinese banks’ balance sheets (doesn’t it sound like subprime mortgage and commercial backed securities to you?). Since nobody can really understand what is happening in the Middle Kingdom, the information is slowly leaking and the problem hasn’t spread around the world yet.

I don’t like people screaming their heads off that the world is going to collapse, but I’m pretty sure the Chinese Housing Bubble is not going to help us on the Western side of the world.

How China Affects Your Dividend Holdings

First things, first, if you hold any Canadian resource companies, I would consider selling them. The price for commodities and metals will most likely continue their drop if the bubble in China would burst. The Chinese Gov’t has the money to back up their companies, pay their dues and keep their system alive. However, they will definitely stop consuming resources at the pace they were. It has already started since 2011 and it will simply continue to get worse.

Then, don’t expect companies focusing on their Chinese market to become stellar dividend stocks. Strong companies such as Coca-Cola (KO), Wal-Mart (WMT) or McDonald’s (MCD) will survive this crisis but they won’t publish their strongest results during this period either. Most US consumers will be hurt but they will rely on a very strong base of clients in the US.

Try finding companies strong in the US and / or Europe. They will less likely be affected by what is happening in China. Still, I’m not too enthusiastic about this situation, are you?

Disclaimer: I own shares of KO, WMT and MCD

Bonds are not paying enough interest and you’re looking for « safer » dividend stocks to compensate? Utilities stocks may be the solution for your portfolio. But, don’t think that all utilities are safe investments. They are still companies and can still leave you with a sour taste in your mouth. This is why we will look into the world of utilities.

First; Why Invest in Utilities?

The utility sector is particularly interesting in the US for dividend investors. This is the realm of steady and high dividend yields. In this sector, it’s not hard to find a 4% dividend stock (there are also a few great 5% stocks too!). The utility sector is known to maintain a dividend payout ratio around 50% (electricity) and 60%-70% (water) and it is useful to follow these guidelines. The sector will bring stability and push your overall portfolio dividend yield higher.

As the current stock market is put under pressure, utility stocks can be a great way to diversify your portfolio while adding more stability. Don’t expect incredible growth from this sector, remember, we are not talking about the techno boom, we are talking about companies supplying electricity and water. As people don’t make their utility bills explode because they suddenly need to consume more electricity, there is more of a steady increase due to demographics, inflation as well as bad weather from time to time. 2013 was particularly cold in the USA (trust me, in Canada too!) and this is why utility stocks were able to follow the bullish parade.

Dividend Stocks Rock Premium Newsletter covered 8 utilities showing strong metrics. I’m sharing here with you 1 stock analysis that scored very high in our ranking.

Wisconsin Energy (WEC) Rock Solid Ranking 78pts

Wisconsin Energy Corporation’s principal business is providing electric and natural gas service. Based in Milwaukee, Wisconsin, it serves more than 1.1 million electric customers in Wisconsin and Michigan’s Upper Peninsula and more than 1 million natural gas customers in Wisconsin through its utility subsidiary, We Energies. Other subsidiaries are We Power, which designs, builds and owns electric generating plants; and Wispark, LLC, which develops and invests in real estate, industrial/office buildings and urban redevelopment projects. The company was founded in 1981.

It has been chosen in my best 2012, 2013 and 2014 dividend stocks. Each year, WEC has proven it deserves its place each time. Management has made a strong commitment to pay down debts and respect a 55% debt to equity ratio.

Both EPS and dividend payouts are heading in the same direction… up!

Its leadership position in its market allows Wisconsin Energy to benefit from a constant income which has led WED to increase its dividend payout several times over the past 5 years (the dividend doubled from 2007 to 2012). A new share repurchase program announced in December along with higher expectations from management should be enough to push WEC a little further. I like utility stocks like WEC as you can count on a solid performance year after year.

Unfortunately, all good things are not forever. Regulations may slowdown income growth in the future and could hurt WEC. Since it is currently trading at a relatively high P/E ratio (18.72), I would prefer to buy IDA than WEC at the moment (especially since WEC is up another 13% ytd!).

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