In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises SMEs get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets such as land or implicit government backing that State-Owned Enterprises SOEs enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan which it otherwise would have been reluctant to make. In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap CDS — to the bank for a risky loan, with the borrower forking over the premium.