Praying for a miracle

Tokyo’s glitzy, neon-bright Ginza district still swarms with early evening shoppers and diners. White-gloved taxi- drivers in spotless cabs, with antimacassars on the headrests, still sit patiently in the disciplined traffic that clogs the city’s main arteries. And local bankers still flock to the numerous golf courses as soon as they can cast off the regulation dark suit and tie.
It is hard to reconcile this outwardly prosperous appearance with a country where falling equity and land prices have wiped a staggering ¥1,000 trillion ($8.5 trillion) off the value of Japanese assets during the 1990s – a figure twice the size of the country’s annual gross domestic product. There is little to indicate that a decade of recession and deflation has produced the highest general government debt in the developed world, and no hint of how Japan’s slow-burning crisis will end.

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Can the second most-economically powerful country continue to muddle through? Or is it heading, in the words of Massachusetts Institute of Technology (MIT) economics professor Rudi Dornbusch, for a “rendezvous with bankruptcy?”
By most measures, the overall credit situation of Japan Inc. is continuing to deteriorate. In late January, the rating agency Standard & Poor’s warned that credit risks are rising “across the board”. The number of debt defaults, already at a record level, “is bound to increase in 2001,” while credit downgrades are “likely to continue outnumbering upgrades”. Jesper Koll, chief economist for Japan at Merrill Lynch, predicts “bankruptcies will skyrocket”. The level of debts owed by bankrupt companies was already breaking records in 2000. A new wave of failed companies will be a further blow to creditor banks still punch-drunk from the 1998-99 financial crisis, and struggling with their own seriously weakened balance sheets.
Even the creditworthiness of the government itself is being more closely scrutinised. A restructuring of Japanese government bonds (JGBs) may seem scarcely conceivable, but two international rating agencies (Moody’s Investors Service and Fitch) have downgraded the ratings they assign to domestic sovereign debt since 1998. Although this does not imply a much greater probability of default, it removes the triple-A badge of distinction so coveted by the most strongest nations.
Perhaps, more significantly, the cost of insuring against a JGB default in the derivatives market is now materially higher than for debt of any other member of the Group of Seven (G7) industrialised countries. A dollar-denominated, five-year credit default swap on JGBs cost 19 basis points – effectively, an insurance premium – in early February. A similar maturity default swap on US Treasury debt trades at a theoretical price of 1bp, in part because creditors rarely actually seek such protection. Even the government paper of highly-indebted Italy only commands a bid/offer default swap price of 4-7bp. Default swaps on the sovereign debts of Greece and Australia – countries that are a few notches below triple-A – cost 8-14bp and 5-8bp respectively. Clearly, the market no longer judges the risk of a Japanese government default to be a zero probability – as it once did.
There are two main reasons why the general credit situation in Japan seems to be taking a turn for the worse, after a period last summer when the situation looked to be stabilising. One is the weakening in the economy. After the recession of the late 1990s, Japanese output growth seemed to be clawing back to around 1.5% in 2000 and was widely predicted last autumn to settle at around 2% this year and next. In recent weeks, however, output forecasts have been revised down.
Economists at JP Morgan now believe that Japan’s GDP probably expanded by a little over 1% last year, and will be less than that in 2001. This is the kind of anaemic average growth achieved between 1992 and 2000, compared with an average of nearly 3% for the major industrialised countries. Japanese consumers are still reluctant to spend heavily, because of concerns about their future prospects, while a recession in the US would hurt Japanese exports. A return to low national growth will in turn cut company earnings and make it impossible for many more struggling companies to avoid bankruptcy.
The second reason why insolvencies are set to rise, with all the worrying implications for creditors, is that corporate restructuring is gaining momentum. Government reforms have started to speed up, after years in which the political establishment refused to accept that the collapse of Japan’s extraordinary financial bubble in 1990 had left the country with a problem – a state of denial that resulted in “the lost decade”. Deregulation and the government’s waning commitment to bailing out troubled companies are forcing them to merge or refocus on their core businesses. This is leading to closures and job losses. In the financial services industry, the “Big Bang” reforms are ending the divisions that kept firms specialising in particular types of lending or securities trading. Before long, everybody in the financial field will be able to do almost everything. New boutique firms are setting up venture capital, hedge fund and asset management operations. Foreign banks are building up and competition is growing. These reforms, and the financial crisis of 1998-99, are producing mega-mergers in the Japanese banking industry.

Land reform in Akasaka

New issues of J-REITS and residential-backed mortgage securities will push Japanese securitisation to new heights of activity in 2001. Melvyn Westlake reports from Tokyo
Issuance in Japan’s securitisation market is expected to jump more than 50% in 2001, powered by new products, new issuers and a seemingly insatiable hunger among Japanese investors for increased returns on their investments.
Two major initiatives are already at the starting blocks. In March, the state-owned Government Housing Loan Corporation (GHLC) will make its debut in the market with a ¥50 billion ($430 million) issue, the first of four such offerings planned for 2001. As GHLC is the dominant source of housing finance in Japan, with more than 40% of the country’s ¥175 trillion ($1.5 trillion) residential loans, its involvement in the two-year old residential mortgage-backed securities market is set to transform the sector. Credit Suisse First Boston is structuring the transaction. Bankers are saying the GHLC issues will act as benchmarks, helping to develop a market that has been previously constrained by technical difficulties and the relative expense of such deals.

Yasuko Okamoto, JP Morgan: Illiquid real estate assets can be bought by J-REITS, releasing cash to companies
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The second big development is also in the property arena. This is the launch in Japan of US-style real estate investment trusts (REITs). Until a recent change in the law, which comes into effect in April, the establishment of such trusts had been inhibited by technical restrictions and a double-taxation penalty. Although not strictly viewed as securitisations, so-called J-REITs are being planned by several Japanese and foreign banks. They are predicted to have a considerable impact on a property market that has slumped more than 80% from its peak at the height of Japan’s asset bubble in the late 1980s – when the imperial palace and grounds in Tokyo were valued at more than the whole of Manhattan. “The potential for the J-REIT to provide liquidity and help restore real estate as a viable asset class, and thereby inject market disciplines and management efficiency into the sector, is probably the single most exciting development we are likely to see this year,” says Thomas Dunn, Tokyo-based head of JP Morgan’s Asia credit markets.
Companies’ illiquid real estate assets can be bought by these vehicles, to provide a stream of rental income for different types of investors, while releasing cash for companies that need it, adds Yasuko Okamoto, vice-president for Asia debt capital markets at JP Morgan in Tokyo. The first J-REITS, which will trade like shares, are expected to be listed in June or July. Among the firms preparing to launch such a real estate vehicle are Mitsubishi Corporation and UBS Asset Management, which announced their intention to do so, jointly, last August. They are aiming for a trust with ¥100 billion under management.
Although institutional investors are likely to be attracted to this kind of vehicle, many of the investment trust shares are expected to be targeted at Japanese retail investors, who will then, indirectly, own bits of office buildings all over Tokyo and other cities. “Where securitisation comes into play, is that some amount of leverage will be desirable to provide an appropriate return to the equity holders,” explains Karl Essig, co-global head of securitisation at Morgan Stanley Dean Witter in Tokyo. So, the REIT will also often issue bonds, securitised against part of the property income. Typically, the REIT’s funding will come in equal parts from equity issuance and securitisations.
Securitisation is expected this year to be driven up sharply by all this activity in real estate, which is still easily the largest asset class in Japan, including government bonds. On some estimates, the country’s commercial real estate has a ¥700 trillion price tag even after the steep fall in property values, with barely 1% securitised so far.
According to rating agency Fitch, the amount of securitised debt issued last year in Japan reached the equivalent of $22 billion (¥2.5 trillion). Of this, more than a quarter represented commercial mortgage-backed paper – both performing assets (where debts on the property are being fully met) and non-performing. At $6 billion, commercial mortgage securitisations have now overtaken deals for equipment leasing, the mainstay of Japan’s asset-backed business. Together, commercial and residential mortgages accounted for 44% of all such activities in 2000.

SAS skirmish

The planned implementation of a new accounting standard in July is set to transform the way Singapore companies treat derivatives on their balance sheets. But as the deadline looms, it appears that few firms are aware of the extent of the legislation.
The Statement of Accounting Standard 33 (SAS 33), which is comparable to the IAS 39 standard issued by the International Accounting Standards Committee, compels all Singapore companies that hold derivatives – including financial institutions – to demonstrate their effectiveness as hedging instruments, or include the derivative positions as profits or losses on their balance sheets. To qualify for hedge accounting, the hedge must prove to be “highly effective” at offsetting gains or losses on a hedged item, according to The Institute of Certified Public Accountants of Singapore, which published the document last July. An effective hedge is classified as one that almost fully offsets the changes in the fair-value of the hedged item within a range of 80%-125%.

Chua Kim Chiu, PwC: “Time is running out very fast”

To accomplish this, companies must mark-to-market all their hedges with the corresponding hedged items, formulate concise risk management strategies and devise effectiveness tests for the hedges. What’s more, the firms have to prove the hedges are effective both at inception and on an ongoing basis, an extensive workload for risk management executives.
The Singapore financial year runs from January to December, so although the legislation is effective on 1 July this year, in reality banks will not have to report using the new standard until December 31 2002.
However, according to David Belmont, a Singapore-based director of financial and commodity risk practice at Arthur Andersen, a number of Singapore institutions are unaware of the vast swathe of data needed to comply with SAS 33. They should start preparing for implementation now.
“Banks and other firms really do need to focus on the challenge to get ready,” he says. “All firms have to produce a lot of documentation before the end of 2002 to show that when the derivatives were initially purchased, they were purchased for the purpose of a hedge and at the time they were purchased that the correlation was strong. You have to then show that the hedge relationship continues to hold. If it doesn’t continue to hold, you can’t continue to account for it under hedge accounting.”
Chua Kim Chiu, head of the financial services industry and a partner at
PricewaterhouseCoopers in Singapore, agrees that SAS 33 will be a big change for a number of institutions in Singapore, and notes that a lot of work needs to be done before the reporting period begins.
“I think [Singapore companies] are broadly aware of [SAS 33], but they have not been fully appreciative of the extent of the issues,” he says. “I think if they work hard on this, they should be okay by January 1 2002, but time is running out very fast.”
Chua notes that many companies will need to invest in or modify existing risk management systems to comply with the standard, pointing out that the systems need to be capable of establishing a clear link between the hedged item and hedging instrument to qualify for hedge accounting. “If you buy new systems, there will be some costs involved. But I don’t believe that the cost is prohibitive,” he adds.
However, the hedge must relate to a specific designated risk rather than overall business risk. Chua points out that this could potentially lead to greater levels of risk as companies shy away from purchasing complex derivatives without a specified hedge item.
In addition, with fewer derivatives likely to qualify for hedge accounting, the company’s share price could experience greater volatility due to the fluctuations in fair value of the derivatives now marked to market and reported on the balance sheet.
“It is going to narrow down what derivative positions you can count for hedge accounting,” says Belmont. “You are not going to be able to accrue gains or losses on as many positions as you used to be able to. Consequently, you are going to have to mark-to-market those positions now and that will likely lead to more volatility of income for the banks that have derivative positions.”

A good RMBS result

The first securitisation of residential mortgages by a public Japanese agency is judged a success in Tokyo’s financial markets. But it was helped by a timely and fortuitous policy change on March 19 by the Bank of Japan (BoJ), which effectively meant a return to zero interest on the key overnight money market rate. When the deal for ¥50 billion ($403 million) of bonds, backed by Government Home Loan Corporation (GHLC) residential mortgages, closed on March 22, it was fully sold, according to Credit Suisse First Boston (CSFB), one of the joint lead underwriters.

Investors lined up for the GHLC residential mortgage deal

The deal was regarded as a critical test of both the investor appetite for residential mortgage-backed paper and the ability of Japanese state agencies (known as zaitokikansai) to obtain funding from the capital markets rather than through the government budget. As a result of a recent government policy change, some 20 state agencies will now have to fund themselves through the markets.
It is also hoped that a successful GHLC issue will give a big boost to the development of a mortgage-backed securities market, along the lines of the one created in the US around the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). The GHLC issue, which is expected to be the first of four ¥50 billion offerings this year, has closely followed the US model, according to Simon Maru, Tokyo head of debt capital markets at CSFB, which underwrote the transaction together with Goldman Sachs Securities and Sanwa Securities. There have been a handful of residential mortgage securitisations from private lenders since the market was introduced in 1999, but it has developed more slowly than the commercial mortgage-backed sector. Most important now, says Maru, is for the investment banks to create an active secondary market in residential mortgage-backed securities (RMBS).
The GHLC’s 35-year amortising bonds carry a 1.75% fixed coupon and were issued at par. Initial investor response had been muted. But the BoJ’s package of measures, which involve injecting increased liquidity into the Japanese economy (and a presumed consequent drop in interest rates to zero), brought a late surge in demand for the pioneering bond issue. Soon after the deal closed, the bonds were trading at 100.34% to 100.41%. Underwriters say the triple-A rated bonds were bought by major life insurance companies, city banks and regional and savings banks. “Because this was an important trial issue, we roadshowed from Hokkaido to Kyushu [the most southern and northern of Japan’s five main islands],” says Maru.
The deal was 9.3% over-collateralised on a pool of ¥55.126 billion in mortgages. To take into account prepayment risk on the underlying mortgages, the GHLC deal assumes a 3% prepayment rate and an average life of 12.6 years for the underlying pool of mortgages. But to build in some leeway, the corporation has a call option to retire its bonds after 30 years.
Of the 20 state agencies that must now fund in the markets, only GHLC and the Japan Finance Corporation for Municipal Enterprises (JFM) are able to use the securitisation route. JFM, which also has a loan portfolio, is thought to be planning a ¥100 billion loan-backed bond issue in October or November, underwritten by Mizuho Bank.

Unleashing Asia’s demons

Asia’s banks are only now slowly emerging from the economic crisis that ravaged the region between 1997–98. Many smaller institutions, still weighed down by crippling debt levels and high funding costs, are struggling to implement vast restructuring programmes. But the publication of the Committee’s latest consultative paper on capital adequacy could stretch many of Asia’s banks even further. While the new Accord pledges to create a level playing field across the world’s banking systems, some of Asia’s troubled institutions face tough times ahead, with soaring funding costs and heavy investments in risk management systems. Indeed, some bankers in the region even question its relevance to Asia’s banking systems.

One prominent Singapore-based banker, who requested anonymity, says he feels that the Accord may be too much of a leap for many of Asia’s banks. He says: “Not many Asian banks – I think one in Singapore, and maybe two or three in Hong Kong – are aggressively addressing capital adequacy, capital structure and balance sheets. Most of the banks, to put it very bluntly, are so far behind the curve, I’m not sure this Accord really means a lot.”

The Asian Crisis clearly demonstrated that the 1988 Accord was in dire need of a comprehensive overhaul. While the vast majority of the region’s financial institutions claimed to have implemented the proposals, in many cases they were paying mere lip service to the recommended 8% capital adequacy ratio. In reality, a large number of banks were crippled by ballooning non-performing loans (NPLs) and had dwindling capital reserves to deal with the problem, transforming what could have been at best a currency misalignment to an out-and-out economic crisis.

The result, a new consultative proposal on the Basel Accord, was presented on January 16. It attempts to address some of the shortcomings of the original agreement. The primary objective, says William McDonough, president of the Federal Bank of New York and chairman of the Basel Committee, is to make the new Accord more “risk-sensitive” and to strengthen banking systems hardest hit by the crisis by revamping the methodology for calculating capital levels.

Consequently, the new proposal ditches the one-size-fits-all approach and adopts a methodology for gauging capital adequacy ratios based on credit risk, while also incorporating charges for operational risk. Also included are proposals for a stringent supervisory review process and recommendations for increased levels of market discipline. The new document extends many of the characteristics of the first consultative paper published in June 1999, but leaves a consultation period of only four-and-a-half months, with a planned implementation in January 2004.

Central to the new framework is the idea that sophisticated international banks meeting stringent regulatory standards can internally assess the risk levels of their portfolios, effectively allowing the larger banks to calculate their own capital charges. The Committee estimates that high investment grade banks using this model, called the Internal Ratings-Based (IRB) approach, could reduce risk capital levels by around 2–3%, effectively acting as an incentive for investment in risk 
management systems.

This IRB approach is divided into two components. The first is a foundation approach, which allows banks to estimate the probability of default for each borrower, with other risk factors supplied by the regulator. The second, the advanced approach, enables banks meeting tough regulatory criteria to utilise their credit risk models to calculate additional risk factors.

Investors’ Brazilian love affair?

The energy industry is at the forefront of Brazil’s privatisation programme. The monopoly status enjoyed by state oil and gas company Petrobras and its electricity counterpart Eletrobras has now been removed, and these markets are opening to competition.

This, added to the new currency stability after devaluation of the Brazilian real in January 1999, has attracted much-needed foreign investment (see box, page 21). But risks inherent to nascent energy markets and emerging countries threaten to keep investors at bay.

Certainly Vittorio Perona, director of utilities, Latin America, at Rio-based investment bank Dresdner Kleinwort Wasserstein, feels the climate is right for investment in Brazilian energy. “A lot of people see Brazil as a very promising market,” he says. “Despite the devaluation of the real, inflation has not shot up and the investment climate in Brazil is looking as good as it has been for 15 years.”


Currency risk

But Brazil’s attempts to lure investors have been hindered by the currency risks faced by entrants to the energy markets. Amerada Hess, the New York-based independent energy company, is just one example of a firm that nearly reconsidered participating in the country’s energy market after discovering the tight controls due to be enforced by the government.

Under its original rules, the government would not allow foreign companies to hold non-real denominated accounts, thereby forcing the companies to convert money every time they wanted to trade internationally. After negotiations with the government, a compromise was reached.

Tim Kieft, Amerada Hess’ director for Brazil, explains: “We now have a halfway-house solution where we are allowed nominated dollar accounts for certain activities and our currency risk is reduced, but it is still there.”

Another major currency stumbling block in the Brazilian natural gas market comes at the Bolivian border, where gas is bought from Bolivia in US dollars by companies dealing in Brazilian reais. But Dresdner Kleinwort Wassterstein’s Perona says this currency clash might soon be resolved. “The government is meeting with the industry and regulators to address the currency mismatch. There are many proposals and one or two ideas are looking pretty promising,” he adds.

As well as currency risk, companies also have to contend with each of the local taxes imposed by the country’s 26 states. This tax can be traded off against business units in other states, but there is industry pressure on the government to act to reduce this added cost. Amerada Hess’ Kieft says: “Everyone is waiting to see if the government can revamp the tax structure to bring in a federal value-added tax, in place of the current individual state taxes, which we would definitely see as a benefit.”

Brazil’s attempts to lure investors have been hindered by the currency risks faced by entrants to the energy markets

What troubles many is the fact that there is little opportunity to hedge the currency risk and so other solutions have to be found. Some US firms have built secretive “black box” solutions that protect them to an extent, but others have adopted a more fundamental approach. 

Bruce Williamson, president and chief executive officer of Houston-based Duke Energy International, tries to stem risk at the source. “We are looking very carefully at structuring our portfolios to mitigate all the expected risk,” he says.

But Williamson recognises that the biggest risk of all in Latin America is not to invest in Brazil at all. “The size and overall fundamentals of Brazil’s economy made it a place we knew we should be looking at,” he says.

Duke Energy International, an arm of Duke Energy, has interests in Australia, Asia and Europe, and in other Latin American countries as well as Brazil. The company has a 95% stake in Paranapanema, a 2,300 megawatt (MW) hydropower plant in São Paulo state in Brazil, where it also has a 520 MW gas-fired thermal plant. Duke is also planning two peaking gas plants in conjunction with Petrobras, one either side of the Bolivia-Brazil border.

Power shortage

What has drawn many energy companies to Brazil is the forecast power shortage the country is facing as its economy grows. A long-running lack of investment in generation and an increase in demand has led to a large predicted shortfall in electricity supply. 

The Brazilian government estimates that the current power generation capacity of nearly 70,000 MW will not be able to prevent an undersupply of around 15% for 2001. The prediction is that 4,330 MW of new generating capacity is required every year for the next 10 years if supply is to keep up with expected demand.

Thankfully for Brazil, ambitious building and buying schemes are commonplace there. As well as Duke, other Houston-based energy companies are jumping on the generation bandwagon. 

El Paso Corp has bought the 158 MW Rio Negro plant and is building a 409 MW facility in western Brazil. These plants contribute to El Paso’s status as the largest independent power producer in the country. 

To the north-east, in January 2000, Alliant Energy took stakes in four privatised utilities at a cost of $347 million. Jim Hoffman, president of Madison, Wisconsin-based Alliant Energy Resources at the time of the acquisitions, predicted a return of at least 15% on the investment. Since those acquisitions, Alliant has continued to buy assets, thereby strengthening its position and servicing at total of 1.6 million customers. 
John Peterson, president of Alliant Energy International, says: “We are successfully executing our strategy to take advantage of the business opportunities that exist there. Energy consumption there is growing faster than electricity use in US homes and business.” 

Other major US and European energy companies have been quick to seize upon the opportunities afforded by Brazilian privatisation. Established companies such as the US’s Enron Corp and AES have invested significant amounts in South America, particularly in Brazil. And these firms have been rubbing shoulders with European companies including Belgium’s Tractebel, Spain’s Endesa, Electricidade de Portugal (EdP), and Paris-based monopoly Electricité de France (EdF).

The next generation

The Brazilian government is keen to reduce the country’s reliance on hydropower – currently more than 90% of Brazil’s generation capacity is hydroelectric. 

Key to this hydro capacity is the mighty Itaipu facility on the Paraná river at the Paraguay-Brazil border to the south-west. It is the world’s largest hydroelectric generator, producing 12,600 MW. The plant feeds the south of Brazil, where electricity-hungry cities such as Rio de Janeiro and São Paulo are growing. 

But this region still needs a great deal more electricity from somewhere. And while there is significant hydro potential far to the north, the cost of transmission makes it impossible for electricity to reach the southern regions.

Consequently, the government is looking to natural gas. It aims to raise the consumption of natural gas to 10% by 2010 from 3% in 1998, primarily for electricity generation. In 1999, the Ministry of Energy and Mines introduced the Emergency Thermoelectric Programme, an initiative aimed at creating new gas-fired power plants, totalling 1,500 MW of capacity, by the end of 2003. Analysts expect the total investment required for this undertaking will be in the region of $6.6 billion. 

Duke’s Williamson feels the building programme in Brazil is facilitated by lessons learned from other markets. “Facilities can be built in Brazil far more quickly than in other places, such as California, as there are clear incentives [offered by the government for such investment].” But he is wary of the same mistakes made in California being made in Brazil: “It is important that Brazil doesn’t start capping prices and scaring investors away,” he adds.

Nonetheless, one head of corporate finance at a major European utility investing in Brazil, is certainly excited about the increasing number of opportunities in the natural gas sector. “Brazil has much larger gas reserves than was initially thought,” he says. “Our plan is to be a major player in gas and power, as the two are going to be so closely linked in Brazil.” 

He is also upbeat about the competition coming in from experienced European and US players. “Companies like [Spain’s] Iberdrola and EdF are establishing a real presence in Brazil, particularly in electricity, and other companies like TotalFina Elf are going about it by buying generation assets in Argentina,” he says.

A surfeit of oil

The oil industry is another business Brazil’s President Cardoso was keen to open to competition and investment. Hence, in 1997, the National Petroleum Agency (ANP) was set up to oversee its running. 

Brazil’s oil reserves are estimated to be the largest in Latin America after Venezuela, and total more than 7 billion barrels (bbl). Over the past two years, Brazil has been successful in attracting foreign companies to its richest oil and gas fields in the Santos and Campos basins, off the south-east coast. Auctions for exploration and production blocks in these areas were conducted in June 1999 and 2000, with another due to take place this summer. 

Petrobras owns a large proportion of these blocks and has the advantage of having been in the region longer than others. The company’s expertise is envied in the region as it sets records for depths of exploration and drilling.