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.”