Is Japan Subprime's Next Flashpoint?

An article published by The Telegraph newspaper suggests Japan is the next sub-prime flashpoint. Ambrose Evans-Pritchard says "there is still $300 billion of bad debt out there, and Japan could be hiding most of it." Evans-Pritchard discusses the nagging fear that Japan's lenders - the conduit for the world's greatest stash of savings - have taken on a far bigger chunk of mortgage securities, collateralized loans obligations and other exotica from America's structured credit boom than they have yet revealed.

"Americans and Europeans have so far confessed to $130 billion of the estimated $400 billion to $500 billion of wealth that has vanished into the sub-prime hole," he says. So far, Japan's biggest three banks have admitted to just $4.7 billion in total losses between them. "Somebody, somewhere, must be sitting on a vast nexus of undisclosed losses." Evans-Pritchard asks: "Where have the Japanese recycled the quarter trillion dollars they earn each year from their surplus? Official data shows that their holdings in U.S. Treasury bonds have not risen." The implication here is that Japanese savings may have gone into higher yielding subprime investments instead of safer and lower yielding U.S. treasuries.

The main worry is that the Japanese may have been trying to cover up the extent of their subprime losses, just as they did at the start of the Asian financial crisis in the 90s. But let's not jump to conclusions, and assume they have been honest with their disclosures. If this is the case, evidence suggests that they don't have a grip on the gravity of the situation. As an example, MUFG, Japan's largest bank, recently said subprime-related losses had ballooned to ¥55 billion, or more than 13 times the ¥4 billion it revealed in November.

Hans Redeker, currency chief at BNP Paribas, says they "think this is where the next big problem is going to pop up [i.e. Japan]. We know from Bank of Japan's lending survey that the banks are already tightening hard, so something is brewing. Right now, we are in the lull before the second storm in global markets, and Asia is going to be the source of the nasty surprises."

If Japan had to become the epicenter of another credit storm, the impact may be compounded by a potential leadership vacuum at the Bank of Japan (BoJ). The central bank's leadership changes in March 2008, and it remains to be seen if the change of guard will slow down the central bank's reaction to any potential crisis. "For policy implications, with the shock waves from the subprime issue extending their reach, time is running out for the current BoJ leadership," says Morgan Stanley in a recent research note. "Moreover, with the Democratic Party - which effectively has the power of veto over choices at the top of the BoJ - insisting that the issue must be deferred to the next Administration after the general election, a general election taking place at around the same time as the terms run out on March 19 could have the effect of creating a vacuum - if only temporary - in the positions of governor and deputy governors."

Another complication: The Japanese may have limited ammunition to deal with a credit crisis. "Interest rates are 0.5 per cent. So it's back to zero, and helicopters of central bank cash ("quantitative easing"), those peculiar hallmarks of Japan's past battle with deflation. The brief attempt to "normalize" Japan Inc has already failed," said The Telegraph article.

Are these concerns valid? Up until recently the assumption has been that Japanese financial institutions have only the smallest exposure to subprime debt. In general, the appetite for leverage is tiny in comparison with America's or Europe's. Richard Jerram of Macquarie Research points out that the value of all corporate bonds outstanding in Japan is equivalent to just under 10% of GDP, roughly the same ratio as subprime and other high-risk debt alone in America.

Perhaps the most interesting question: If Japanese banks are buckling under the pressure of subprime investments, as The Telegraph suggests, why would they increase their subprime exposure? During January Mizuho Bank agreed to buy Merrill Lynch convertible preferred shares as part of the U.S. firm's $6.6 billion fundraising. "The capital is flowing back across the Pacific because the Japanese banks have escaped the worst of the subprime problems," said Brett Hemsley, banking analyst at HSBC, during the time of the announcement. Is Mr. Hemsley's assumption wrong? Some Tokyo market participants likened Mizuho's purchase of a Merrill stake to further investment in the subprime market. Is this a case of Japan doubling down on bad subprime bets?

"We may find out soon enough whether the hold-outs are in Japan," says Evans-Pritchard. "The banks have to come clean under the country's strict new audit codes by the end of the tax year in March." Time will tell…

Disclosure: None

Comments

[RichShinnick]

Funny how nobody knows who owns this stuff...except the people that packaged and sold it who know exactly who they sold it to and consequently know exactly whose shares to sell short. Yep, they catch you coming and going..nice gig.

[jcrash]

How are they "tightening" if rates are .5%

[gwendolynpigeon]

The best thing is to see the actual amount/issuance of CDO in Japanese capital markets. It is very tiny amount (less than 5%) and there has been no single default even though the CDS indices are extremely high. What Japanese investors are doing now is to invest in CDS before it goes back to normal (under 50bp) as the market undervalues the situation.
Best to ask one of Japanese mega bank. They will say the same thing. Former Sony CEO also says the same thing.