Is Japan the Next "Subprime Flashpoint"?

Some observers, such as The Daily Telegraph (Feb. 13.08, "Japan is the Next Subprime Flashpoint") and others, have suggested that Japan may be the next "subprime flashpoint". As the old adage goes "where there is smoke, there is usually fire"; these articles carry an element of truth, but tend to confuse the issue.

The Japan Financial Services Agency's [FSA] estimate of subprime exposure for 684 "deposit-taking institutions" as of last December estimates that these institutions hold a total of JPY1.519 trillion ($14.1 billion at current Yen/Dollar exchange rates) of such products, up from JPY1.40 trillion ($13 trillion) last September.

Estimated losses on these holdings are JPY600 billion ($5.6 billion), no less than JPY500 billion of which was born by the major four banks, i.e., Mitsubishi UFJ Financial Group, Mizuho Financial Group, Sumitomo Mitsui Financial Group and Sumitomo Trust & Banking. Mizuho FG and Mitsubishi UFJ FG in particular appear to have the largest exposure.

However, these losses compare to total capital of JPY49.4 trillion ($458 billion), meaning that these losses, while painful for reported profits, are not large enough (at 1%~2% of total capital) to cause any scramble to beef up the banks' capital base, as is the case in the U.S. Moreover, the major Japanese banks still had unrealized capital gains on stock holdings of JPY10.1 trillion ($94 billion) as of December last year, which is more than enough to offset the subprime-related losses, even if they are twice what the FSA has estimated. As of September 2007, the FSA also reported in its regular survey of the major Japanese banks that NPLs (non-performing loans) were just 1.5% of total outstanding loans.

Another issue however is the non-reporting of significant amounts of assets in special purpose corporations [SPC], mainly among the major banks and real estate companies. A recent survey by the Nihon Keizai Shimbun (Nikkei) revealed that the 34 companies that disclosed their SPCs had no less than 163 such SPCs that held some JPY10.62 trillion ($98 billion) of assets, or around 2% of the 34 reporting companies' total assets.

Examples of off-balance sheet SPC assets at Japanese companies.

• Mizuho FG (MFG), JPY3.1 trillion (2% of total consolidated assets).
• Sumitomo Mitsui FG (SMCKF.PK), JPY2.86 trillion (2.7%)
• Sumitomo Realty (SURDF.PK), JPY7.75 trillion (28.2%)
• Tokyu Land (TOLAF.PK), JPY7.0 trillion (72.5%)
• Takefuji (TAKAF.PK), JPY2.95 trillion (19.8%)

The disclosed amount of assets in off-balance sheet SPCs of course is only a small portion of the true size of assets in Japanese SPCs. The Japanese banks use these SPCs to support the asset securitization of their customers (borrowers), buying accounts receivable from the customer and issuing commercial paper based on the appraised value of these receivables, which was sold to investors.

The Japanese real estate companies on the other hand used their SPCs to pursue an "asset-less" strategy, whereby the SPC would buy from and manage commercial buildings for rent from the real estate company, and use financing from their real estate company parent or the banks to invest in more property. As can be seen in the above numbers, however, the exposure of the big banks to such SPCs is 2%~3% of total assets, while it is substantially more for the Japanese real estate companies.

While JPY600 billion of write-offs will make a large dent in the profits of the major Japanese banks (i.e., some 20% of aggregate net business profits of around JPY3 trillion), the losses do not seriously threaten their capital base, which is not the case for some of the global investment banks.