Japanese Buy US Financials, and Nomura Is Getting the Best Deal

During the 1990s, Japan was struggling with the Heisei Malaise and its banking sector was rapidly shrinking, to a handful of "megabanks" led by Mitsubishi UFJ Financial Group (MTU). Japan's big four brokers had all but completely been decimated, with Nomura Holdings (NMR) being essentially the only broker to remain standing as an independent. Nomura had suffered from a major insider trading scandal which revealed dealings with Japan's Yakuza, and was again slammed by an insider trading scandal more recently involving Chinese employees.

In addition, its retail equity operations were under siege from online brokers offering steep trading commission discounts, and their underwriting franchise was under siege from foreign brokers that had become entrenched in the Japanese market, including Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER) and Lehman Brothers. By 2007, the firm had fallen off the Forbes list of the largest 500 global companies, ranking below Isuzu, which itself just barely made the list at 497.

Internationally, Nomura had built a major presence in the UK's pub securitization business, but made a 2 billion pound sterling exit in 2002 by offering 4,189 pubs it owned to a private equity consortium led by Cinven to offset significant losses in other businesses in 2002 as domestic investors all but stopped trading stocks and the firm was hit by substantial redemptions in its funds.

It was quick to exit the US residential mortgage-backed securities business in the first half of 2007, taking a $621 million loss and reorganizing its US business by laying off about 30% of its local workforce. Nevertheless, it has soldiered on, harboring global investment banking aspirations, and having a plan to increase client assets under management from JPY85 trillion at present to JPY100 trillion by 2010.

Meanwhile, it amassed a $5.6 billion war chest to expand internationally. In 2007, the firm purchased electronic broker Instinet from Silver Lake for $1 billion, giving Silver Lake a tidy profit of $792 million over the $208 million it had paid just a year earlier, but beat Citibank (C) and State Street to the prize. With Instinet, it got institutional broking, global portfolio trading, direct market access and algorithmic trading systems it did not have before, and began to show up here-and-there as prime brokers, albeit in only a token role compared to prime broker giants Goldman Sachs, Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers. Other small acquisitions included the joint purchase of Saudi Pak Commercial Bank in Pakistan in May of this year.

But the financial typhoon hitting the US investment banks presented Nomura with a major opportunity as Lehman Brothers, the fourth largest US investment bank, declared bankruptcy. While all of Wall Street and the City in London were picking over Lehman's carcass for parts they could use in their businesses, Nomura picked up Lehman's Asia operations (including Japan and Australia) for only $225 million, and agreed to hire all of Lehman's 2,500 employees in Europe (including the Middle East) while leaving Lehman's real estate and securities assets and debt to other carnivores, for a princely sum of $2.

With the Lehman purchases, they have substantially expanded their global footprint, in addition to gaining a proprietary stock trading system for European shares that is eating into the London Stock Exchange's share of trading. With no need to provide reserves for additional losses from Lehman's, Nomura has set aside a $1 billion bonus pool to make sure that valuable Lehman employees do not bolt after the deal is done. This is a decidedly different approach than Nomura has taken in the past.

Prior attempts to take over US money management or brokerage operations ended badly when valuable employee assets of the acquired firm simply walked, leaving the company with essentially just an office and a company name. In addition, Japanese companies like NTT DoCoMo (DCM) and Matsushita (MC) have a very spotty record in acclimating overseas operations into domestic operations in Japan.

Nomura's new approach may be more like that of ABN AMRO (ABN). While ABN AMRO's equity operations were in the end unsuccessful, the company's equity operations were essentially taken over by the core Hoare Govett brokerage operations in London, with headquarters in the Netherlands providing budgeting and control. Thus Nomura may be more successful in simply incorporating its overseas operations into the Lehman base initially, then importing what it can use into its Japanese operations.

While the general view at present is that the high risk, high leverage Wall Street Investment Banking model is dead, Nomura is doubtless keen to absorb these techniques to become a new global investment banking powerhouse.

Investors' initial reactions to Nomura's bold strategic move were positive, but this was only after the stock (underlying shares) had fallen 46% from a 52-week peak to a recent low of JPY1,176, as Nomura's net income had deteriorated from a high of JPY304.3 billion in FY2005 to a negative JPY67.8 billion in FY2007. In FY2008, the company is expected to return to the black in recording a JPY18 billion profit before the acquisition of the Lehman resources. As there was quite a lot of cumulative trading volume built up between JPY1,400 and JPY1,600, the stock could struggle to break up through this resistance for the foreseeable future.

Mitsubishi UFJ Financial Group: What Does It Get for Its 20% in Morgan Stanley?

On the other hand, we have trouble getting excited about Mitsubishi UFJ's purchase of 20% of Morgan Stanley, at least from the perspective of MUFJ's shareholders. One has to wonder just what the megabank will get from the deal, even if it gets a seat on MS's board.

Yes, it will be a valuable learning experience to see first-hand how a first-rate US investment bank operates, but unlike Nomura who got the valuable personnel but left the real estate and securities holdings to other carnivores, MUFJ gets exposure to MS lock, stock and barrel, i.e., including any toxic waste MS may have lying around in its closet.

Moreover, MS will emerge from this debacle a much less leveraged and more highly regulated institution, meaning that high two-digit returns may be a thing of the past, while MS needs to get its balance sheet leverage back to "boring commercial bank" levels. Unlike Warren Buffett's 10% dividend returns for Goldman perpetual preferred shares, MUFJ will have to stand in line behind bond and preferred holders and will have little say in how Morgan actually runs its business.

The same is true for Sumitomo Mitsui's (SMFJY.PK) considered investment in Goldman's upcoming $2.5 billion equity offering. As a passive investor, SMFJY will not get the sweet deal that Warren Buffett did, i.e., $5 billion of perpetual preferred shares with a dividend of 10%, and $5 billion of warrants to purchase Goldman's shares at $115/share any time over the next five years, versus a recent quote of $125.05.

Stock position: None.