Japan’s structured credit market holds its breath

WHEN EUROMONEY SET out to gauge the mood of structured credit bankers in Japan as the fallout from the US sub-prime crisis spread east, the initial signs weren’t promising. One banker in Tokyo arrives late for the first time for his meeting, cordial as ever but looking slightly flustered. Another is accompanied by an unprecedented total of three corporate communications officers, one wielding a Dictaphone and all looking somewhat grave. A third banker visibly winces at the mention of the words "sub-prime". Despite the immediate stresses of post-crisis volatility, however, the general mood among Japan’s credit bankers is positive: long regarded as something of a late-adopter of innovative financial products, the country’s markets are starting to catch up and a new generation of structured credit products that cater to the unique demands of the investor base has been unleashed. The question on everyone’s minds is what the long-term fallout from the sub-prime crisis will be, and whether the developing structured credit market will suffer a serious setback.

"I came back to Japan from London in 2003," says Yasuhiro Shibata, general manager, global structured credit products at Mizuho, "to find that no real Japanese CDO market existed. Most US and European houses were concentrating on marketing external products into Japan; BNP Paribas and Deutsche Bank were perhaps the only ones delivering local capabilities. So I thought it would be a good opportunity for Mizuho to leverage its competitive advantage in the Japanese market and deliver strong local products."

Now synthetic CDOs are popular investments, and larger accounts have begun trading them. The innate conservatism of the domestic investor base, however, imposes its own restrictions on the products that can be successfully marketed in Japan. The critical differentiating factor in Japan’s structured credit market, according to all the bankers interviewed for this story, is the need for a high rating.

Japanese institutions seem so far to have escaped from events in the US relatively unscathed as a result of this tendency towards low-risk investment strategies. The larger banks are reporting losses of a few billion yen: megabank Mitsubishi UFJ Financial Group announced it had lost about ¥5 billion ($43 million) by the end of July on securities related to US sub-prime loans, a comparatively small sum when compared with the hundreds of millions lost by some US institutions. Japanese institutions, and especially the larger investors, such as the megabanks, prefer instruments with higher ratings than sub-prime-related CDOs can generally achieve.

"It’s certainly true that the market here is very ratings-driven," says Vincent Thebault, head of credit markets and CDO, Japan, at Calyon, "and I’d say that two-thirds of the products we sell have to be AA or AAA-rated. We tend to sell the senior tranches in Japan, and often the lower parts of the capital structure go elsewhere."

Investors in Japan want high-rated products, but of course they also want decent returns on their investments. The premium placed on extra yield is especially high in an environment where interest rates are only just starting to creep above zero after years of stagnation. For the moment, the bulk of the developing structured credit market is synthetic CDOs.

"Without wishing to generalize," says Mizuho’s Shibata, "Japanese investors tend to prefer a standardized product with a proven track record. There has, however, been a dramatic change of sentiment in one regard. When the CDO market began, investors here preferred unmanaged CDOs because they didn’t like third-party involvement. They didn’t know who the CDO managers were, and they didn’t feel comfortable having someone else assemble the portfolio. Investors often preferred to try to pick each credit in the portfolio themselves, but now they are starting to learn that this is not something that they should necessarily be doing themselves and managed products are much more popular."

Levels of risk

Calyon’s Thebault offers an additional reason for this development that is linked to the investors’ overriding concern for ratings. "We really started to see this switch towards managed CDOs at the beginning of 2006, when a period of extreme LBO activity led to the downgrade of several CDO tranches," he says. "When a firm goes from investment grade to a lower rating it can affect the rating of the tranche of the CDO that the firm is in, and investors here were frightened by a downgrade of their tranche. An active manager can work to protect the rating of the CDO, and although it’s possible to foresee slightly less LBO activity than we have had, the popularity of managed CDOs seems to be increasing steadily."

Banks have had mixed success at importing other structured credit products developed abroad. In Japan, CPDOs have yet to replicate their popularity elsewhere and the most common reason cited by bankers is uncertainty surrounding the product’s treatment by Basle II regulations.

"We’ve found some difficulty in placing CPDOs in the market," says Muneto Ikeda, co-head of the global structured credit structuring and marketing group at JPMorgan Securities. "Some bank clients think that the new BIS treatment of this product is unclear."

As well as being concerned about how to allocate capital against CPDOs, it’s possible that the structure is perceived as being too risky by Japanese investors. As another banker at a non-Japanese institution puts it: "CPDO has been marketed in Japan and it simply didn’t fly. The thing generally starts with a leverage of 15, which is pretty unnerving for investors here, and because of the way it’s put together the size of the portfolio actually increases the worse it performs. Investors aren’t sure how the product works with the new regulations, and they’re worried by such highly leveraged instruments."

"We’ve found some difficulty in placing CPDOs in the market, some bank clients think that the new BIS treatment of this product is unclear" Muneto Ikeda