Japanese debt: Selling the securitization story

The bad-loan troubles of Japan’s banks are no secret. Western vultures have been circling Tokyo for months knowing that at some point the banks would go through their pain threshold. When that happened they would start offloading problem loans at the best prices they could muster. For many Japanese banks that point has been reached and the market in Japanese distressed loans is getting into full swing. US banks especially are expanding distressed trading operations in Tokyo – Morgan Stanley Dean Witter, Goldman Sachs and Merrill Lynch have all recently expanded their operations.

But it’s not just the bad loans that are weighing down the Japanese banks’ balance sheets. Par loans are equally problematic.

Since Yamaichi went bust, Japanese banks have been forced to pay a premium to fund in the interbank market. That premium makes the returns they are achieving on existing loans to good-quality credits inadequate to cover their funding costs. “The obvious route is to dispose of the lower-yielding assets on your balance sheet,” says one banker. “The irony is that they are inevitably the safest assets to hold.”

The straightforward solution would be to sell the loans, either individually or bundled together as a portfolio. London-based loan traders report a significant increase in volumes. Japanese banks have withdrawn from supporting new loans and begun selling assets in a move that has driven up pricing for A-rated and better borrowers. But exiting the loans through a straightforward sale risks exiting the accompanying client relationships. That’s not an ideal outcome for Japanese banks at home where the relationship culture is ingrained.

In this awkward situation, securitization would seem to be a godsend. Through structuring a collateralized loan obligation (CLO) a bank can bundle together a portfolio of loans and remove it from its balance sheet without risking relationships with clients, who need never know that their loans are now floating offshore in a special purpose vehicle (SPV). In one fell swoop, the bank improves its balance sheet, frees credit lines and raises return on equity while simultaneously raising funds at an attractive level through the accompanying bond issue.

Given this rosy outcome one would expect to see Japanese bank CLOs swamping the market. Think again. Since the first such deal from a Japanese bank, last June’s $800 million Wizard Finance issue from Tokyo-Mitsubishi, there have been only six major deals in the international market and most of those have been secured on foreign loans not domestic Japanese assets. Sumitomo, Sanwa and IBJ have all securitized US loans, and Sumitomo is the first bank to securitize European loans with its recent issues through Aurora Funding, led by Lehman Brothers. Only IBJ and Sakura have issued notes backed by Japanese market loans. As a structured financier at one Japanese bank observes: “If you have a balance sheet of $500 billion, securitizing $2 billion helps, but doesn’t solve the issue.”

Some foreign banks have grown tired of attempting to market the idea in Japan. “At the beginning of the year we were very actively pushing the idea to Japanese banks, now we have shifted focus to Europe,” says a credit derivatives specialist at a US bank.

Others are more bullish. Having marketed CLOs to Japan since the start of 1997, Lehman Brothers has this year led major deals for Sumitomo and Sanwa and expects the market to be worth $60 billion to $70 billion by the year-end. “I don’t know what you call ‘significant size’ but those figures seem pretty significant to me,” says a Lehman banker.

There are some mitigating factors contributing to Japanese banks’ perceived reluctance to issue CLOs, not least investors’ negative view of Japanese bank credit. “In the near term it is all a matter of pricing,” says a banker. He points out that Fuji Bank withdrew a $2 billion deal in late March because the margin the market was demanding was beyond its expectations. “It is a matter of economics: do you pay a premium now or do you sit and wait for things to get better?” he says.

The regulatory situation in Japan is a further stumbling block. “There must be a drive to securitize assets out of Japan, but the legal system is still an obstacle course,” says a market expert. The main problem is that under current Japanese legislation it is very difficult for a bank to delink its own credit rating from that of the SPV in which the loans are deposited. That makes it virtually impossible to gain a triple-A rating for the lead tranches of the CLO. “With a normal CLO, the delinking structure gives investors a lot of confidence and in comparison Japan isn’t very attractive,” says a banker.

A further problem is that Japanese law makes it hard to achieve perfected sale of the underlying loans. It demands that the bank notify the obligors, which puts a strain on client relationships. Some banks have been content with contingent perfection: if the bank is downgraded beyond a certain level it must notify the obligors.

IBJ was not happy with using this structure for its recent Lily Funding issue, and instead negotiated a credit support agreement with triple-A rated Sumitomo Marine & Fire Insurance. That policy removes any IBJ credit risk from the structure, giving investors pure exposure to the underlying portfolio of Japanese loans. According to IBJ, the structure was well accepted by investors, but such credit support has a price and may not always be available.

According to one source at a Japanese bank, there are moves to ease the regulatory situation by introducing a law along the lines of the US Uniform Commercial Codes, perhaps as early as September. That would enable banks to repackage domestic loans in a way similar to that in which Sumitomo Bank recently securitized US and UK loans, setting up a master trust and achieving a complete delinking from the bank’s credit and obtaining a triple-A rating for the senior tranches of each issue.

There is, however, a continuing debate as to whether CLOs succeed in removing the loan risk from the bank’s balance sheet. In many cases, the deal will be structured in five tranches, A to E, with the issuing bank retaining the E tranche, which effectively contains the portfolio’s most risky loans. In this way the bank succeeds in freeing regulatory capital, without removing all, if any, of its economic risk.

A more straightforward method of balance-sheet massage is to set up an asset-backed commercial paper, or medium-term note, programme under an SPV. A number of banks took this route during 1997, including Sumitomo, IBJ and Fuji.

Since signing in August, Sumitomo’s L’Arc Finance MTN programme has issued approaching $2 billion equivalent in 28 issues, all with maturities of less than a year. In September alone it issued over $750 million of yen notes.

By issuing short-term debt backed by the loans over an accounting period, a bank can remove the loan from its balance sheet for a matter of months (even though the average maturity of the portfolio may be a number of years), cosmetically enhancing its balance sheet and return on equity in the process. The securitization seldom has any advantages in terms of cost of funds, the banks being content to meet their capital targets and cover costs.

Not all Japanese banks feel that the exercise is worthwhile: “All you are effectively doing is parking the risk outside the bank,” says a Japanese banker. “It is just a regulatory play and not a solution to the problem.” James Rutter