[A-List] US imperialism: Japan

["Michael Keaney" <michael.keaney@xxxxxx>]

As the Nikkei slides and nationalisation looms, Wall Street buys into
Japan's banks
By David Ibison
Financial Times; Mar 13, 2003

Wall Street is taking abet on Japan. At a time when stock markets
arestruggling and a possible war in Iraq is threatening to destabilisethe
global economy, US investment banks are pouring billions of dollars into
Japanese banks.

In January, Goldman Sachs announced it would invest Y150bn ($1.28bn) in
preference shares issued by SMFG, Japan's second largest bank. Merrill Lynch
has agreed to put Y120bn into a new company with UFJ, the fourth largest
lender, to restructure or sell bad loans. They are not alone: bankers say
every "bulge bracket" investment bank with a presence in Japan has
approached banks to ask about forming some kind of relationship. MTFG, the
third largest Japanese bank, chose Morgan Stanley to help it raise Y360bn
from the issue of common shares. Mizuho hired Merrill Lynch to handle the
international tranche of its Y1,100bn issue of preference shares, which was
pulled yesterday owing to a lack of demand.

The moves prompt the question: why would US banks want to expose themselves
financially and reputationally to some of the most troubled companies in the
world?

The short answer is that Wall Street sees opportunity in Japan's
misfortunes. Struggling under the weight of an estimated Y52,400bn in bad
loans, Japanese banks are high on the agenda for Junichiro Koizumi, the
prime minister. US investment banks see recent moves by Heizo Takenaka, the
former academic who is now minister of the economy and financial services,
as evidence that Tokyo may at last be getting serious about implementing
banking reform. They also believe they can profit from resolving bad loans
or advising on mergers and acquisitions of the non-performing companies in
banks' loan portfolios.

Faced with the threat of nationalisation, the banks - long seen as the
proudest and most isolationist of all Japanese companies - see alliances
with western investment banks as a convenient way to fend off the
government.

Next month, the Financial Services Agency is expected to announce that its
latest inspection of the banks - ordered by Mr Koizumi - has revealed
further bad loans, forcing the banks to make additional loan loss provisions
to cover them. Without further capital raising, this would have eroded their
capital bases and could have triggered an injection of public money.

The country's five largest lenders - Mizuho, SMFG, MTFG, UFJ and Resona -
have already started a drive to bolster their financial strength by raising
additional Tier 1 capital - the minimum level of capital banks are required
to set against risk-weighted assets - by issuing shares. Total equity put on
offer by the top five has reached more than Y2,000bn. But this is still not
enough to stave off nationalisation - hence the decision to turn to western
investment banks. This is not a pro-active move, say Japanese bankers. "Even
foreigners' money," says one, "is better than government money."

That nationalisation is even on the agenda is a testament to the severity of
Japanese banks' problems. The sector, long mired in difficulties, is facing
what could be its largest financial crisis yet. Even with the additional
Y2,000bn in Tier 1 capital, average capital adequacy ratios will rise by
only 0.5 per cent. Analysts warn that balance sheets and operations will
still be hampered and non-performing loans will remain an underestimated
threat. "They may look a little better from a domestic perspective," says
one, "but from an international point of view they are still in a terrible
state."

Banks are scrambling to adjust their balance sheets. According to Ned Akov,
analyst at ING, banks have shifted assets from loans to Japanese government
bonds. Loans have fallen from 62.7 per cent of assets in March 1996 to 55
per cent recently, while JGBs have risen from 3 per cent of assets in 1996
to 9.3 per cent recently. "By shifting balance sheets from 100 per cent
risk-weighted corporate loans to zero risk- weighted JGBs the banks have
significantly eased the strain on the Bank for International Settlement
[BIS] ratios," he says.

Jason Rogers, analyst at Barclays Capital, calculates that the big banks
intend to reduce risk-weighted assets such as loans and equity holdings by
about Y40,000bn this year, equivalent to 7 per cent of gross domestic
product. "It is plain that these capital-raising efforts and sharp reduction
in risk-weighted assets [are] aimed at staving off full or partial
nationalisation."

There are also substantial pressures on operating earnings. More than 70 per
cent of net revenues are now generated from net interest income, six times
more than income derived from fees and commissions. The banks have been
trying to widen net interest margins but all the indications are that they
are failing. "There is minimal evidence of any increase in higher rate
lending over the past two years," says Mr Akov at ING.

Rather, he says, there has been a marked increase in low-rate lending. The
proportion of loans paying below the short-term prime rate rose from 6.9 per
cent in 1995 to 14 per cent in 1999 and 25 per cent in 2002. About 21 per
cent of all bank loans carry a rate of less than 100 basis points.

There are also serious questions about the quality of the banks' capital
owing to their reliance on deferred tax assets, otherwise known as "tax loss
carry forwards". New research from the FSA reveals that if the banks did not
use DTAs, their capital adequacy ratios would fall to 5.5 per cent, well
below the BIS-mandated minimum of 8 per cent. Mr Takenaka has instructed the
FSA to draw up new guidelines on the use of DTAs (which have yet to be
announced) but it seems certain that the new rules will limit their use and
thus weaken the banks' capital adequacy ratios even further.

The banks also face the more immediate threat of exposure to the stock
market through their securities portfolios. The Nikkei 225 recently fell
below 8,000 - a 20-year low - and the Topix index has fallen below 800
points. With the crisis deepening on the Korean peninsula and the outbreak
of war with Iraq looming, the markets are likely to decline further. This
means that the banks face unrealised losses on their portfolios, which must
be booked at market prices at the end of the financial year. Mr Rogers
estimates that if the Topix falls to between 700 and 750 points, unrealised
losses on the largest banks' equity portfolios would swell to about
Y6,500bn, taking the average Tier 1 and total capital ratio below the
regulatory minimum of 8 per cent.

Underlying all these concerns remains the nagging issue of bad loans. The
official FSA figure for the amount of non-performing loans in the entire
banking sector as of March 2002 is Y52,400bn, with the leading banks
accounting for Y28,400bn. But there are significant discrepancies between
official figures and those generated by private sector analysis. The biggest
estimate comes from Goldman Sachs, which puts it at $1,924bn.

The reason for the split is twofold. First, in a zero interest rate
environment, judging a bad borrower by its ability to repay interest on
loans is meaningless. Second, the banks have deliberately mis-classified bad
loans to avoid having to make provisions for them. "The banks have correctly
identified the broad list of potentially troubled borrowers [but] they have
overstated the quality of a significant portion of their credit," says Mr
Akov.

Officially, the banks deny they have mis-classified their loans; but they
privately admit they were forced to do so, either to avoid having to make
provisions for them or because they had long-standing relationships with the
borrowers and were reluctant to call in their loans.

The FSA inspections are targeted at narrowing the gap between the estimates
and reality. The results of the inspection are likely to reveal a more
accurate number. ING estimates that if the banks classify so-called "watch
list" loans correctly, they face additional provision payments of about
Y10,900bn. This makes the additional Y2,000bn in capital raised recently
from the equity issues look paltry in comparison.

The scope of the banks' problems underscores the size of US investment
banks' gamble. "Analysts in New York are worried," says Naoko Nemoto,
director for financial services ratings at Standard & Poor's. "They think
that being exposed to Japan's banks is not a very good idea. They have bad
transparency and there is a risk they might be nationalised."

But the banks believe that profits will be forthcoming from restructuring
non-performing companies through advising on mergers and acquisitions, which
generates fees, or from handling the disposal or restructuring of
non-performing loans. They will also gain access to banks' borrowers. For
example, documents filed to the US Securities and Exchange Commission
regarding Goldman Sachs' investment in SMFG show that the US bank will have
"certain rights with respect to assets sales of SMFG and its affiliates and
debtors".

Internal research from a western bank obtained by the Financial Times
reveals how lucrative their commitment to Japan's banks could be. The
research shows that one US fund's investments during 1997-98 returned an
internal rate of return of more than 35 per cent and its investments in 2002
are projected to return more than 25 per cent.

NPL investments as a class have performed well and investors have produced
leveraged returns in excess of 15 per cent since 1997, the research finds.
The report also says: "NPL buyers are predominantly non-Japanese opportunity
funds [such as private equity funds] and investment banks. Japanese groups
have generally not been active in this market because of the stigma
associated with making a profit from someone else's misfortune."

The market for bad loan resolution is enormous. Estimates of the total size
of the bad loan problem range from $437bn (the government's estimate) to
$1,924bn, between 3.5 and 15 times greater in size than the $126bn US
savings and loan problem in the early 1990s. Mark Grinis, managing partner
at Ernst & Young, points out that when the FSA completes its inspections in
April, more companies will be forced to conduct a restructuring through
mergers or acquisitions and more loans will be made available for work-out.

Mr Grinis believes that conditions are right for Japan to finally tackle the
problems in its banking sector. "This," says Mr Grinis, "is the beginning of
the year of the NPL."

Indeed, the moves by the international banks suggest that foreign investors
see Japan as a credible investment opportunity. They are also a vote of
confidence by the international financial community that the country may not
be a meltdown in the making; it may in fact stand a chance of sustained
recovery. But if Wall Street is wrong, its gamble could cost it dearly.

Goldman Sachsand SMFG assuage sceptics

When Goldman Sachs said in January that it would invest Y150bn ($1.3bn) in
preference shares issued by Sumitomo Mitsui Financial group, Tokyo bankers
were cynical about the terms of the deal. "You can screw a Japanese bank but
you can't screw them that hard," said the head of one international
investment bank.

To some in the Tokyo financial community, it appeared that SMFG,in a
desperate attempt to raise capital, had agreed to hand over its balance
sheet, a lot of cash and access to lucrative investment banking mandates
from its clients. "[It] was the best [proprietary] deal in town," said
another senior banker.

Even before the deal, foreign capital was viewed with scepticism in Japan.
So-called "vulture" capitalists had a reputation for seeking to pick up
prime assets cheaply, profiting from the country's economic misfortune.

At issue in this particular deal was the guaranteed annual dividend on the
shares of 4.5 per cent, the 67 per cent downside protection on the
conversion price and loss protection provided by SMFG worth up to $2.125bn.
This allowed Goldman Sachs to issue investment-grade credits and have
potential losses covered by SMFG. In addition, a filing to the US Securities
and Exchange Commission offered clues about the ancillary benefits: "They
are entering into an agreement that will afford Goldman Sachs certain rights
with respect to asset sales of SMFG and its affiliates and debtors, SMFG's
equity related offerings [and] investment banking services for SMFG and its
affiliates and customers."

Last, once the US bank's preference shares were converted into common
shares, worth about 7 per cent of the bank, it stood to benefit from any
share price appreciation.

In return, SMFG received a 0.43 percentage point boost to its capital
adequacy ratio, needed because Financial Services Agency inspections into
its bad loans meant it faced making additional provisions and therefore
wanted to strengthen its capital base.

But accusations that the US bank manipulated the Japanese bank are something
both sides dispute. They say that Goldman Sachs was the first international
bank to invest in a troubled Japanese lender and deserved a premium for
doing so.

They add that SMFG will receive sizeable fees from Goldman Sachs as part of
the investment and that the yield available on the preference shares is less
than that offered on similar shares issued in 1998. And SMFG will receive 95
per cent of the fees generated by Goldman Sachs from the provision of
commitment lines to investment-grade borrowers, potentially generating tens
of billions of yen in earnings.

The US bank will also take on the staffing and marketing costs associated
with the commitment lines, so that SMFG receives 95 per cent of the revenues
from the lines and incurs virtually none of the costs.

"The scheme has the advantage that it enables SMFG to hedge liquidity risk
completely and reduce operational costs substantially, compared with
traditional transactions in which a bank itself offers commitment lines,
while it has the same risk/return profile," an SMFG official says.

The official also points out that in 1998 the bank issued $1.8bn worth of
shares, which carry a dividend of between 8 and 9 per cent in US dollar
terms, equivalent to about 5 per cent in yen terms, indicating that the
terms of the Goldman Sachs deal were not especially generous. He also says
the US bank is "naked long", meaning it cannot hedge or transfer its
investment for two years, which helps to justify the dividend.

While the terms of the deal are indeed favourable for Goldman Sachs, the
notion that SMFG got a raw deal is too strong. That honour could perhaps go
to JP Morgan Chase, which originally had the idea of an alliance with SMFG,
suggested it to the Japanese bank and then watched Goldman Sachs go through
with it.

As a consolation, JP Morgan Chase was offered a joint lead managership of a
subsequent Y345bn share issue from SMFG. The other lead managers came as no
surprise: Goldman Sachs and Daiwa SMBC, the investment banking arm of SMFG.