Default debate impacts Japan

Japan’s credit derivatives industry will closely watch the results of the first meeting of the International Swaps and Derivatives Association’s new credit derivatives committee on market practices, on March 12. Committee members will be groping for a solution to the most controversial issue to hit the industry in its short existence.

The emotive subject, which turns on whether corporate debt restructuring should trigger a swap default payout, erupted last September when a group of 10 major banks in New York arbitrarily changed the rules. This resulted in a two-tier US market, with higher prices for default swaps that include a debt restructuring clause.

Although Isda has an existing credit derivatives committee, this is chiefly comprised of lawyers dealing with documentation. The first meeting of the new committee, aimed at bringing together deal-makers and traders, will video-link London and New York. Market heavyweights will chair each end – Blythe Masters, head of JP Morgan’s structured credit products in New York, and Paul Varotsis, executive director for structured credit trading at Lehman Brothers in London.
In Japan, the level of corporate restructuring is making the issue especially significant. Under present Isda documentation, a debt restructuring is one of several credit events – along with bankruptcy, failure to pay and debt repudiation – which oblige the seller of protection in a credit default swap to pay out. But the Japanese big banks, which are often large sellers of protection, say that creditors and lenders (buyers of protection) often do not lose out when a company restructures its debt, and therefore receive a windfall gain from a default swap payout.

Among the possible solutions is a deletion of the restructuring clause from Isda documentation, or a new form of wording that draws much more tightly the
circumstances in which the clause is activated. Bank regulators are saying that if debt restructuring is not included in default swap contracts, there will have to be an increase in the amount of capital that banks must maintain against such deals.
For default swap traders in Japan, the problem is not just the high level of corporate restructuring, but also the lack of transparency surrounding such events and the close relationships between banks and their customers, says Terry Tanaka, head of legal and regulatory affairs in the international treasury department of the Industrial Bank of Japan, and an Isda board member. It is often very difficult for a protection seller to know what really goes on behind closed doors when one or two banks restructure their loans to a corporate customer. He cannot know which loans have been restructured, whether the creditors have actually lost any money, or whether they have received additional collateral. It creates the conditions for abuse, says Tanaka.

Whirlwind growth

Weather derivatives trading in Japan will see very rapid growth in 2001, with volumes tripling or quadrupling compared with activity over the past 18 months.
According to Jonathan Whitehead, vice-president for trading and origination at Enron Japan, a subsidiary of the Houston-based Enron energy group, the market in these products, although still in its infancy, is “moving very fast. We are starting to see the Japanese energy companies taking a lot of interest”.
Until now, the leading participants in this market have been financial institutions, such as reinsurance companies and banks. Although there have only been about 30 or 40 transactions since the market got going in the latter part of 1999, half of those have come in the last three months, says the Tokyo-based Whitehead. He predicts liquidity in the market will increase significantly in the coming months.

Jonathan Whitehead, Enron: “We are likely to begin getting linked deals”
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Big deals
At the moment, individual transactions are much bigger in Japan than in either the US or Europe, where a typical deal would mean having $1 million at risk. Japanese deals tend to be 10 or 20 times bigger, according to Whitehead. The reason is that many of these are undertaken by insurance companies, “which tend to be aggregators of much smaller risks. They then lay these risks off in one large transaction”, he says.
The chief forms of weather derivatives are heating or cooling degree-day swaps, which commonly use a reference temperature of 18°C (people tend to turn their heating on at temperatures below that level and the air conditioning on at temperatures above that level). The fixed leg of the swap is an agreed value, while the payout on the floating leg is determined, in the summer months for example, by the number of cooling degree-days during a specified period. However, in Japan, options on swaps are the most popular, partly because they are preferred by financial institutions.
Deregulation of the Japanese energy markets is set to give a big push to the expansion of weather derivatives. “As in the US and Europe, deregulation is the catalyst,” says Whitehead. Electricity deregulation is just getting underway, and foreign energy companies are now allowed to compete. The first phase came a year ago, when transmission grids were opened up to all electricity generators over a certain size.
“As we get a more liquid electricity market, and a greater acceptance of weather derivatives among other energy companies, such as the oil firms, we are likely to begin getting linked deals,” predicts Whitehead. This could mean, say, having weather derivatives embedded into electricity supply deals, where the amount provided is determined – on a sliding scale and at a pre-set price – according to the number of days the temperature is above or below a specified temperature. Such linked deals would be particularly applicable to the market in kerosene, which is widely used for heating in Japan. That would be an ideal commodity to link to weather derivatives, says Whitehead.

JapanRisk Comment

Japan seems poised between two paths. Option number one would mean that the nation achieves what it has not been able to do convincingly for nearly a decade now – reform the way it handles credit risk measurement and management throughout its entire economy. Option number two is to keep muddling along, with politicians implementing stop-gap measures designed to stave off the inevitable.
This is certainly a scenario where fortune would favour the bold. The right moves on the part of the Japanese government could avert disaster and put the country on the path to recovery. A failure to act could result in a repeat of the nation’s “lost decade” of the 1990s. Either way, the credit risk industry stands to profit – by playing a part in cleaning up credit messes, or helping implement new risk measurement and management systems.


In this special issue, JapanRisk, the staff of AsiaRisk look at the entire credit risk picture. Contributing editor Melvyn Westlake travelled to Tokyo to write a trilogy of articles on the subject. The first piece looks at the fundamentals that are driving the overall credit risk deterioration and how this could play out over the longer term. Then he turns his attention to the subjects of securitisation and credit derivatives, to examine how these tools are being used in Japan to help banks put their books to rights.
Furthermore, AsiaRisk deputy editor Nick Sawyer looks at the internet-based derivatives and foreign exchange trading platforms that are springing up across Tokyo, and how the unprecedented access and transparency that these will bring to the markets will help boost the use of those products.
The Risk Waters Group hopes that this will be the first of many new products – both from the editorial and the conference division – geared towards the needs of Japan’s risk management community.