Escape route for troubled banks

Japan’s banks are starting to use credit derivatives to manage their balance sheets. The creation of synthetic portfolios as a way to reduce loan exposures should spur the credit derivatives market to new heights. Melvyn Westlake reports from Tokyo
Credit derivative specialists are sometimes viewed as medieval alchemists transmuting base metals into gold, complains a Tokyo-based practitioner of the most recent of the two recondite occupations. “Some creditors think that these derivative products will magically transform their bad loan books. Of course the alchemists didn’t have much success either,” he quips.

James Singh, UBS Warburg: Credit derivatives are now linked with other instruments to create credit solutions
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Magic may not be possible, but demand for credit derivative products is expanding very fast in a country where credit distinction was an alien concept until quite recently. Indeed, conditions in Japan are more favourable to growth and innovation in the credit industry than ever before, say deal arrangers and traders.
Not only is Japan’s investor base for credit risk products broadening, but there are the first signs that domestic creditors are beginning to hedge risk or consider shrinking their balance sheets, spurred on by corporate restructuring and merger activity. The credit derivatives business in Japan, which is really only four or five years old, has been growing at an annual rate of 100% since 1998, reckons Malcolm Perry, vice-president for credit derivatives trading at JP Morgan in Tokyo. This year should see a further 50% to 70% increase – off a larger base – he predicts. In trading volume terms, the equivalent of $1 billion to $1.5 billion of business was going through the market each month in 2000, Perry estimates. The figure for 2001 is likely to be around $2 billion.
Also changing is the character of the business. In the early days, the market was driven by participating Western banks hedging their own positions. “But in the past 12 or 18 months, these derivatives have become another investor product. And now the business is often driven by investors looking for assets, because if you can get an asset in derivative form, you will get a better yield than from a cash instrument. The problem today is often finding the risk exposure,” says Perry.
Japanese banks that are anxious to generate income are easily the largest investors, he says. By selling protection – that is, taking the credit risk on a particular debt through a default swap – these banks can often earn three times what they get from the loans they make to the same corporate debtors, Perry adds.
However, the Japanese banks, which hold huge credit exposure, have not tended to be buyers of such protection (sellers of risk). Not least of the reasons is that a premium of, say, 150 basis points, would in many cases be higher than the income from the loans (at perhaps 50bp).
Seeking exposures
As a result, the intermediary banks, chiefly the Western institutions, have spent a lot of time trawling the market for the kind of credit exposures that might interest investors. Foreign institutions holding Japanese debts have been one source. Repackaging Japanese convertible bonds (CBs) provides another. Such bonds are widely held. A derivatives house will typically seek out the holder of CBs, possibly a western hedge fund, and offer to strip out the equity, which the fund is happy to retain. The credit exposure in the bond will then be repackaged in a default swap and sold to Japanese investors, such as city banks, regional banks, life insurance companies and even some of the more cash-rich companies, explains Guillaume Barrier, head of credit derivatives at BNP Paribas in Tokyo.
But this pattern, where Japanese risk-takers are plentiful and risk-sellers scarce, is about to change, according to market participants.
In the US and Europe, according to Tokyo-based Jeffrey Zavattero, Deutsche Bank’s head of global credit derivatives – Japan, “banks are increasingly seeking to reduce their risk, particularly when it is highly concentrated. And they are starting to assign fair market values to this risk. In some cases, financial institutions are looking more closely at the levels of return on equity, in response to shareholder pressure. This is going to happen in Japan, too.” Deutsche Bank claims to be one of the two biggest players in the market, along with JP Morgan.
Now is the time when Japanese banks are most likely to go down this route, he says, because they are having so much trouble raising capital. It has been extremely expensive for them to do so. They have capital targets, which many of them cannot meet. “So instead of concentrating on the numerator in the equation [the level of capital], they should look at the denominator [the level of loans]. Credit derivatives provide a way for them to shrink the denominator,” argues Zavattero.
There are also other factors at work. Corporate restructuring and mergers, particularly in the banking industry, are resulting in concentrations of credit risk far higher than desired. The merger of Industrial Bank of Japan, Dai-ichi Kangyo and Fuji Bank – which is likely to be completed in April 2002, creating the huge Mizuho Financial Group, with assets of $1.4 trillion – is just the most glaring example of where high-risk concentrations seem inevitable.
As well as the long-term structural developments that are likely to drive the credit derivatives market, there are some shorter-term cyclical ones. A trader of these derivatives at one large US investment bank in Tokyo says that the development of the instrument’s usage in Japan follows the bear market cycle. “The more bearish people are, the more volume you see,” says the trader. “Credit derivative usage in Asia and Japan boomed in 1997 and 1998, as the financial situation deteriorated first outside Japan, and then in that country,” he says. “There was big speculative interest from banks wanting to ‘short’ credit spreads as they widened, as well as foreign institutions trying to hedge. After the crisis passed in 1999, things calmed down, credit spreads narrowed rapidly, and credit derivative trading volumes dropped as the fear factor declined. But since the final weeks of 2000, many negative factors have returned to the market. Foreigners are again looking for protection on an increasing scale,” the trader says. “And there are many betting on another crisis erupting in Japan in the coming months. They are ‘shorting’ Japan credit. If they are right and credit spreads widen out a lot further, they are going to make a lot of money,” he adds.
Zavattero adds in somewhat more muted terms: “The widening of Japanese credit spreads is causing a fair amount of volatility in them. This is creating trading opportunities that did not exist when everybody believed that companies in Japan had an implicit government guarantee and that their debt would trade at the same level as government bonds. Until the financial situation started to deteriorate ahead of the 1998 banking crisis, there was rarely any kind of credit spread movement or volatility at all.”