The UK has it’s first bank run in 150 years. Citibank fired it’s CEO. The whole financial world is reeling from the financial mess called subprime (see here for our easy to understand footnote on subprime).
Even GM (last I checked they made cars and not houses!) has been forced to book a multi-billion dollar loss due to subprime. While hedge fund managers are collapsing left, right and centre, could there possibly be a Saviour? What’s that I see on the horizon? Is it a bird? Is it a plane? No… it’s a Japanese farmer!???
This sort of turmoil in the international financial market is unusual. In July Ben Bernanke, head of the US Fed, saw subprime losses reaching $100 billion US dollars. By early October, most market watchers had increased this figure to $400 billion US dollars. And with yet another collapse in asset backed securities (ABS) prices in the last few weeks, the growth in the turmoil seems to be growing again.
Perhaps what has been scarier has been the vast number of “respectable” financial institutions who have been hit. I’m still amazed that Bear Stearns was forced to go crying to the Chinese government for a bail out after its two hedge funds blew up over subprime. First Merrill Lynch and now Citibank announce huge multi-billion dollar write-offs for losses in the subprime investments that they claimed they never had. While we haven’t seen that many losses amongst Japanese financial institutions, the share prices of Japanese banks have collapsed on the assumption that they inevitably have lost a lot of money on subprime, but they probably just haven’t realized it themselves yet. (Three cheers for Japanese corporate governance standards!)
So why, you ask, is stippy.com boring you with a commentary on the subtleties of losses by US investment banks in exotic derivatives crafted around the hopes and dreams of rural Americans who thought that their home prices would continue to rise for ever? Well there is one Japanese organization who has been taking an active roll in this financial ponzi scheme and they are not taking the losses sitting down. In stark contract to the Yanks who are all too keen to take samurai style responsibility and resign after such losses (think Chuck Prince at Citibank), you won’t see a single person at this mysterious Japanese organization do anything like that. In fact they are standing up, and taking the losses in the stomach like Asashoryu (朝青龍） when he’s playing soccer back in Korea (bad example maybe?). Who am I talking about? I’m talking about the proverbial Mr. Watanabe from the inaka, our friendly neighbourhood farmer. A little confused? It’s a little known secret, that Japan’s farmers control one of the largest banks in the world. With 68 trillion yen of assets, the Norinchukin Bank (農林中金) has been one of the biggest Asian players in the bank rolling of credit to subprime lenders. You don’t regularly borrow money from your local rice growers, you say?
Norinchukin often hides behind the better known face of its sister bank, JA bank, the official window to the farmers of Japan. While it plasters its homepage with the word agrifinance (担い手金融、ninaite kin’yu） pretending to be the financier to the farmer, in reality it dedicates only a tiny portion of its time (and less than 20% of its assets!) to lending money at all. In reality it (and the fishery bank and the forestry bank) channels the vast majority of it’s assets to the Norinchukin to manage. Why lend to a local farmer yen for 1~2% interest when the Norinchukin will help you earn double digit returns lending dollars to un-creditworthy American workers? Given that the JA bank has about 80 trillion yen ($750 billion US dollars!) of farmers deposits, it’s no surprise that they need a dedicated body to work out how to manage these funds.
When I first read that the Norinchukin Bank had lost about 500 million US dollars in the first half of this year in subprime related investment, I have to confess that I was a little condescending. After all, What more could you expect from a bunch of imokusai country bumpkins dabbling in the financial matters of American blue collar workers? What stopped me in my tracks was this thread on 2 channel, Japan’s leading BBS site. At first I thought I’d misread it (after all it is in Japanese). But no, even after a second appraisal it seems that the guys at Norinchukin are potentially the ballsiest farmers in the world. Not only did they admit that they have invested over 4 trillion yen in various securitized derivatives to date, the head of bond trading has signalled to the market that the bank is going to invest another 3 trillion yen into this troubled market before the end of the year! When every single Western bank is racing to hedge their exposure to subprime by purchasing vast quantities of credit default swaps, it seems that the only investor with enough confidence to stick up for himself, fight back, protect his position and buy more (a true example of 逆張り, gyakubari) is this odd collection of Japanese farmers. That man – a 3 trillion yen big swinging dick – I take my hat off to.
The ability to take risk is the best definition of a professional investor. Think back to the famous Chandler brothers from New Zealand who had the guts to buy 5% of UFJ Bank back in February ‘04 (full story here). UFJ’s share price had fallen 90% in two years and it was market consensus that it and almost all other Japanese banks would go belly up. The people who best knew Japan – the local investors – called them crazy but low and behold (despite the stock falling 30% in the month after they bought it), UFJ bank’s share price then rallied 6 fold within the following 12 months. Does something sound familiar? Domestic investors (read Citibank, Merrill Lynch) are panicking and selling/hedging out their exposure to sub prime. As you can see from the chart below prices in all but the safest sub prime portfolios have fallen off a cliff steeper than the Mino waterfall (箕面滝)!
Unless you’re a shareholder of Livedoor, I’m sure you’ll agree that losing 80% of market value in such a short time is not common. Remember, each of these lines represents a diversified portfolio of loans. If the market thinks that all of those loans will be repaid without a problem then it should never trade below 100 (which means 100 cents in the dollar or 100% of the loan will be returned to the lender on maturity). In other words, the market is trying to tell you (and the Japanese farmers) that 8/10 owners of houses whose mortgages make up the BBB-tranche will not be able to repay their loans. They’ll go bankrupt when they finally realise why they should have read the “fine print” before they signed off on the loan. That’s pretty extreme. You can see why Norinchukin are getting excited. If US housing prices pick up, enabling America’s low income workers to escape bankruptcy then that red line should trend back to 100. Buy at 20. Sell at 100. Five times your money. Very nice. (Obviously the risk is that if you’re wrong you lose everything, but let’s not focus on the downside just yet).
Taking huge and controversial risks is nothing new to Norinchukin. Not only do they have the biggest non-JGB (Japanese Govt. Bond) portfolio of all banks, they are also by far and away the largest Japanese player in the “alternative investment” market (otherwise known as hedge funds). Although it is quite normal for Western banks and insurance companies to invest in a wide range of investment funds, the world of exotic finance (read “positive returns”) has been taboo in the deep, low backed, 1970s style leather seats that deck the boardrooms of Japanese banks. Not so for our rice growing friends. While Japanese banks spent the last five years trying to squeeze half a percent of interest out of their troubled borrowers, Norinchukin cut it’s loan balance by a third and instead increased its investments in derivatives and funds by 50% (source). In addition to a handy 15 trillion of investments in foreign debt related investments (aka subprime), they also have another 15 trillion yen of “alternative” investments. Between these two asset groups that accounts for almost half of their entire asset base. I don’t know about you but that makes my 401k pale in insignificance. Norinchukin has been funnelling cash by the barrel load into hedge funds, private equity funds, subprime loans, etc for years. I wonder how much longer they will get away with calling themselves a bank. The “real” banks in Japan are too scared to take on these risks due to the high BIS penalty associated when calculating their regulatory capital (in laymans terms, they don’t have the financial strength to withstand the potential losses from anything riskier than a Japanese government bond). It was these same “real” bankers that thought the shift to Basel II would be enough to scare even Norinchukin from continuing its investment strategy but this gutsy proclamation to double up (難平買い, nannpinngai) on subprime will prove them wrong. It’s rare that I take a step back and say “wow” with respect for the risk taking of Japanese management, but this is one of those times. Farmers 1. “Real” bankers 0.
So what is subprime and why is what Norinchukin doing so amazingly risky? Let me try to describe the current problem with subprime (and why it is given the nickname “toxic waste”).
Although we’re used to low interest rates here in Japan, the low interest rates in the US for the past 10 years were unusual and triggered a perception that money was almost free. Even people who had low incomes could afford to buy a house because the monthly repayments necessary were a very small part of their disposable income. Land prices continued to rise (did someone say bubble? not me!), so it was unlikely that these borrowers would have any trouble repaying their loans. Worst case scenario, you could sell your house for a profit to repay the loan. Couldn’t be simpler! The concept was so popular that a bunch of cunning businessmen (who had never worked at banks) decided that they’d make these loans available to even the lowest of income earners in America. Because they didn’t know much about the business, they focused on the marketing of the loans. I’m sure you’ve seen those annoying ads on the web:
- No down payment required!
- No proof of income required!
- No repayment of principal needed!
- Special discount interest rates!
Too good to be true? Of course it was. But nobody even bothered to read the small print. The “special discount interest rates” had a life-span of only 2 years. Most of the loans had “resets” at the start of the third year that rocketed the interest rate up to over 10%. Even on these reduced “special” interest rates, these low income borrowers were on average paying away about 1/3 of their pre-tax incomes (assuming of course they didn’t lie about their salary on the application form). It should be no surprise to you now that most of the blue collar workers are going to struggling to foot the interest bill at the higher rates (let alone the principal). Oh and by the way, housing prices have been falling for the past year so their house isn’t even worth as much as it was when they bought it. The vast majority of these loans were done in the three years between 2004-2006. As anyone who can do simple addition has probably already worked out, the “special” interest rates on those loans are going to be rest to “normal” rates, one by one between 2007-2009. It’s no coincidence that the first of these reset periods coincided with the huge losses that American banks have been announcing since July.
But hold on a sec, just because a couple of home owners go bankrupt, the law of large numbers should mean that the losses are limited, right? This is where the magic of investment banks comes in. American Investment banks aggressively bought all of these loans from the cunning marketers and created “diversified” funds that consisted of the loans to hundreds and hundreds of home buyers. Better yet, in order to make these funds more attractive to their clients (naive US banks, General Motors, Norinchukin etc) they split the funds up into several tranches. Each trance had it’s own credit rating and you can see the price of each of those tranches on the chart (with the coloured lines) above in this article. The pink AAA tranche (the one that is only down a little bit) is structured in such a way that you only lose money as an investor (ie get less than 100 at maturity) after 20% or more of all of the home owners have gone bankrupt. The green AA tranche is structured in such a way that you only lose money (ie don’t get your original 100 back) after 15% or more of all of the home owners have gone bankrupt (but you lose all of your money if 20% or more of the home owners have gone bankrupt). The blue A tranche is structured in such a way that you only lose money after 9% or more of all of the home owners have gone bankrupt (but lose every dime if more than 15% of home owners file for bankruptcy). I think you are starting to get the picture. Pretty much everything below A is known as toxic waste. We then skip a few tranches, but the red BBB-tranche is structured in such a way that if more than 7% of home owners go bankrupt then you will lose every grain of rice you invested in the fund. (Check this website for more up to date prices on each of these tranches)
So why is it so risky investing in subprime now? Put simply, those friendly “resets” will continue at the same pace for at least the next 12 months if not more. If we are already seeing huge numbers of personal bankruptcies after 2-3 months of resets, how will this be after we see the ”resets” hit tens times as many home owners. Things are going to get a lot uglier before they get better.
Finally, let me leave you with my favourite subprime quote out there. It’s from an Aussie called Nick Parsons (from NAB), who was commenting on US treasury secretary, Hank Paulson’s (an ex-Goldman Sachs investment banker) plan to bail out a bunch of these funds:
“By insulating the junk from the sellers of junk, the holders of junk should be spared the problems of junk. The one flaw in this cunning plan, however, would be if investors took fright at being reminded just how much junk is still in the system.” I guess that is what we have Japanese farmers for.