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The U.S. subprime loan problem is turning into a serious financial crisis, and the sense of uncertainty in the markets shows no sign of clearing out despite the considerable efforts of the governments and financial authorities in the U.S. and Europe. In Japan as well, we believe that the continued widening of the credit default swap (CDS) premium combined with the risk of an economic downturn presents a major turning point in the market. Resuming from where we left off on the subject (Japan Credit Perspectives, October 2007), let us consider the possible timing of a bottoming out in the subprime troubles and the outlook for Japanese credit markets. The report will also touch upon the situation in the U.S. and Europe in connection with this theme based on the estimates and analysis of this author, who takes full responsibility for the report’s contents.

Subprime developments force adjustment in bank business model
The subprime difficulties began with the failure of mortgage lenders such as New Century in February-March 2007 and led to the collapse of several hedge funds in May-June, culminating in a liquidity crunch in asset-backed commercial paper (ABCP) markets in August. Subsequently, from October on, we saw massive losses and related capital infusions at major financial institutions in the U.S. and Europe. In other words, the problem spread from the periphery of the banking world to the core of the banking system itself, and from a liquidity crisis to a full-blown threat to the solvency of financial institutions. (Figure 1) This indicates that the subprime loan problem is not just a matter of bad debt due to a correction in housing prices; the very structure of financial markets that has taken shape over the past several years now needs to be reconsidered. Several factors – the bursting of the U.S. housing bubble, the unwinding of financial product leverage, the mounting liquidity risk of off-balance bank vehicles such as ABCP and structured investment vehicles (SIV), complications from a diffusion of risk and a lack of transaction transparency, and an adjustment in the unduly tight risk premium – have converged to undermine the foundations of financial markets.

Overview of subprime problem
A rash of financial woes have recently made headlines, including the liquidity crunch in ABCP and SIVs, the deteriorating creditworthiness of monoline insurers, and questions over the viability of government sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac. To understand how these are linked to the subprime issue, let us turn to the overall subprime drama with a summary of the main players and their roles. (Figure 2) We estimate that nearly 70% of subprime home mortgages are securitised (around 40% of which are re-securitised) and held by financial institutions and investors. Financial institutions such as banks and securities brokers hold an estimated 40% or around $800 billion of all subprime loans, and some also hold nearly $100 billion in SIVs. Fannie Mae and Freddie Mac have around $200 billion of subprime-related assets on their own investment books, while monoline insurers guarantee $900 billion in residential mortgage-backed securities (RMBS), including asset backed securities (ABS) and collateralised debt obligations (CDO). The subprime chaos involves all of these players, creating a chain of credit-related fears.

We examined in our previous report how the subprime loan problem evolved into a financial market liquidity crisis. We now turn to the troubles that have since emerged at monoline insurers and GSEs.

Rating downgrades for monoline insurers
Monoline insurers were established in the 1970s as institutions that guarantee municipal and other public-sector bonds. (They currently guarantee $1.5 trillion in such bonds.) In recent years, they have moved into a wider range of securitised products, and provide guarantees for $900 billion in (primarily high-rated) RMBS and other products. Four companies – MBIA, AMBAC, FGIC and FSA – account for an overwhelming 90% share of the market. Given the nature of the financial guarantee industry, a AAA rating is considered essential for business. However, with the nosedive in ABS market prices in October and November, when the “AAA” ABX index plunged 30%, the insurers posted valuation losses that led to a reduction in capital. This in turn caused rating agencies to place their AAA ratings on review for possible downgrade. A downgrade in a monoline insurer would trigger a rating cut for assets it guarantees, leading to yet another downgrade in the insurer that would initiate a downward ratings spiral. The ultimate risk is that the products and markets underpinned by monoline insurer guarantees could cease to function. Moreover, the psychological effect from damage to the insurer’s credit guarantee, the bedrock of its credibility, could have a powerful impact on the entire market. The major monoline insurers are seeking capital increases to avoid a downgrade, and we do not foresee a downgrade escalation that could heighten actual systemic risk. Still, the situation looks to remain touch and go until ratings stabilise again.

Problem with Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are GSEs, as they are privately held corporations with implicit government guarantees that grant them AAA status. They enjoy a number of preferential measures, including an emergency credit line of $2.25 billion from the Treasury Department, and exemption from corporate taxation and from registration of their bonds with the SEC. Also, banks have no limitations on the volume of GSE bonds they are allowed to hold. The problem began with the announcement by Freddie Mac in November of a $2 billion loss in the third quarter, which prompted the Office of Federal Housing Enterprise Oversight (OFHEO) to order the firm to boost its capital. Shares of both Freddie Mac and Fannie Mae plummeted, sparking fears in the market of a drop in the creditworthiness of GSEs. However, we should note that Freddie Mac’s losses were related strictly to subprime investments in its own investment book and did not imply any decay in the quality of its securitised and guaranteed agency mortgage backed securities (MBS). Given the importance of GSEs for the U.S. housing market, we believe that the implicit government guarantees will remain in place and that agency MBS and other senior bonds will retain their AAA ratings.

Lessons of Japan’s bad loan dilemma
Returning to the real problem, let us consider anew what is needed in order to bring the subprime mess to an end. Market stabilisation packages implemented or planned by governments and central banks include banking system stabilisation measures (e.g., liquidity provisions and deposit guarantees), monetary measures (rate cuts) and debtor rescue strategies. Private financial institutions have also taken initiatives such as a bridge facility for problem debt (e.g., the subprime rescue fund) and an increase in equity capital. These steps remind us of the initiatives adopted for Japan’s bad loan problem. While some observers may feel that the subprime issue is completely different from Japan’s case where the problem was concentrated in the banks, with the situation threatening bank solvency, we believe that the problem at its core has many close similarities to Japan’s bad loan days. Japan’s experience taught us that: 

1. Asset inflation cannot be halted artificially.
2. Putting off a solution simply deepens the ultimate pain.
3. Financial markets will not stabilise until financial institutions dispose completely of all their bad debt.

We believe these lessons apply directly to the subprime loan situation. While the measures above help to some extent, they are not a cure on their own.

Conditions for market stabilisation
In addition to driving the stock markets downward, the subprime loan problem had an even more severe impact on the credit markets. The credit market turmoil stems from the virtual halt in the brokerage function of the financial institutions, the very lubricant of the markets, due to a drop in their risk-taking capability. In this sense, we consider the credit market chaos to be the result of a liquidity crisis in financial markets and, going further, of the weak financial standing of financial institutions. A recovery in bank finances would mean the complete disposal of losses and a restructuring of capital. In other words, the road to resolution will take considerable time.

Road to resolution
In order to measure the distance to a resolution of the problem, we need to estimate the extent of the valuation losses in subprime loans and related products. There is no clear answer, but data from the International Monetary Fund (IMF) and the Organization for Economic Co-operation and Development (OECD) suggest subprime losses of $300 billion. Roughly speaking, this is equivalent to 15% (40% default rate times 40% loss rate) of the $2 trillion in outstanding subprime home mortgages including Alt-A loans. However, judging from losses announced recently by financial institutions, we believe that actual overall subprime losses come to nearly double this figure or approximately $500 billion. This is because in addition to losses on subprime loans themselves, there were also steep valuation losses on other securitised products that make up nearly half the total. Financial institutions have an exposure of about 40%, so we believe that their latent losses amount to $200-250 billion.

Let us now examine the disparity between these potential losses and the actual losses (including valuation losses) posted by financial institutions. Losses declared by the major banks as of the end of last year came to around $100 billion, roughly 40-50% of the estimated latent loss. (Figure 3)

Next is the sensitivity of the banks’ financial strength to changes in their latent losses. In fiscal year 2006, the year prior to the outbreak of the subprime loan problem, large financial institutions in the U.S. and Europe (50 top banks and 10 top securities firms) posted net worth of $2.5 trillion and annual net profit of $300 billion. The latter figure is greater than the aforementioned $200-250 billion in subprime related losses. A further increase in those latent losses would eat away at the banks’ net worth and could develop into a threat to their solvency. However, we believe that over half the risk has been passed on to general investors through securitisation, and see little chance that the financial system as a whole will fall into insolvency. (Figure 4) In addition, the latent losses are concentrated heavily in the major banks, which had put together securitised products and dealt in ABCP, SIVs and such. That is, the burden was not spread evenly but borne mostly by a small number of major financial institutions. Recent reports that a major European bank had raised capital double the size of its losses is best understood in this context.

From this perspective, the financial industry seem to have come only 40-50% of the way in sorting out the problem, meaning a full bottoming out in financial institution fundamentals and a comeback in financial markets are not likely any time soon. Considering the pace at which banks have acknowledged their losses to date, we believe that this process will take at least two quarters. Still, if the industry can clean up in less than one year a problem that took Japan 15 years to resolve, we would consider this exceptionally speedy. The presence of active suppliers of capital such as sovereign wealth funds from the Middle East and Asia should also be a major help for financial institutions.

Nevertheless, the stress in the markets could linger for an extended period even after the financial system crisis settles down. For one, we believe that loss write-offs on securities by investors other than financial institutions will not be resolved easily. Also, there could be a further increase in losses stemming from the drop in housing prices.

State of Japanese credit markets
We now turn to the state of Japanese credit markets. While subprime and CDO losses at Japanese financial institutions do appear to be higher than initially estimated, we believe that the total will be modest, considering overall profits. The Financial Services Agency puts the exposure of Japanese banks to subprime loans at $11 billion. Losses announced to this point are around $5 billion. It is difficult to pinpoint the exact amount due to the ambiguous definition, but even if the losses should double, they could easily be covered by annual earnings flow. Liquidity is also flush in financial markets, and we cannot foresee a systemic risk as in the U.S. and Europe that might upend the credit markets as a whole.

Still, the impact from global widening of spreads is gradually permeating the Japanese credit markets. For example, in the CDS market, there has been a prolonged weakness in hedging activity by overseas investors. The CDS index (iTraxx Japan), which had narrowed to 30 basis points in September-October, began to widen again in November, reaching 50 basis points at one time. It stands now at around 40 basis points. (Figure 5)

Growing linkage with overseas trends
Japanese credit markets are a colossal local market and tend to move on factors that are relatively independent from U.S. and European trends. However, the linkage between Japanese and overseas markets has been strengthening over the past several years, and we can no longer ignore the impact from abroad. For major suppliers of funds such as banks and nonbanks, for instance, bond offerings in overseas markets, once used sparingly as a way of raising funds, have grown in importance as a safety valve for adjustments in supply and demand at home. Deterioration in the bond issuance environment abroad could cause this safety valve to function improperly.

Japanese corporate bond markets offer the cheapest means in the world at present for issuers to raise money, and we expect the volume of bond issuance to increase going forward, including a shift from stocks to bonds as the fund procurement method. This, along with the increasing popularity of samurai bonds by U.S. and European banks and Asian issuers, could cause the balance in corporate bond markets to swing from excessive demand to oversupply within the next six to twelve months.

Furthermore, the widening spread in global bank capital is raising fund procurement costs for Japanese banks. The banks are likely to toughen their lending standards, thus spurring an adjustment in lending rates and overall credit spreads. Given such developments as well as the change in supply and demand conditions, we believe that the groundwork is gradually being laid for a correction in the abnormally narrow spreads that have taken hold in recent years.

Imminent impact of U.S. slowdown
Another route in which the subprime loan mayhem could affect the world economy is macroeconomic, with falling housing prices in the U.S. causing a falloff in consumption, a decay in corporate earnings and an economic downturn. We believe that Japan will come to feel the full impact of these developments in the coming months. Earnings at export industries, the power behind the Japanese economy in the past several years, are slowing, and we believe that small businesses, which are already weakening, will experience even tougher conditions ahead. As such, we predict that Japanese corporate fundamentals, which have recovered sharply since 2003, will soon hit their peak, and the downside risks will increase gradually going forward.

Some market participants may feel that Japan’s situation is different from the U.S. and Europe, and should be fine. We believe that such a stance would replicate the euphoric claims in U.S. corporate bond markets in 2005-06 that the credit markets were structurally sound.

Changing tides
Unlike temporary localised cases such as Enron, WorldCom, GM and Ford, we feel that the subprime loan crisis represents a fundamental change reflecting a structural problem in financial markets. The risk premium continues to correct on a global scale, and Japan is no exception. We believe that we are seeing the makings of a sweeping change in the level of the risk premium in line not only with adjustments in both prices and the supply and demand balance in financial and corporate bond markets, but with macroeconomic developments and the resulting changes in the corporate fundamentals. With a certain time lag from the U.S. and Europe, we anticipate a slow but steady widening in the credit spread, led by the CDS market.

Implications for credit investment
Given the investment environment in global markets, we believe that while there is no longer a significant systemic risk in financial markets, corporate fundamentals could weaken due to the U.S. downturn, and the risk premium could climb due to the worsening supply and demand balance. As such, our basic global credit strategy would be a defensive portfolio focused on quality credits.

For Japan, we believe that the adjustment in the risk premium will proceed apace in line with global trends, albeit slightly behind those in Europe and the U.S. We would recommend a cautious investment stance.

At the same time, past experience suggests that turmoil in the markets during a financial crisis can present unique investment opportunities. One effective move from a long-term standpoint might be to invest in credit taking advantage of the supply- and demand-related widening in the spread. We believe that a key investment theme over the coming three months will be to seek the best timing for taking risk based on constant analysis of both macroeconomic and corporate trends.

Koyo Ozeki
Executive Vice President