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In recent months, the U.S. subprime loan problem has evolved into a full-scale crisis that has roiled financial markets worldwide and significantly impacted monetary policy in various nations. The troubles have spread to a wide range of investors through credit products such as asset-backed securities (ABS) and collateralised debt obligations (CDOs), affecting not only the credit and stock markets but the global financial system itself. Like other global economies, Japan has felt some impact from the mess in the U.S. subprime sector. But based on what we’ve seen in Japanese credit markets thus far, we think the impact of the subprime loan crisis has been much lighter than in other markets, particularly Europe.

How the U.S. Subprime Problem Went Global
Though the specifics of the U.S. subprime mortgage mess have been widely dissected elsewhere, understanding its global impact requires a look at how this U.S.-based problem crept into the international financial system. The source of the subprime loan trouble was, of course, the emergence of the U.S. housing bubble and excessive lending to borrowers with poor credit. The first phase of the crisis in February and March this year took the form of an increase in reserve funds at financial institutions and the failure of some non-banks with large outstanding subprime loan portfolios. The impact at that point was largely limited to certain industries and corporations.

The second phase, starting around July, showed the problem spreading overseas to European financial markets, following news in August that a major French bank was freezing certain funds due to subprime loan losses. This signalled that the situation had precipitated a liquidity crunch in the U.S. and European financial systems. Liquidity in asset-backed commercial paper (ABCP) markets – short-term loans that are backed by assets such as mortgages that provide liquidity for many types of lending – dried up as far afield as Germany, Canada and Australia. Adding to this, a medium-sized U.K. financial institution experienced a sudden run in mid-September, causing the government to take the exceedingly rare step of guaranteeing all of the bank’s deposits.

The rapid spread of the crisis into a global phenomenon stemmed from the wide dispersal of risk, as the loans were held by a broad scope of financial institutions and investors through securitised products backed by subprime loans. We believe that another important factor behind the rapid credit squeeze, however, was the massive leverage involved in these products via ABCP.

The spread of the subprime crisis makes it evident that what is happening is not simply the collapse of a U.S. housing bubble and falloff in securitised product prices. Rather, the numerous factors that have supported the narrowing in credit market spreads for some years now are unravelling, and markets are undergoing important structural changes. The elements of this change include the correction in housing prices, unwinding of leverage in financial markets, correction in risk premiums, and banks’ reconsideration of the “off-balance-sheet-risk” business model. These factors illustrate clearly why the subprime loan problem sparked a liquidity crunch in the financial system, especially in the money markets. The crisis began with bankruptcies of non-banks, widened to the periphery of banks that sponsor or support ABCP programs, and erupted into an actual liquidity crisis at banks that rely heavily on wholesale funding, thus spreading ever closer to the core of the banking system.

Past Financial and Credit Crises

Figure 1

Scale of Past Financial Crises:
Bad Debt and Public Debt Cost

Figure 2

Connections Between The Subprime Crisis and Markets
There are two main routes through which the subprime crisis spread into markets. First, there is the macroeconomic route of an economic slowdown via a correction in the housing market. The rise in housing prices gave consumers added borrowing power:  thanks to higher prices, homes became veritable cash dispensers supporting U.S. consumption. The loss of this underpinning could have a considerable impact on consumption, affecting not only the U.S. economy, but other economies that export to the U.S.

Next is the adverse economic effect of a credit crunch due to financial market disorder or lower credit capacity at financial institutions. Because banks boast fairly solid balance sheets, the markets initially dismissed the threat from this route. However, the advent of the liquidity crisis in August has made this a more realistic possibility. Past financial crises, particularly in Japan, have demonstrated all too clearly how a credit squeeze combined with asset deflation can create a truly dangerous situation.

Impact on Japanese Credit Markets
Though the overall impact from the subprime crisis in Japan has been more muted than in the U.S. and Europe, there have been some clear effects. Japanese share prices have tumbled more than 10% since July, and credit market spreads have widened roughly in line with those in the U.S. and Europe (Figure 3). This trend has been particularly striking in the credit default swap (CDS) markets, where overseas investors are the main players. Hedging activity by such investors caused the CDS index (iTraxx) to widen ahead of single name credits, moving in tandem with foreign market trends, albeit on a more modest scale.

5yr CDS Indices (Investment Grade)

Figure 3

On the other hand, the widening in Japanese cash bond spreads has been fairly limited, with each sector driven by its own particular factors (Figure 4). That is, the subprime loan situation has not necessarily produced a perfect correlation between Japan and the U.S. and Europe. For example, the spread widening in blue chips, which are highly sensitive to interest rates, was primarily due to expectations around July of a rate hike by the Bank of Japan, while triple-B bond spreads widened on the deteriorating creditworthiness of consumer loan companies. Also, there has been no great impact at this time on ABS or CDOs that are backed by domestic assets.

Corporate Spread History by Rating (vs. JBG Spread)

Figure 4

Spreads on Japanese bank capital in the Yankee and euro markets (bank’s subordinated debt bonds, preferred securities) widened greatly along with U.S. and European bank spreads. As a result, banks saw a sharp expansion in their CDS premiums due to the hedging needs of overseas investors and securities firms. To date, this is the movement that has most directly reflected the subprime-related widening in global market spreads. At the same time, domestic Japanese bond markets remain buoyant, and new issues continue to be absorbed smoothly at low spreads, differing starkly from their dollar-denominated bond counterparts.

Japanese financial institutions and investors also did not have great exposure to subprime loans or ABS and CDOs in the first place – the leading banks have an average exposure of a less than one percent of total assets – so we feel that the chances of any change in credit risk are negligible. Banks have firmed up their balance sheets and boast ample deposit-loan ratios, leaving little risk of a liquidity crunch similar to that in the U.S. and Europe (Figure 5).

Trends in Loan/Deposit Ratio

Figure 5

Japan Investment Implications
Thus, Japanese markets have been fairly isolated from the subprime loan troubles, and the reaction to the crisis has been much different from that in foreign markets. The question is how long this situation will continue.

There are five ways in which global market trends could influence Japanese markets:

1. A direct impact through a widening in samurai bond spreads or purchasing of Japanese-name credits in CDS markets by overseas investors seeking protection;
2. Changes in Japanese share prices due to a shift in stance by foreign investors, affecting credit markets through the impact on investor risk tolerance and market sentiment;
3. The impact of global market performance on corporate bond markets through changes in asset allocation by domestic investors;
4. A U.S. economic slowdown that damages the fundamentals of Japanese corporations, prompting a widening of credit spreads;
5. Changes in global money flows or the long-term risk tolerance of investors.

The first two are already a reality, but the impact has been mild, as discussed above. The key now will be the potential effect from macroeconomic factors such as asset allocation, fundamentals and global money flows.

Setting aside short-term market fluctuations, we believe that the credit market correction worldwide is not simply a matter of the amount of losses incurred due to subprime loan exposure. We feel that it stems rather from ongoing changes in the structural factors that have supported the narrowing in spreads in recent years. In this sense, we suspect that the correction could persist for the long term and that the effect on Japanese markets could slowly but surely intensify. The correction in risk premium levels is a global theme, and Japan cannot remain isolated from this trend forever.

Credit markets experience major periods of transformation once every few years. Some bond spreads have widenend too much, and such times offer a buying opportunity. In these periods, when price distortions in the market tend to reach high proportions, it is best to step back and look at market movements from a wide perspective and pursue cross-market investment opportunities. We see this as crucial to adding alpha.

Koyo Ozeki
Executive Vice President