Securitization of troubled loans in Japan (September 25, 1997)
The following is the script of my presentation prepared for a certain group of executives who works at foreign financial institutions in Tokyo and is interested in the current financial movement in Japan. I hope this script is of some help for those who are interested in Securitization of troubled loans in Japan and not successful in finding English resources to explain the current movement toward securitization of troubled loans in Japanese financial industry.
In my opinion, securitization structure itself is not something new. It simply repackage the troubled loans as underlying assets and issue new securities with justifiable pricing, and create secondary market for liquidity. This should have been started in Japan right after Bubble collapsed. But for some reasons, it could not be started. I would like to focus upon explaining why this could not be started six years ago and why now it is a hot topic.
In other words, although my presentation is titled "Securitization of Troubled Japanese Loans", it is focused upon more generic explanation of post-bubble situation, Japanese banks' behavior, and movement toward the securitization. Not very technical analysis of securitization structure.
There are four purposes for my presentation.
* To overview factual background surrounding Japanese financial industry in post-bubble days.
* To overview Japanese financial institutions' approach to cope with troubled domestic loans.
* To overview structure for securitization of troubled domestic loans.
* To analyze future development of securitization of troubled domestic loans.
I think it is good idea to give you my conclusion at the very first part of the presentation. In short, foreign commercial banks' involvement in the securitization structure is quite limited.
There should be four kind of major parties involved. A provider of underlying assets, an arranger who structure the securitization, a servicer who takes care of collection and collateral management, and an investor who invests moneys into the securities to be issued.
You cannot be a bank which provides underlying assets, that is troubled loans, which I believe you do not have very much. I feel jealous about it because I have worked for more than six years to get rid of all those troubled loans.
Second party. an arranger. This should be done by an investment bank, securities firm, not a commercial bank.
Third party, a servicer. This function requires very domestic practice. Selling and managing domestic real estate and negotiating with domestic borrowers. Of course, if you feel confident, you may step into this role. But I believe it is very tough for you to keep cutting edge in this field. Because you should compete with several Japanese companies not only banks but also real estate companies who have long experiences and sophisticated skills in Japanese real estate markets.
The last party, an investor. As you can see, securities to be issued are very speculative and basically high risk-high return product. Proper pricing and portfolio management may make it possible to control overall risks related to the investments. However, this type of investment is for speculative investors such as hedge funds and opportunity funds. You cannot treat this type of product as a substitution for conventional lending in Japan.
I am not saying that there's totally no room for foreign commercial banks to get involved. There may exist some chances, such as a liaison to fill the gap between the major four parties. Unfortunately, I cannot be very specific because no such businesses are needed so far. One thing I can be sure is that You should be very creative to find out business opportunities in the securitization process.
These are my conclusions for today's presentation. I believe, with the conclusion at least you can prepare a memo responding to your headquarters' inquiry as to the possible business opportunities in securitization for Japanese troubled loans and avoid further pressure with legitimate grounds to say "Sorry, there's no profitable market for us at this moment.".
Fortunately, some of you have never experienced Bubble Economy and Bubble Collapse in the early '90s. Let me briefly explain what happened during the period.
I am not an economist, so I am not going to discuss why Bubble Economy occurred and why it collapsed in detail.
In analyzing Japanese banks behavior During Bubble Economy, there were two key markets. One is stock market and another is real estate market. Japanese banks advanced huge amount of loans into those two markets during bubble economy. Those lending were supported by positive spiral. The spiral was the following;
Stock Market and Real Estate market grew drastically. Borrowers could use the equity in the assets created by the market appreciation to borrow more money from banks. Borrowers borrowed money and then purchased stocks and real-estate. Because of those purchases, two markets continued to go up and borrowers again used further appreciation to raise funds and bought stocks and real-estate. It seemed to continue forever during Bubble Economy.
Nobody could think of collapse of those markets. If we look back now, Japanese banks seemed to forget about credit policy and just pursued to maximize their short term profits. Unfortunately, that was the case.
There were borrowers who needed huge amount of money to buy stocks and real estate and get quick profit from the short term sale. No doubt over the growth of stock and real estate market, which could secure the value of collateral for the loans. In those circumstances, why you should hesitate? Japanese banks decision was very simple. Just go for it.
At that time, Japanese real estate, especially commercial property market, had very high liquidity and was like a financial instrument.
However, this positive spiral changed suddenly. In response to national criticism against over-heated land prices, Japanese government introduced regulations which limited banks' total lending amount into certain industries, such as real estate and non-banking industry. Because the chain of positive spiral was cut by this regulation, the spiral became negative spiral. No more money could be lent to expand the markets. That was the end of Bubble Economy.
Once the negative spiral started, everything became all the way around. Most of the land transactions made during bubble economy was for speculation and the increase of the value was supported solely by the high liquidity of the market. No new buyers were out there. It was like putting a wooden bar into front wheel of running bicycle.
The liquidity of the real estate market was drastically reduced and that ended up the collapse of real estate market and sudden decrease of real estate value. Most of Japanese banks real estate lending became under-secured.
Before explaining Japanese banks' approach to cope with this sudden collapse, let me mention to some issues related to Japanese real estate market. Those are issues regarding Japanese appraisal method and foreclosure procedure.
There are two major approach to evaluate the value of land. One is neighbor comparison approach and another one is cashflow discount approach.
The latter approach is to treat a target property as a cash generating product and price the cash flow to be generated. This approach is well received to those who works in international finance.
In Japan, of course there existed a flavor of cashflow discount approach, but neighbor comparison approach was more influential and controlling method to appraise the lands. There are several reasons for that. One is Japanese people's attachment to the lands and public norm that land price never goes down, which was turned out not to be true. One is Japanese lease agreement is relatively short and it is hard to obtain cashflow estimation to support cashflow discount method. Another is that the market level was far beyond the level which could be justified by CF discount method.
Sudden collapse of real estate market revealed the limit of neighbor comparison method and caused serious impact upon Japanese banks' alternatives to cope with bubble collapse.
Because the collapse of the market was so quick, literally the market was frozen. No new transactions were made. That means no transaction existed to compare with. Therefore, an appraisal based upon neighbor comparison method could not reflect the sudden change of the market properly. The market offer price was far below the appraised value.
This could give some room for Japanese banks to use their discretion to write off their troubled loans. I will explain this further in later part of my presentation. In short, because of the variance between appraised value and actual market level, Japanese banks underestimated their losses. Or otherwise, they could obtain certain supporting evidences to minimize their post-bubble losses in their balance sheet.
Next issue is foreclosure proceeding in Japan.
Unlike common law system, Japanese mortgage never allows a mortgagee a power of sale. That means you have only two choices to get your money repaid. One is a judicial foreclosure and another is a voluntary sale by a mortgagor.
If a judicial foreclosure is very effective method, you just simply recourse to it and get your money back quickly. However, unfortunately, that was not the case in Japan.
First headache is court congestion. In Japanese history, no such many foreclosure filings were made within very short time period. Japanese court could not handle so many foreclosure filings. Especially, Tokyo and Osaka District Court faces serious congestion in docketing the foreclosure proceedings. In worst case, it took more than two years to complete a foreclosure proceeding.
Another problem is a concept so-called "minimum foreclosure price". In foreclosure proceedings, Japanese court decides a minimum foreclosure price based upon the appraisal. If the actual bid is lower than this price, the foreclosure sale cannot be completed.
Because it took long time to complete the foreclosure proceeding, the real estate market level went down below the minimum foreclosure price decided at the first stage of the proceeding. This caused serious delay in completing foreclosure proceeding.
In addition to those two problems, Japanese foreclosure process protects certain interest holders in a mortgaged property. It is called "Tekijyo" and defined in Civil Code. Moreover, Japanese foreclosure process cannot wipe out all the interest holders of mortgaged property. Some short term lease interest is senior to a mortgage because of tenant laws which was intended to promote tenants position under the shortage of residence supply right after Second World War.
Because of all those problems, foreclosure proceeding is very time consuming process and many Japanese bankers think the foreclosure is the worst case scenario.
Then, we would like to see how Japanese banks coped with bubble collapse.
Typical process for handling troubled loans is very simple and universal. No special method is available.
First Step: Writing off the possible loan losses.
Second Step: Selling loan interests to a third party.
Or otherwise, file foreclosure proceeding and recourse to collateral or have borrower to dispose collateral voluntarily.
Sooner or later, you should follow these steps. Like Citibank, many US banks which faced the similar real estate lending problems in S&L crisis, selected to boost these steps using bulk sale of their loan portfolio. In my opinion, this is sounder approach as a commercial bank.
However, Japanese banks selected to defer the final solution and wanted to wait for real estate market recovery.
The reasons are the following;
Japanese banks believed that the real estate market could have been recovered within reasonable time period and they could stand for it by using hidden profit in their portfolio (FUKUMI-EKI). This was wrong.
Without realizing the actual losses, if you write off the losses, you should have a provision for bad loans. Under Japanese taxation, you should prove the possible loss amount to obtain tax deduction for the provision. Most of the case, you are required to use an appraisal report to show the value of the collateral. As I explained earlier, there existed the variance between appraised value and actual market level. This resulted in the difficulties to obtain full tax deduction to have sufficient provision. As you know, if you write off your troubled loans without tax deduction, that is not very happy thing to do.
Even if you want to realize the actual loss through foreclosure proceeding, it was time consuming process.
For those reasons, Japanese banks could not fully step into the very first stage of the work out, which is the writing off the possible loan losses, and preferred to defer the final solution and have their borrower to sell collateral on voluntary sale basis.
Even if you decided to wait, you cannot wait forever. Japanese government created a quasi-governmental vehicle which provide tax sweetener to boost the work-out process. That is CCPC.
The structure of CCPC is the following;
A bank sells its troubled loan secured by a domestic real estate to CCPC based upon the value of the collateral.
A selling bank makes a loan to CCPC to fund the purchase of loan interest by CCPC.
A bank is allowed to tax deduct the realized loss through the sale of loan interest to CCPC.
A bank will continue to serve as a servicer and handle all the negotiation and processing the bookings. In that regard, CCPC is just a virtual existence.
CCPC will dissolve in 2003. At the time of dissolution, all the loan interests sold to CCPC should be bought back by the selling banks.
The advantage CCPC provides is a tax deduction of the realized loss based upon collateral value through loan sales.
Under Japanese taxation, there is no non-recourse loan concept. All the loans should be a recourse loan. If you sell your loan to a troubled borrower based upon collateral valuation, tax authority may challenge the tax deduction of realized loss by saying you sold the loan in cheaper price in ignoring the possible collection from residual value of the borrower.
Because there is no established market for troubled loans in Japan, all the transactions are made deal by deal basis. Therefore, your possible argument that the sale is made to a third party and arm*s length transaction, thus the loss should be tax deductible, may be subject to challenge by tax authority. This uncertainty was too big to assume for Japanese banks.
CCPC provides clear cut exemption for this uncertainty. To enjoy this tax merit, Japanese banks sold substantial amount of troubled loans to CCPC.
Although CCPC provides tax merit to Japanese banks, it is just a virtual existence. Lender-borrower relationship never changes after the sale of loan interest to CCPC. The original lender should take care of all the negotiation. CCPC accelerate Japanese banks* write off but it could not be a perfect answer for promoting the sale of collateral.
Many Japanese bankers tend to think that once the loan is sold to CCPC, the work out process is over. This is wrong. The real estate market continued to go down, market level went below a sales price to CCPC. In the disclosed amount of troubled loans of Japanese banks, this secondary loss in loans to CCPC is not included. The secondary loss in the loans to CCPC should be realized through the final sales of collateral.
Under the strong disbelief in Japanese financial system, such as Japan premium, Japanese government decided to introduce big change in its financial regulation policy. It is called SOKI ZESEI SOCHI. This is bundled with Japanese Big Bang, relaxation of financial regulations.
This is a change of the regulatory principal. In short, you may do whatever you like, but you should disclose everything and be responsible for the results. Some of you may feel "Hey, so what?". But for Japanese industry, it is a big change.
Under SOKI ZESEI SOCHI, all the banks are required to undertake self evaluation of their assets including loan portfolio and obtain certification by an independent auditor. Troubled loans are subject to more stringent scrutiny under this regulation than before. If Japanese banks defer the final solution, that will cost a lot for them.
Moreover, for Japanese money center banks, it is urgent to get rid of all the troubled loans to achieve sufficient financial credibility as a minimum basis for forth coming competition under Japanese Big Bang.
Under those changing circumstances, Japanese banks finally have strong incentive to step forward to solve troubled loan problems and I believe the key to the final solution is Securitization of troubled loans.
The possible structure for securitization of troubled loans is very simple. As you can see in the chart, SPC is created and purchases troubled loan interests from Japanese banks and issues new security to fund the purchase money. Possible purchase price is very low given the practical difficulties to collect. Maybe less than 20 cents per dollar. At most 30 cents. Even with that pricing, the investment is very speculative and possible investors are quite limited until the sufficient liquidity is provided by the creation of secondary markets.
In my opinion, the most important part of the structure is a servicer. Because the servicer*s capability directly affects collection results which is a return on investment. We have never had a servicer business in Japanese financial market before. No body knows what the best solution is. I guess many investment bankers structuring securitization of Japanese troubled loans have a big headache in this part. If you are successful in establishing very efficient servicer function, you have the fortune.
Japanese RTC now indicates its intention to step into this business. Real estate companies are one of best candidates. Trust banks are also one of the candidates.
Now, Japanese banks are ready to sell their troubled loan portfolio and the structure is to be ready. So what is the remaining factor. The remaining factor is regulatory issue. There are two big regulatory issues, Taxation and MOF regulations.
The former issue is tax authority's position toward the tax deduction of losses realized through loan sales. I explained this at CCPC*s part. The uncertainty associated with the losses through loan sales is very important issue for selling banks.
The latter issue is MOF regulation KURAGIN 800. Under KURAGIN 800, there are several restrictions in selling banks* loan interests. This may reduce the flexibility of the structure.
In my speculation, those regulatory issues are to be solved sooner. Because Japanese government officially indicated its intention to promote securitization of troubled loans through Minister Mitsuzuka's statement in G-10 meeting. If you are serious in structuring the issuance, you should keep good contact with government officials and watch out the change in their positions. I guess this is too obvious for those who are serious in this business.
The last key is a secondary market. Because the troubled loans ready to be sold are so huge, if you cannot create sufficient secondary market which assures liquidity, securitization of Japanese troubled loans cannot be very successful. I believe security firms and investment banks are very good at creating secondary market. Therefore, I am not worried about this part. Moreover, I speculate that some support are to be provided by Japanese government to promote the secondary market for troubled loan securities. Because I think Japanese government official is smart enough to know that without overseas investment into Japanese real estate market, troubled domestic loan problems cannot be solved.