BANKING FOCUS – JAPAN
Floundering foreign banks face questions over strategy
Mid-sized lenders Shinsei and Aozora have seen their profits hurt by the unhappy combination of ill-judged investments and miniscule margins. Observers are sceptical about their business models and managements, and are asking: does either bank really have a role to play in Japan? Peter McGill reports.
"I've given up on Shinsei Bank," states Ed Merner, the president of Atlantis Investment Research. "I'll change if they put in new management and get a new strategy."
The mention of Japan's first foreign-controlled bank is enough to make one of the land's most seasoned fund managers frown. "Can you tell me anything in which they have an ongoing success?" he asks.
Ironically, years after being bailed out themselves, some of the nation's biggest financial institutions are now in a position to rescue what remains of Wall Street. In early October, Morgan Stanley's shares had plummeted to the point that Mitsubishi UFJ Group's (MUFG's) offer to invest US$9 billion in it could almost have bought the entire investment bank.
Yet while Japan's larger banks have flourished, the foreign-owned Shinsei and Aozora have withered.
In the fiscal year ending in March 31, 2007, Shinsei lost ¥60.9 billion (US$605.9 million). It only managed to record a ¥60.1 billion profit for the latest full fiscal year by selling the bank's Tokyo headquarters overlooking Hibiya Park for US$1.18 billion.
The bank then astonished the market in June by hauling its first president and CEO, Masamoto Yashiro, out of a third retirement to become non-executive chairman. Yashiro, now aged 79, is based not in Tokyo but in Beijing, where he works as a part-time adviser to Chinese banks.
Meanwhile, Aozora's net profit in the last fiscal year slumped 93% to ¥5.9 billion because of losses on collateralised debt obligations, bonds and write-downs from its disastrous 2006 investment in General Motors' finance arm, GMAC. Its share price has slid even more precipitously than that of Shinsei, dropping 70% in the past year to close at ¥105 on October 16. Shinsei's shares set a one-year low of ¥197 on October 10, less than a quarter of their ¥827 price when first listed in 2004.
The current fiscal year doesn't hold out much promise, either. Shinsei and Aozora are both set to report first-half losses and are targeting miniscule profitability over the full financial year.
As both institutions cast around for a winning strategy, the question on some lips is: does either bank really have a role to play in Japan?
Back in 2007, Federico Sacasa, then Aozora's president, seemed confident about his bank's future. He said that Aozora was not a traditional corporate lender to its 2,500 mostly mid-cap clients because "straight corporate relationship banking just is not very profitable". Neither was Aozora a trading bank, a global investment bank or a regional bank.
The connection with US private equity group Cerberus, which now owns 32.6% of the bank (see box), offered Aozora "access to a global network, investment banks as sponsors and advisers, and information and capability that a typical mid-size Japanese bank would not have".
He added that Aozora was "beautifully positioned" to take advantage of a shake-up in banking caused by the global credit crunch as it had one of the highest capital adequacy ratios in Japan.
But so far it hasn't worked out that way. In 2006 Aozora opted to put US$500 million into a Cerberus-led purchase of 51% of GMAC. The finance arm of General Motors has haemorrhaged cash since. The bank has also written off most of its US$484 million portfolio of collateralised debt obligations (CDOs). Depending on tax treatment, the losses have cost Aozora 2% to 3% of its capital. Its tier-one ratio fell from 16.83% at the end of September 2007 to 15.03% by this June.
Last year Cerberus also bought most of money-losing Chrysler for US$7.4 billion. This became an even greater millstone than GMAC. Cerberus is now seeking to merge Chrysler with GM, which in turn has lost almost US$70 billion since the end of 2004.
In an interview just before Asiamoney went to press, Sacasa admits that poor investments had damaged profits. But he insists they were "insignificant in terms of our capital and total assets".
As GMAC continues to bleed money, Aozora has slashed its profit forecast for the half-year to September 30 to a ¥4 billion loss; by next March it hopes to recover a profit of ¥15 billion for the full year.
Moody's, meanwhile, in September placed Aozora's credit ratings under review for a possible downgrade. The agency noted that "its short-term earnings scenarios have become increasingly undermined by the negative credit developments outside Japan. As such, doubts have emerged about the profitability and sustainability of its investment banking and global investment businesses."
In a written comment, Aozora claims that Moody's appears to be worrying about damage from the GMAC investment. "We do not believe [the GMAC investment] is relevant to our ability to generate strong and less volatile earnings in future years," it says.
But "GMAC is not an issue," counters Maki Hanatate, a senior credit officer at Moody's Japan. "They are pursuing a wholesale banking model, and we are not sure if it can generate stable profitability. Our concern is their stability over the next few years."
Moody's concern derives from Aozora's high dependence on debentures as a source of funding, its limited franchise and deposit base in Japan and its strategy of overseas growth.
Dealing in disasters
The outlook appears troubled, too, for Shinsei. It has revised down its forecast for the first six months to a loss of ¥15 billion and is targeting a ¥12 billion profit for the full fiscal year, one-fifth of earlier targets.
Both Shinsei and Aozora have yet to pay back all the public funds they have received. As a result, if their net profit undershoots targets by 30% for two consecutive years, the Financial Supervisory Agency (FSA) can demand the resignation of their top executives, cuts in salary, or reductions in staff.
The presidents of three Japanese banks that badly missed their targets two years in a row – UFJ Bank and Kumamoto Family Bank in 2004, and Kyushu Shinwa Bank in 2005 – all resigned. There was media speculation that Shinsei sold its headquarters at the end of the latest fiscal year to bolster profits and avoid the FSA stepping in.
The bank blames its poor recent performance on a ¥38 billion exposure to the bankruptcy of Lehman Brothers, as well as losses on European asset-backed investments and securities, and "global turmoil".
But these exposures result in large part from a multi-year plan to invest in overseas securities. Shinsei started to do so almost as soon as it received money from the Japanese government in 2000 (see box).
One of the founding partners of Ripplewood tells Asiamoney that Shinsei has increasingly focused on short-term profit since coming under the control of the investor group led by J.C. Flowers.
Like Aozora, some of its investments have been little short of disastrous. In 2000, the bank invested about US$3.7 billion in a portfolio of corporate bonds, including WorldCom, but in its 2004 annual report, Shinsei confessed that the portfolio's value had shrivelled to US$900 million. Shinsei stopped discussing this bond portfolio in further annual reports.
Subsequently it invested in collateralised debt. At the end of this June, Shinsei was exposed to US$270 million in US residential mortgages, after US$406.4 million of mark-downs and credit reserves since the start of fiscal 2007. It still had ¥241 billion of securitised products, including collateralised debt obligations and mortgage-backed securities.
Shinsei was also part of the group of investors led by J.C. Flowers that acquired a 24% stake in Germany's Hypo Real Estate Holdings in June for US$1.7 billion. On October 5, the German government and the country's financial institutions bailed out Hypo for US$68 billion, the largest financial rescue in German history. Hypo's stock has fallen more than 75% since J.C. Flowers and Shinsei bought in.
Revolution at a cost
Domestically, Shinsei has become reliant on property lending to make money. It accounted for 23.6% of all lending in the fiscal year ending on March 31 this year. Non-recourse finance, a business that Shinsei helped to pioneer in Japan, accounted for half of the ¥1.295 trillion on loan to the property industry.
But property prices have undergone a sharp downturn since April last year. "Shinsei's main business has been very much formed around financing special situations, especially companies that need loans before a building project gets started," says Paul Heaton, who manages the Japanese stock portfolio at fund management firm Pyrford International in London.
"They could charge high rates, but were always having to look for the next short-term lending deal. It's an extremely strenuous activity, and of concern during a downturn."
Shinsei can rightfully claim to have sparked change in retail banking. Following its example, other Japanese banks have cut or abolished ATM and money-transfer fees, shortened waiting times, and expanded working hours. Many have also tried to emulate Shinsei's widely admired website.
"It's all very flash and whizz-bang," says Brian Waterhouse, a bank analyst at Japaninvest. "It's been used as a calling card and attracts a lot of people. The problem with Shinsei's retail banking is that its cost is greater than its income. It's won accolades but can't make money."
Losses from Shinsei's retail business quadrupled from ¥1.6 billion in fiscal 2006 to ¥6.3 billion in fiscal 2007. The retail bank lost another ¥300 million in the first quarter of this fiscal year, ending June 30.
Shouldering the blame
Some observers feel that the responsibility for Shinsei's woes should fall on the shoulders of its president and CEO, Thierry Porté.
"I can't work out the reason for Porté still being there," one equity analyst says. "Anywhere else in the world he would have been fired by now. He's been in charge for three-and-a-half years and he hasn't turned it around."
Porté was head of Morgan Stanley in Japan for 10 years before joining Shinsei. He enjoys a close friendship with J. Christopher Flowers, who heads Shinsei's biggest investor, springing from their days together at Harvard University.
Observers note that Porté is fiercely intelligent, but his aggressive management style has left some people cold. "Thierry Porté always comes across as abrasive with Japanese investors and authorities," says Waterhouse.
Merner of Atlantis Investment Research describes Porté's attitude as colonial.
"I don't like him," adds Hironari Nozaki, managing director for equity research at Nikko Citigroup. "At results meetings, he hesitates to clarify answers to questions."
Shinsei, which claims to have "uncompromising levels of integrity and transparency", declined Asiamoney's request to interview Porté, Yashiro, or chief financial officer Rahul Gupta, and declined to answer submitted questions. Flowers also declined to answer questions emailed to him via his personal assistant in New York.
For its part, Aozora has had a shake-up of its senior management. In February, the board voted to make Sacasa, already president, the CEO as well, supplanting Kimikazu Noumi, who had been appointed CEO and chairman exactly one year earlier. Noumi then retired as chairman in May. As yet no successor to him has been chosen, despite a frenzy of executive and board changes – eight appointments, 14 reassignments, four resignations and three retirements – since Sacasa took the reins.
"We can't present ourselves as a Japanese bank and not have a Japanese chairman. It's part of our normalisation," were Sacasa's words a year ago. He added that Noumi was "a very respected Japanese banker".
But rumours of a rift between the two are rife. "Cerberus thought Noumi should be the external face of Aozora, while Sacasa should actually run the business," says one senior analyst in Tokyo. "It appears Noumi and Sacasa both thought they were running the business, and so a choice had to be made."
Sacasa declines to comment on Noumi's resignation. "You better ask him," he tells Asiamoney.
Like Porté, Sacasa has his detractors. Nikko Citi's Nozaki says that Sacasa "talks too much and knows little about Japanese banking".
He adds: "With only 18 branches of its own, Aozora should have made much better use of its strong ties to regional banks to distribute its products."
But others are more supportive. "I think he's quite impressive, but it's not clear how long he intends to be in Japan. There's always a feeling of impermanence about Aozora management," the senior analyst notes.
The biggest problem facing both Shinsei and Aozora, and part of the reason that they have engaged in some ill-advised offshore investments, is that Japan's reinvigorated mega-banks – MUFG, Sumitomo Mitsui and Mizuho – leave them with little room to compete.
MUFG, for instance, has more than ¥194 trillion in assets, 1,246 bank branches and offices in Japan, and a further 28,300 ATMs. Shinsei, with total assets of ¥12.4 trillion, has closed several branches and now has just 36 outlets. Aozora has ¥7 trillion in assets and only 18 branches.
Corporate lending has proved difficult. Almost half of all Japanese companies are free from debt, and domestic lending margins are wafer thin.
"Japan is fundamentally over-banked," explains Jesper Koll, who runs the Japan end of Singapore-based hedge fund Tantallon. "Over the last five years, bank deposits have grown at a rate of between 3% and 4% but bank loans have fallen. You've got too much money, too much capital, too many deposits. That's a very real problem for Shinsei and Aozora."
The chief equity analyst at a Wall Street investment bank has a more radical view: "The fundamental problem with these two banks is they're not needed in Japan."
He points to the fact that under Japan's old banking system in the 1980s, commercial banks would lend for up to three years, the trust banks for three-to-seven, and the long-term banks that used debentures for funding – such as Aozora and Shinsei's forebears – seven years plus. But in 1989 the markets were liberalised, and commercial banks began using their deposit bases to offer cheaper long-term funding than their debenture-issuing counterparts.
"[The government] should have wound up LTCB and NCB (see box) in an orderly manner...because they're not needed any more," he says.
He adds that Aozora or Shinsei don't even appeal as acquisition targets. "Neither of them has anything that the Japanese really want. And if you want some of their staff, you just poach them anyway."
David Threadgold, Japan branch manager of Fox-Pitt, Kelton, adds: "The question is: can they eke out a profitable existence, nipping between the legs of these slow-moving dinosaurs [Japan's big three banks]? If the dinosaurs leave these mammals a lot of space to grow and prosper, then maybe, in a few millennia, a new life form will take over from the old."
Serving a purpose
Aozora can never aspire to be a mass retail bank. In the last fiscal year ending March 31, two-thirds of its ¥3.3 trillion in deposits came from time deposits held by 220,000 individual customers, who are mainly elderly and affluent.
In addition, the bank also issues fixed-rate debentures to 500 of the 700 regional banks in Japan, a process that accounts for just over 30% of Aozora's funding. Its issuance of debentures in the 12 months to March 31 climbed 40% in the 2008 fiscal year to ¥2 trillion, a dependency far higher than Shinsei, with ¥5.8 trillion in deposits but only ¥662 billion in debentures.
Worryingly for Aozora, its licence to issue debentures expires in 2016, and a push into online banking is unlikely to attract enough deposits.
"We have eight years left to find a substitute. We understand that, we are clear on that," Sacasa says. "We're looking at a variety of instruments. Corporate bonds will be part of it. We will actively look at anything to extend our franchise and diversify our funding sources. We have the capital to deploy."
Sacasa is frank about Aozora being a niche player. "We're not going to compete on size in this market. We can't be all things to all people. We want to be special to certain people."
He sees secured lending as the key. "That is the strength of our business model, our sweet spot." He also wants to distribute assets that until now have been held on Aozora's balance sheet. "Non-recourse finance to real estate, leveraged finance and project finance are all areas in which we want to be strong, not only in origination but also in distribution."
Foresight or folly?
Porté, meanwhile, seems to be pinning Shinsei's future on consumer lending.
Japan's entire consumer finance industry has fallen on hard times since 2006, when a Supreme Court ruling placed more power with Japanese borrowers suffering from 'excessive' interest rate payments. All the major companies suffered sizeable losses as a result, with some smaller ones going bust.
Shinsei has been growing in this space for some time. After acquiring control of smaller lenders APLUS in 2004 and Shinki in 2007, in September the bank acquired GE's Japanese consumer finance division for ¥580 billion in cash.
Observers are sharply divided about the move. Some see it as an act of far-sighted genius, others as reckless folly.
"I think the time for this strategy is exactly right, because consumer finance over the last couple of years has been squeezed by new rules and regulations, and everyone is scrambling for a new business model," says Koll. "The lending margin has been slashed, but Shinsei can still make a profit by funding from its deposits."
"The big guys in this business – Promise, Takefuji, Orient Finance – are all having a terrible time," counters Merner. "Why couldn't GE, with its triple A rating, succeed in this? Why did Citicorp get out of consumer finance in Japan? What makes Shinsei think they can succeed? Do they have very talented people? Do they have a lot of experience in this business? I don't think so."
Concern about the effect of the GE acquisition on Shinsei's credit quality has prompted Moody's to put all of its credit ratings for Shinsei, and Standard & Poor's all but one, on review for possible downgrade. As one analyst notes of this consumer finance push: "Porté has bet the bank."
Both Shinsei and Aozora need to convince an increasingly sceptical audience that they still serve a purpose in Japan's banking industry. And they had better do it fast, because the market is not going to get easier any time soon.
Falls and foreign ownership
Not long ago, Shinsei Bank elicited a positive reaction from investors and peers.
In 2000, its forerunner the Long Term Credit Bank (LTCB) collapsed under the weight of bad debts. The Japanese government spent ¥336.9 billion on recapitalising the bank and almost ¥3 trillion more on cleaning up its balance sheet. A consortium of investors, led by Tim Collins' Ripplewood Holdings, was able to buy a majority stake in LTCB's carcass for ¥121 billion.
The private equity firm lined up a consortium of prominent institutions to help finance the bid. Some individuals also lent their name to show ideological support. David Rockefeller invested a few million dollars to help promote "free enterprise" in Japan. Paul Volcker, former head of the Federal Reserve Board, agreed to become a senior adviser to Shinsei out of a wish to reform the Japanese financial system.
The bank was re-launched as Shinsei, which translates as "new life", in June 2000. Four years after making the acquisition, Ripplewood made around US$2 billion by selling 30% of its stake. Most of the kudos for rescuing the bank went to Collins, his partner J. Christopher Flowers, and Shinsei's then-CEO Masamoto Yashiro.
The government remains Shinsei's second largest shareholder, converting its preference shares to 23.9% of common shares in March. To prevent it becoming the largest shareholder, a group of investors led by investment firm J.C. Flowers bought more shares in February to give them 32.6%.
Rescue of Aozora
Aozora's roots also lie in a public rescue; in its case it was the old Nippon Credit Bank (NCB).
The publicly owned forerunner of NCB, Nippon Fudosan Bank, was created in 1957 out of the Japanese assets of the Bank of Chosen, the central bank of Korea during Japanese rule from 1910 to 1945. Nippon Fudosan was listed in 1964 and changed its name to Nippon Credit Bank in 1977. NCB inherited extensive ties to the Korean community in Japan.
NCB collapsed in 1998 and was nationalised. Tadayo Honma headed the bank in 2000 when it was sold to a consortium and renamed Aozora, which translates as "blue sky". US private equity group Cerberus then bought an 11.5% stake in Aozora as part of a consortium led by Japan's Softbank Corp.
Dan Quayle, the foot-in-mouth American vice-president under George Bush Sr., represented Cerberus as a member of Aozora's board. But the bursting of the technology bubble forced Softbank's president, Masayoshi Son, to sell his 49% stake in 2003, which Cerberus bought for US$101.1 billion.
Cerberus then sold part of its controlling stake when the shares were listed in 2006. The private equity house raised its stake once more this year after Tokio Marine & Fire Insurance, one of the original investors, sold its 9% holding in Aozora. Cerberus now owns 46% of the bank. The Japanese government would own 22% of Aozora if its preference shares in the bank were converted into common shares. ֶ