Quantifying the risks in a riskier world

For some investors, a security offering what appears to be quasi-sovereign risk with a healthy yield pick-up might amount to a no-brainer. But analysts are quick to concede that JHF MBS are not risk-free.

  • 07 Dec 2010
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One risk for investors in JHF’s mortgaged backed securities would appear to be the quality of the assets underlying the issuance of those securities, which has conspicuously deteriorated in recent years. This is in part a reflection of the weak global macroeconomic environment, as well as of declining wages and disposable income levels in Japan; and in part it is a direct consequence of the much looser lending standards that have progressively been introduced under the Flat 35 mechanism.

Today, Japan’s government will effectively pay close to half of a borrower’s fixed rate interest repayments for 10 years on a Flat 35 loan with no downpayment and a loan to value (LTV) of 100% or possibly more. The government’s largesse towards home-buyers and its relaxed attitude towards high LTVs is in very marked contrast to the jitters that some European policy makers have about homeowners’ indebtedness. Take the example of the FSA in the UK, which is weighing up whether or not to impose restrictions on home lending based on maximum LTVs. Or look at the precedent of Sweden, where at the start of October the regulator capped new home loans at an LTV of 85%, a move that was applauded by Moody’s for one.

Analysts report that there is already clear evidence of a slide in the credit quality of Flat 35 facilities in Japan and therefore of the loan pools underlying JHF’s MBS. In an analysis published at the end of August, S&P observes that "the proportion of borrowers with an aggregate annual income of ¥5m or less has risen to about 35% in recent series, from about 20%, which was seen when JHF was established. In addition, a raised maximum LTV ratio has led to an increase in the maximum amount of loans available to borrowers. Accordingly, the ratio of total borrowing amount to aggregate annual income has been rising. In the most recent series, the ratio stood at about five times, up from about 4.2 times when JHF was formed. Given that the ratio of borrowings to annual income stands at around 3.5 times to 4.5 times for the private sector RMBS rated by S&P in 2009, recent borrowers under the Flat 35 programme are facing [a] heavy loan burden."

Unnervingly, the agency adds that "there [is] a growing proportion of lower income borrowers who are facing repayment burdens that are heavier than S&P’s assumptions."

Those repayment burdens are unlikely to become any lighter in the foreseeable future. Quite the reverse. A general consensus that seems to be building is that Japan’s consumption tax (the equivalent of European value added tax) will need to rise from its very low current level of 5%. A framework for reforming the social security system is due to be drafted by the end of 2010, which is widely expected to increase proposals on increasing the consumption tax, perhaps to 10%.

Relaxed about tax

This will inevitably exert added pressures on household budgets in Japan, but Moody’s, for one, is relaxed about the effect that a doubling of the consumption tax would have on the RMBS market. In a research update published in July, it observed that "defaults for standard residential loans — wherein obligors’ annual incomes are about ¥6m — would increase by a little more than a 10th if... Japan’s consumption tax were raised from 5% to 10%, all other things being equal."

Nevertheless, for those who fret about rising government debt, the rapid deterioration in the quality of heavily subsidised Flat 35 mortgages may be a concern. But should any of this unsettle local or international investors in JHF’s MBS? The answer is almost certainly no, for two very compelling reasons.

The first is that JHF is widely perceived as being a quasi-government issuer. That means that rather than taking exposure to the underlying mortgage collateral, investors are effectively taking risk that at a minimum is on a par with Japanese sovereign risk.

"Until certain trigger events occur, payments of principle and interest (P&I) on JHF RMBS are the direct obligation of the issuer," explains Yukio Egawa, head of the financial strategy division at Shinsei Securities in Tokyo. "That means that no matter how badly the underlying pool of housing loans performs, the issuer remains obligated to pay P&I. In other words, investors are dependent on the credit quality of the issuer rather than the underlying collateral."

Today, of course, the creditworthiness of the Japanese government — in the eyes of the ratings agencies — is not quite as ironclad as it once was, with Moody’s having stripped the sovereign of its last Aaa rating in May 2009.

However, a second reason why investors in JHF’s RMBS should be relaxed about the deteriorating asset quality of the mortgage pools underlying the securities is the comfort they are offered in the form of a very high (and, some say, an unnecessarily high) over-collateralisation (OC) level. It is that high OC level that allows JHF RMBS to command a higher rating than the government itself from Standard & Poor’s and R&I.

OC levels have been climbing steadily since the establishment of JHF in 2007. According to R&I, JHF No 1, launched in May 2007, had an OC of 8.8%. By June 2008, this had risen to 10.37% for JHF No 14. By March 2010, it had reached 21.5% (JHF No 35), and when JHF No 39 was issued in August 2010, it came with an OC of 27.7%.

These high OC levels play a key role in maintaining the high ratings of JHF RMBS, and will continue to do so. As R&I explains, "because JHF is the issuer of the JHF MBS, any downgrade of JHF’s issuer rating... prior to the time when the beneficial interests are exercised could result in a downgrade of the rating for the JHF MBS. Nevertheless, because sufficient overcollateralisation has been set, and the Corporate Rehabilitation Law, which would greatly limit JHF’s ability to dispose of assets, does not apply, the rating for JHF MBS may be higher than the issuer rating for JHF itself. Therefore, the rating of JHF MBS will have certain risk resilience even if the issuer rating of JHF deteriorates."

Current OC levels, say ratings agencies, are more than adequate to compensate for any shocks that Japanese homeowners are likely to suffer from, for example, an increase in consumption tax. As Moody’s commented in its report on consumption tax, "in Moody’s rated Japanese RMBS deals, credit enhancement protects the rated securities from the losses caused by defaults, and such enhancement is usually raised over time by the existence of a sequential payment structure. The rising enhancement would absorb the additional loan defaults caused by the tax rise."

With credit quality therefore presenting negligible risk for investors, why are investors offered an issue spread in excess of 40bp for buying into bonds with a credit quality that can be construed as being — if anything — stronger than the Japanese government.

Main focus

This spread appears to be the price investors demand for the three risks they theoretically incur in the market for JHF MBS. Probably the most minor of these is liquidity risk, which analysts say is minimal. "JHF is definitely seen as a rates rather than a credit product, because it has the double protection of government sponsorship and high over-collateralisation," says Tomohiro Miyasaka, director of securitised product research at Credit Suisse in Tokyo. "After the Lehman shock Japanese investors recognised how important liquidity is. That is why the main focus of investors sensitive to liquidity has been on municipal and government-guaranteed bonds in 2009. The focus is also on JHF MBS because more than 10 securities companies provide secondary prices."

The second potential risk identified by analysts is early redemption or pre-payment risk, with MBS investors effectively carrying a short position on mortgage borrowers’ call options. Again, analysts play down this element, saying that this has historically been much less of a risk in the Japanese market than it has been in US MBS. "Japanese homeowners have historically been less sensitive than those in the US to interest rate fluctuations," says Kaoru Kondo, structured finance analyst at Bank of America Merrill Lynch. "Historical highest levels of prepayment rates (CPR) are about 16% in Japan compared with around 40% in the US."

This leaves the third risk, which is a change in JHF’s legal status and a weakening (real or perceived) of government support for the agency. "The real risk is privatisation risk," says Jumichi Shimizu, securitisation products analyst at Deutsche Bank in Tokyo. "If the corporate structure of JHF remains unchanged, JHF will continue to bear the default risk for ever. If the corporate structure changes, the default risk will be borne by the investor."

"If certain trigger events occur, such as the changing of the corporate status of the issuer into a joint stock corporation, meaning that it would be subject to Japan’s Corporate Reorganization Law, then the security holders’ interests might not be fully protected," says Shinsei’s Egawa.

However, although former Prime Minister Koizumi was known to favour the divestment of government-owned assets, analysts insist that privatisation risk is remote. "JHF has a very important role to play in the Japanese housing market and will therefore not be sold by the government," says Kauru Kondo, structured finance analyst at Bank of America Merrill Lynch.

Safe from sell-off

Analysts report that there has been no indication in the performance of the market that investors have taken fright about the current government’s plans for JHF. "Spreads have been very stable since the new government came in, so the market seems to be indifferent to any political risk at the moment," says Deutsche’s Shimizu.

Looking to the longer term, however, concerns will continue to linger over the broader implications of Japan’s government debt, which according to Fitch reached 201% of GDP at the end of 2009, "by far the highest for any Fitch-rated sovereign." Fitch adds that "on whichever measure is adopted, Japan’s government is one of the most heavily indebted in the world and its debt burden is expected to continue to rise for the foreseeable future, likely putting downwards pressure on creditworthiness in the medium term without sustained economic recovery and fiscal consolidation."

Fitch warns in the same report that the agency "has highlighted that positive rating action on Japan is highly unlikely without the debt ratio path first clearly getting on a lower trend." This caution appears to echo the views of a number of international analysts as well as investors weighing up the benefits (or otherwise) of investing in Japanese public sector bonds. "When we were roadshowing JGBs to central banks recently, the concern we heard a number of times was not the absolute size of the government debt," says one Tokyo banker. "It was the trajectory of government debt relative to Japan’s savings rate."

In other words, he says, if the debt continues to rise, while Japan’s savings rate carries on declining, JGBs will become progressively less attractive to international investors.

Others share this concern. In a recent update, the IMF notes that in the absence of any policy adjustment, Japan’s net public debt will rise and approach 250% of GDP by 2030. "Achieving debt sustainability will require that Japan stabilise and put its debt-to-GDP ratio firmly on a downward path," says the IMF. Achieving that goal, adds the IMF, would call for a range of politically unappealing belt-tightening initiatives. These may include "a withdrawal of stimulus (1.5% of GDP), plus additional policy measures of 8.5% of GDP, of which 4.5 percentage points are assumed to come from a net tax increase including a gradual consumption tax hike starting in 2011," notes the IMF. Another 4%, it adds, would come from "expenditure reforms (by freezing non social security spending in nominal terms and limiting growth in social security spending)."

Controlling the upward trajectory or even reducing the overall size of government debt may or may not call for a reactivation of privatisation in Japan. But any suggestions that political support for a revival of privatisation is gathering momentum, such as the recent endorsement of legislation by Prime Minister Kan on the sale of Japan Post, may prompt some jitters about privatisation risk at JHF.
  • 07 Dec 2010

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1 Citi 8,935.41 24 14.02%
2 HSBC 7,859.72 26 12.33%
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5 Standard Chartered Bank 3,055.20 19 4.79%

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2 HSBC 2,253.75 3 7.17%
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4 Standard Chartered Bank 1,518.77 3 4.83%
5 JPMorgan 1,341.27 2 4.27%

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2 UniCredit 3,440.98 25 8.50%
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5 SG Corporate & Investment Banking 2,478.18 21 6.12%

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Rank Lead Manager Amount $m No of issues Share %
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1 AXIS Bank 77.43 3 24.06%
2 Standard Chartered Bank 45.42 1 14.11%
2 Mitsubishi UFJ Financial Group 45.42 1 14.11%
2 CITIC Securities 45.42 1 14.11%
5 Trust Investment Advisors 31.87 2 9.90%