Japanese Regional Banks On Course To Zero by Shannon McConaghy – Horseman Capital Management

The Bank of Japan (BOJ) “comprehensive assessment” and move to “yield curve control” has further fixed the Japanese regional banks on a course to zero; with the BOJ explicitly committing, over the “long-run”, to negative interest rates in the maturities most crucial for bank survival. Around 87% of regional bank assets have maturities between the overnight “short-term policy rate” and 10 year “target long term rate”. Over coming quarters more and more regional bank loans and J GB holdings will re-set onto interest rates that fail to cover the cost of bank operations. I feel there is a dramatic underappreciation of the sustained dive coming for regional bank earnings as yields remain around current levels.

This note looks at the ways in which the new BOJ policy could drive regional bank earnings negative. As such, the base-case assumption throughout is that the BOJ maintains current targeted interest rates. In reality, it is probable that at some stage the BOJ will push rates further negative. BOJ Governor Kuroda recently stated that the BOJ will “respond to developments in economic activity and prices as well as financial conditions” and “with regard to possible options for additional easing, the main policy tool will be fixrther cuts in the negative short-term policy interest rate and lowering the target level of the long-term interest rate”. Kuroda’s reaction function for further negative rates appears to be declining inflation numbers and implicitly Yen strength, which leads to falling inflation. In my opinion we can expect 1) Declining inflation; as point-of-sales price data, which provides a reliable leading indicator, shows “The falling trend in price is extending to more categories of products, and the negative growth is looming into view” (N owCast), and 2) Yen strength; the Yen still has 14% to strengthen to its long term real effective exchange rate, Japan’s current account surplus remains near record levels and one of J apan’s largest trading partners, China, remains on a devaluation path.

In visualising the scale of the effects to come from existing policy on regional banks I felt the following graph was most helpful. In addition to assuming that yields remain fixed for the foreseeable future the following simple assumptions are made and discussed over the following pages;

  1. Loan Portfolio Income: a 22bp decline in average outstanding loan rates as old loans continue to roll off onto the current new loan rate.
  2. Interest & Dividends on Securities: “gains from cancellation of investment trusts” are depleted and J GB holdings roll onto negative rates.
  3. Ordinag Expenses: Rise as provision rates rise to levels seen in other major developed economies and credit costs return to 4obp.

I believe these are all rather generous assumptions and indeed I expect the situation will likely be worse than these forecasts next year on all counts. Furthermore, these negative earnings impacts are not “one-off ‘ but will rather continue to deteriorate beyond next year. It is also important to remember this is aggregated data and some bank earnings will experience a more rapid decline than the aggregate.

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Japanese Regional Banks

Japanese Regional Banks

Assumption 1: Loan Portfolio Income: a 22bp decline in average loan rates as old loans continue to roll off onto the current new loan rate.

In the chart below, the golden line reflects the average rate that Japanese regional banks secured for new loans in that monthl. The new loan rate has most closely tracked the decline in 3 year J GB yields (brown line). Which is not surprising given regional bank loans have a median of ~3 years to maturity. This year, as Negative Interest Rate Policy (N IRP) removed the zero bound on J GBs, the new loan rate fell by 22bp. The new loan rate remains 1.23% above the 3 year J GB yield, which also happens to be the average spread since 2010. What is highly unfortunate for the banks is that their own borrowing costs have in large not fallen below the zero bound, with ~90% of their funding coming via deposits (green line). That ~85% of regional bank loans have a maturity of less than 10 years, where the BOJ has now pegged the corresponding J GB rates below deposit rates, is a clear reason why the new policy is not favourable for banks. As long as short dated J GBs and the new loan rate remain where they are, the average loan rate for the banks outstanding loan portfolios (black line) will fall to meet the new loan rate. This usually takes around two years. The implied 22bp decline in the average loan rate, with flat deposit rates, would see a ~30% fall in ordinary profit next financial year March 2018.

Japanese Regional Banks

Loan income is also likely to continue to deteriorate beyond next year. The Japanese Financial Services Authority (J FSA) forecasts 60% of regional bank loan books will be loss making by 20252. Importantly the JFSA’s forecasts are based on shrinking loan books due to demographics, effects that are in addition to the roll-down effects from N IRP I have demonstrated above. I have previously written on J apan’s Wage markets, but do not factor these into my base case for next year as these effects are difficult to exactly quantify over the short-term.

Whilst on the subject of mortgages, I feel there has been unwarranted excitement in bank stocks around the steepening of super-long end rates. Firstly, I believe the BOJ is unlikely to allow super-long rates to rise much further for fear of insurance companies repatriating overseas assets and rapidly strengthening the Yen. Secondly, I believe the BOJ’s concerns around the impact of near zero 30 and 40 year rates on the life insurance industry have abated, with Dai-Ichi Life disclosing a return to above 100% economic solvency ratio. It seems the J GB market agrees, super-long yields have fallen over the last week. Thirdly, it is also important to note that the super-long rate segment for banks is dominated by the Japan Housing Finance Agency’s (J HFA) “Flat 35 S”. This is in effect a government mechanism for targeting long dated mortgage rates, the Abe Cabinet has even previously included a reduced rate (via an increased discount factor) as a government growth policy. The J HFA’s KIKO 113 priced on 16th Sept at a record low weighted average coupon of 0.7% for an average maturity of 30.5 years. That is a 32bps fall from the KIKO 105 issued at the start of the year in other words, the decline in long date mortgage rates continues to exceed the 22bps decline in average new loan rates.

Assumption 2: Interest 8: Dividends on Securities: “gains from cancellation of investment trusts” depleted and J GB holdings roll to negative

As previously written, some Japanese banks have been overstating core recurring earnings, by reflecting one-off equity gains on investment trust holdings within Interest and Dividends on Securities. The B_OJ acknowledges “a large amount of profits from investment trusts due to cancellations (realization of unrealized gains) recorded as an increase in net interest income at some banks”. I believe investment trust gains explain the deviation of Interest and Dividend on Securities away from the historical relationship with 4 year J GB yields below. This relationship should hold true with 75% of regional bank security holdings fixed income with an average maturity of 4 years. With equities 13% below the fiscal year Mar 2015-2016 average I expect that the “unrealized gains on investment trusts” will soon be depleted and Interest and Dividends on Securities will fall accordingly.

Japanese Regional Banks

Some banks fully depleted their “unrealized gains on investment trusts” in the past quarter and I expect the coming quarterly results to reflect this. Some banks may also be forced to report substantial equity losses via interest income at some stage. For my base-case assumption for Interest and Dividends on Securities I have assumed 1) “unrealized gains on investment trusts” are fully depleted this year March 2017, meaning they will not lift following year results, 2) average J GB holding yields fall to -O.12% (current 4 year J GB yield is -0.24%), 3) average corporate bond holding yields fall to 0.32% (current average new corporate bond yield is 0.17%), 4) Stocks yield 2.19% dividend in line with the Topix index, and 5) Other Securities (mixture of fixed income and equities) yield 1.0%. Given that longer dated fixed income products will continue to roll into a negative rate environment beyond next year I expect continued deterioration of earnings as long as the BOJ’s yield targets remain in place. Furthermore, significant amounts of the cross-shareholdings at banks are in other banks, I expect their dividend payments to each other to decline.

Assumption 3: Ordinary Expenses: Rise as provision rates rise to levels seen in other developed economies and credit costs return to 4obp.

As previously written, I believe some Japanese banks are understating non-performing loans and credit costs under the small to mid size enterprise finance Facilitation Act {SME FFA). There have been a number of recent articles which further support my views. Economist and bankruptcy specialist Sean Ross summarises the overall picture well against the data in my graph below. “The data for Japan does not make sense, especially that between 2007 and 2010. Nonperforming loan rates more than doubled in the US, Germany and the United Kingdom through those four years, despite the fact that each country experienced stronger gross domestic product (GDP) growth than Japan during the period Bad loans did not disappear. Instead, they were reclassified as assets with modified loan conditions (under the SME FFA)”. The Nikkei recently ran an article entitled Japan’s record low bankruptcies don’t tell the full story in which the number one rated sell-side economist, Ryutaro Kano, states “many bankrupt companies are corporate zombies that have been propped up by heavy borrowing, a phenomenon made possible in part by the SME FFA” the article then goes on to say “The number of companies that requested to defer repayment deadlines increased for the first time in three years in the first half of this year. “”These are companies that had not requested repayment extensions previously but have been newly forced to do so, ” an official at the Financial Services Agency said”. And a comprehensive study from the Research Institute of Economy, Trade and Industgz states “since the SME financial act is valid only for a specific time period, banks cannot hide non-performing loans forever” the “Japanese FSA introduced three years of transitional period after the termination of the SME financial act on March 2013”. It is impossible to know whether or not the FSA will continue with the “transitional period” but as my note points out increasing numbers of baby-boomer SME owners are turning 70 this year and unable to continue their businesses.

In addition to my concerns around SME’s, it appears that the J F SA has become increasingly concerned about a deterioration in quality of real estate loans. The Nikkei recently highlighted a J FSA paper which “sounded an alarm on the rising flow of fimds to the property market, greased by the BOJ’s extended utlraloose monetary policy. Bank loans to the real estate industry have grown fairly consistently. That development is especially notable among Japanese regional banks that have placed an emphasis on loans to individuals for building multifamily dwellings”. This increase supply of real estate is concerning given the decline in population (demand for real estate) and Fujitsu Research forecasts the national vacant housing rate will reach 28.5% in 2033, with vacancy rates in Tokyo not far off the national average at 28.4% in 2033. Another article entitled Japan’s negative rates weigh on inflation via rental market indicates that rents are already beginning to fall from oversupply.

For my base case forecast I have simply assumed that credit costs for Japanese regional banks rise to 4obps. This corresponds with the cycle lows seen in the US now and historically (Source: Federal Reserve), but is below current European banking system credit costs of 49 (Source: European Central Bank). Recent Tokyo Shoko bankruptcy data shows a 15% YoY increase in defaults in August and supports the reflection of higher credit costs from an impossibly low number.

Japanese Regional Banks

I expect the eventual impact of a large realisation of hidden non-performing loans to have a tremendous one-off impact on regional bank earnings. Those that survive will then experience higher credit costs going forward than have been seen in recent years. Given that I estimate hidden non- performing loans equate to 2.7x the size of regional bank net assets many banks won’t survive in my opinion. But, I have to admit timing on the reflection of the true extent of the non-performing loans is unclear.

That said even without an increase to credit costs, Assumptions 1 and 2 which are driven by the decline in interest rates, would see ordinary earnings of Japanese regional banks decline by 68% from March 2016 to March 2018, with ongoing deterioration into negative earnings beyond then. With Japanese regional banks trading on 9.5x P/E on average there is significant downside to come without an increase in credit costs, and arguably a collapse in earnings will instigate investigation into other asset problems at banks. If the BOJ does pursue a further push into negative interest rates the earnings decline will be swifter. If the 80.] allows interest rates to rise then the Yen will strengthen, equities fall and credit costs will rise amongst non-SME borrowers due to interest burden which is another reason why I think rising interest rates in Japan to save the banks are highly unlikely.

Positioning wise our prime broker data shows the short to float ratios in Japanese regional banks remain around half of that seen in the Japanese equity market as a whole, indicating Japanese regional banks are an non-consensus short.

Monetary policy was always going to come with its casualties, Japanese regional banks in my opinion are being sacrificed in the BOJ’s futile attempts to stimulate inflation. It appears to me that the recent rally in Japan and particularly the regional banks affords an excellent outlook for short returns.

See the full PDF below.

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