" The irony is that Japanese regulators were once hugely protective of retail investors"

Yves Smith on Naked Capitalism about PRDC's in Japan:

"This Times Online story is frustratingly vague about the exact nature of these complicated and risky foreign exchange products sold to Japanese retail investors. While the size of the problem ($90 billion) may seem not all that bad in comparison, say, to subprime exposures, recall that these trades are likely to be unwound in a compressed period of time when currency markets are already volatile, thus increasing the potential for havoc.

The irony is that Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them. That attitude clearly went out the window.

From the Times Online:"

Please read the story. Here are my posts, with Yves thrown in:

Don said...

See John Gapper on FT here:

http://blogs.ft.com/gapperblog/2008/10/mrs-watanabe-and-the-sudden-rise-of-the-yen/


"The accounts showed that it was common for Japanese retail investors to be offered leverage of 20 times or more for their cash. In other words, they could deposit the equivalent of $1,000 and take trading positions of $20,000. A lot of them had used the opportunity to buy higher-yielding foreign assets.

The trade worked fine for Japanese investors as long as currencies remained stable and they could in effect switch yen into higher-yielding assets denominated in other currencies. But the sharp rise in the yen - and comparative fall in the value of these foreign assets - is probably landing Mrs Watanabe and her friends with big losses.

Here, to expand the point, is a prescient piece from FT Alphaville a year ago."

Don the libertarian Democrat

October 30, 2008 1:05 AM

And:

Don said...

"The important thing to know about Mrs Watanabe is that, temporarily at least, she has all but stopped flapping her wings"

Who is Mrs. Watanabe?

"Mrs Watanabe is crude shorthand for Japan’s $15,000bn pool of savings, the deepest in the world and worth more than the annual economic output of the US. These vast resources are somewhat apocryphally marshalled by Japanese women, who have traditionally held a firm grip on family finances."

Let's see:

1) Rising yen
2) Lower interest rates
3) Next bubble

David Pilling in the FT:

http://www.ft.com/cms/s/0/0df30044-a5f4-11dd-9d26-000077b07658.html

"The yen carry trade has not been the only cheap source of liquidity in recent years. But Ashraf Laidi, chief currency strategist at CMC Markets, reckons it has been the biggest. He quotes figures suggesting that Japanese households alone, discounting savings mediated through life assurers and other institutions, have mobilised $500bn in outbound funds. That leaves aside speculators, who have borrowed unknowable amounts of yen to invest abroad, often on highly leveraged terms.

Just as state bank bail-outs risk moral hazard, more recklessness and the need for future bail-outs, so the unwinding of the carry trade carries with it the danger of the next great bubble. In Japan, the central bank appears to have reacted to a rising yen and sinking stock market by contemplating the uncontemplatable: a rate cut. Even the rumour of such has provoked a mini equity rally and a weakening of the currency.

This is poison for the BoJ. It hated having to keep rates low, fearing that cheap money can cause bubbles in real estate, in capital investment and in the carry trade. Its sightings of inflationary danger everywhere provoked mirth among outside experts. But few are laughing now."

And so:
"If Japan really is about to reverse course towards zero interest rates, it will once again become the source of almost free money for anyone with an appetite to invest. Worse even than that, says Mr Laidi, is the potential for an even more dangerous dollar carry trade. The Federal Reserve has been desperately cutting rates, and lopped another half point off again on Wednesday. The nearer US interest rates approach zero, the greater the incentive to move dollars into higher-yielding assets elsewhere.

These gyrations do nothing to solve the underlying problem, which is that Asia has an excess of savers and the US and Europe an excess of spenders. Unless that is solved, the world seems condemned to repeat the swings of recent years, as capital is arbitraged between countries where money is cheap to those where it is expensive."

Problems:

1) Dollar carry trade

2) Asia saves, the West spends

3) Here we go again

Is this real?

Don the libertarian Democrat

October 30, 2008 1:27 AM

And:

Don said...

Following an earlier comment about Japan, if you have domestically:
1)Low interest rates
2)Stagnant stock market
3)Stable exchange rate
4)Low inflation
Doesn't it make sense that you would try and invest overseas? And after the tech bubble, doesn't it make sense that you would look for bonds that would provide you higher yields?
Naturally, if any of these variable change significantly, you could be in trouble. So when the story says:
"The products combine exposure to foreign exchange, interest rate differentials and domestic inflation"
it's not saying anything profound.
And when we read this:
"The PRDC's complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility."
it's a little hard to credit, since I just described the investment's worth and problems in a few short lines?

Don the libertarian Democrat

October 30, 2008 10:04 AM

And Yves:

Yves Smith said...

Don,

The shortcoming in the list above is 'stable currency". In a world of floating currencies (or mainly floating, and Japan was not one of the ones maintaining a dollar peg) the FX risk is huge, although for extended period (perhaps up to a couple of years with not too much movement) it can look low.

And if you read the stories on Japanese retail currency traders, they were as frenetic last year as day traders in the tech bubble here.

The yen was in fact cheap, so the risk was that despite the pickup in yield, you would lose far more due to a fall in the higher-yielding currency. When I was a kid, no one would EVER think of making deposits in higher-yielding currencies, everyone understood that the high yield was a big big signal that a price fall was in the cards.

October 30, 2008 6:35 PM

And me again ( the dummy ):

Don said...

Yves, Thanks. Great point. I was just about to mention these PRDC's on a post about securitization. I think that you make my case, and that we're both on the same page.

I agree that the assumptions seem crazy, my only point was that you would have thought the risks you just rightly pointed out should be easily explainable, even if the products inner workings are complex. From your comments, I was trying to understand how even you were having a hard time with them, and I now see that it's the risk as much as the complexity. I hope I've understood you now, and that my point is clearer.

Don the libertarian Democrat

PS Your blog is great. I'm learning so much from it, but I won't blame my mistakes on you. Take care

October 30, 2008 7:14 PM

Securitization Reconsidered

Okay. Big news. Derivative Dribble explains securitization. Let's go back to the Bloomberg article:

"The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion. "

Okay. Claims about securitization:
1) bundles loans and mortgages into securities
2) more than $27 trillion of these securities have been sold since 2001
3) that makes these securities the largest U.S. export since 2000

So what? That hardly seems a bother other than the figure being quite large, but, then, good for the U.S.

So now banks outside the U.S. start doing this:
Result: $667 billion in losses: $260 billion or so outside of U.S.: about $400 billion in the U.S.

Okay. These securities lost this money? How?

"Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade."

Okay, here, I'm lost.

These securities fund:
A. Credit cards
B.Car purchases
C. Leveraged buyouts
D. Subprime mortgages

The "system"
A. Pools loans
B. Spreads risk
C. Makes borrowing cheaper

Voila: A Debt Culture
Does all lowering of interest rates lead to a Debt Culture?

There's $4.2 trillion in money market funds ( deposits paying interest )
Banks made money with the mm funds by funding subprime mortgages and cutting costs
The cutting costs sounds like a good thing, the subprime loans don't

"Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost."

The banks took in deposits, paid interest on the deposits to the depositors, and loaned the money out to borrowers at a higher rate of interest than they were paying depositors or charged fees. This example doesn't make that clear.

Now, after securitization:

"During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest."

How do the banks make money in this? If it's lending, do they get interest, fees, what?

"Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.

``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''

It is a fee business if there's no capital. That's why I asked how the banks make money on these securities. How does the bank originate a loan without capital?

"As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf. ``One of the things the United States exported overseas was a debt culture,'' Haley said."

So, because of these securities, consumer debt tripled in the U.S., and, since we seem to be rich, other nations did the same thing.

I've already gotten a headache, and we're just coming to CDO's.

"Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day."

Okay. CDO's use short term debt which is cheap but comes due fast.

"SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007"."

And:

"Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months."

And:

``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July"

Okay. Short term lending is the problem.

"Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since."

Only it's not. It looks here like lack of collateral.

We've come a long way. Derivative Dribble asked if I was fair to securitization in the first post I did? No, I wasn't. It looks like the culprits are:

A: Lack of capital
B. Poor loans

A poor loan is a poor loan.

Here's Derivative Dribble:

"So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee."

So remember where I said the banks are making money through fees? Banks are making money on these securities, mortgages through fees.

Of course, whether there is enough capital in a bank, or whether a loan or mortgage is sound, are completely separate questions. So until I hear otherwise from Derivative Dribble, it seems to me that, just like CDS's, the problems are lack of collateral and unwise loans, not the investments themselves.

Can people have been deluded?

See my post about coming up about PRDC's in Japan.