Situation in CDS markets
Since the second half of 2007, even as write-downs on securitised products deepened the woes at financial institutions, the impact of the subprime loan crisis on the corporate sector was relatively contained, thanks to solid fundamentals. However, the CDS market – a key indicator for corporate credit spreads – has experienced a dramatic change since February. The benchmark Investment Grade CDS Index has widened sharply in the U.S., Europe and Japan, with the average spread for the three markets as high as 200 basis points in mid-March from about 50 basis points six months earlier (Chart 3).

There are numerous structural and technical factors behind the abrupt widening in CDS premiums, including:

These factors have interacted to produce a chemical reaction of sorts that has proven explosive. The CDS premium has retracted from its March peak, but volatility is likely to remain high as long as financial markets remain under stress.

The effects of changes in the CDS markets could spread beyond limited individual incidents within the markets to trigger adjustments in the broad credit risk premium. Along with the decay in corporate fundamentals, we foresee a further CDS-provoked rise in corporate sector risk premiums over the coming months.

Outlook for the Liquidity Crunch
We think that the deleveraging process is likely to take a considerable period of time, given the vast scale of financial markets. Until then, securities brokers are likely to suffer not only write-downs on their own asset holdings but a falloff in business that could erode their earnings capacity and stubbornly high financing costs that will only get worse if their credit ratings are downgraded. As a result, we suspect that their risk-taking capacity will keep declining for the foreseeable future. At the same time, banks have seen a rising burden on capital due to write-downs and adjustments in business that had focused on securitised and off-balance-sheet products. With the consequent paralysis in brokerage dealing functions and the “crowding out” phenomenon brought about by the colossal financing activity by the banks themselves, we see no light as yet at the end of the credit crunch tunnel.

Solving the Problem
A resolution of the crisis in financial markets will require acknowledgement and disposal of losses by banks and a recovery of the credit creation function through a restructuring of core capital. Banks have recognised their losses at a rapid pitch over the past six months, but the swelling write-downs on various financial products have not indicated any imminent end to the problem. As much as the banks write off, they cannot seem to keep pace with their burgeoning losses, falling into a “moving target” situation.

The IMF’s Global Financial Stability Report estimates that losses at financial institutions as broadly defined (banks, securities firms, insurers, pension funds, government-affiliated lenders, hedge funds) will reach $1 trillion. This scenario assumes that the downturn in property values will extend to commercial real estate, and includes $250 billion in losses on commercial mortgage backed securities and loans. We had estimated at the end of last year that latent losses overall stood at $500-600 billion. Following the subsequent slide in financial product prices and higher risk connected with commercial loans and CMBS, we now believe that the total has doubled to $1.0-1.2 trillion (Chart 4). Notwithstanding slight differences in calculations for individual categories, the total is fairly close to the IMF’s figures.

If we assume that financial institutions as narrowly defined (major banks and securities firms engaged in the securitisation business) represent half of this total, their estimated losses come to around $500 billion. In comparison, the accumulated volume of losses taken by the major financial institutions to this point is around $300 billion, suggesting that they have only written off a bit more than half their total. We believe that it will be another several quarters at least before the markets stabilise, and feel that it is still too early to declare that the worst is over. Even so, if financial institutions make steady progress in their capital raising efforts, we would expect less risk of a hysterical market fallout as seen in March.

While attention has centred mainly on loss disposal at large financial institutions, acknowledgement of losses with other investors (insurers, pension funds, government-affiliated institutions, hedge funds) will soon have to get underway and we believe that the problem is unlikely to reach a conclusion any time in the near future.

Impact and Limitations of Policy Responses
Policy responses to a financial crisis generally include monetary policy, financial system stabilisation measures, and a framework for adjustments in debtor balance sheets.

Let us first look at monetary policy. The Fed slashed its policy rates from 5.25% to 2% between last September and this April, a cut of 325 basis points in eight months. We feel that monetary policymakers have been amply responsive to market needs. Nonetheless, we do not believe that further rate cuts would help directly in stabilising the markets. While rate reductions are indispensable in bolstering the economy and market environment, the impact of monetary policy seems to have reached its limits.

Next is financial system guarantees. In addition to extending the maximum lending period for its Discount Window, the Fed swiftly put together a new liquidity supply framework encompassing a term auction facility (TAF), term securities lending facility (TSLF) and a primary dealer credit facility (PDCF) (Chart 5). In particular, its decision to supply liquidity to securities firms as well as banks to head off systemic risk was a groundbreaking step.

Moreover, as with the Bear Stearns drama in March, the Fed has shown a willingness to act aggressively at its own risk to help rescue flailing financial institutions, such as providing financial backing to firms agreeing to take on high-risk assets (Chart 6). However, it is important to remember that a central bank can only take limited risk onto its balance sheet in trying to salvage a financial institution. If a loan goes bad, it could compromise the credibility of the central bank and generate serious political risk. In Japan’s own recent past, the Bank of Japan provided $3.4 billion in special loans when Yamaichi Securities declared bankruptcy in November 1997, of which $1.1 billion eventually had to be written off as bad debt. As a result of this experience, the BoJ’s tolerance for risk on loans to individual financial institutions shrivelled, and the policy focus shifted to public funding.

As for a framework for debtor balance sheet adjustments, some measures such as an interest rate freeze have been announced, but authorities have yet to work out a comprehensive scheme.

Public Fund Injections: Lessons From Japan’s Experience
There has been a growing body of opinion in the U.S. recently that the government should make use of fiscal funds – in other words, taxpayer money – to stem the financial crisis. Latent losses have widened to an estimated $1 trillion, as mentioned earlier. If the U.S. portion is assumed at half of this or around $500 billion, it would mean that losses amount to 3-4% of the nation’s GDP. Similarly, if 40% or $400 billion is held by European financial institutions and investors, losses would be 3% of Europe’s GDP. In the context of past financial crises in these regions, it is possible to argue that the scale of the problem has reached a level essentially necessitating the injection of public funds.

Japan also turned to public funds as a response to its bad debt problem in the 1990s and the early 2000s. What are the lessons to be learned from this experience? Some observers claim that Japan was able to conquer its financial difficulties with the use of taxpayer funds, and assert that the U.S. should follow its example. We find this contention difficult to support. To the contrary, we would say that Japan’s case offers a negative model; a good chance to learn from failure. It took over five years from the first infusion of taxpayer money into a big bank in 1998 before the banking system finally corrected itself around 2004, showing starkly that public fund supplies into the system (as opposed to individual bank rescues) were no instant cure or magic wand (Chart 7). One lesson is that it is essential to identify plainly the purpose and form of public fund injections to avoid wasting precious time and money for nothing.

There is no doubt in our minds whatsoever that public funds were an indispensable component in Japan’s bad debt disposal process. Without the boost provided to bank capital by taxpayer money, we believe the financial crisis would have been deeper and more prolonged. Nevertheless, why was it that the injections of 1998 and 1999 did not have a sufficient impact? Among a number of possible factors, we feel that the biggest was that the ultimate purpose of the fund supply – to achieve a comprehensive disposal of bad debt by the banks – was not properly stated, causing it to be misinterpreted as a mere measure to address the falloff in lending.

Such efforts to avoid proper mark-to-market and put off the inevitable have not been observed in loss disposal moves by financial majors in the U.S. and Europe. In fact, losses have actually shot higher due to the drastic assessment of asset holdings at the banks, heightening the liquidity crunch. We expect further cases like Bear Stearns, necessitating the injection of public funds backed by Fed loans in order to rescue individual financial institutions, but believe that other methods will be necessary for the more fundamental issue of stabilising the financial markets as a whole.

Conditions for Market Stabilisation
We believe that the subprime loan problem, the source of today’s market troubles, will ultimately require an adjustment in housing prices through natural market forces, and do not feel that any artificial attempt to pump up prices can be made to work. Even so, as a policy priority, it is extremely important that such adjustments be kept orderly. To this purpose, authorities need to prepare a framework that can ensure smooth balance sheet adjustments for debtors. Debt writeoffs and capital restructuring efforts by financial institutions represent balance sheet adjustments on the creditor side, but if this does not lead smoothly to such adjustments for the debtor, asset prices will not bottom out completely via a sufficient correction in the overall economy. This role was played by the Brady Plan when Latin American debtors tottered in the 1980s and the Resolution Trust Corporation during the savings and loan crisis in the late 1980s to early 1990s. In Japan as well, it was only when the framework for debtor support was strengthened – enactment of the Civil Rehabilitation Law in 1999, the greater functionality assigned to the Resolution and Collection Corporation in 2001, the establishment of the Industrial Revitalisation Corporation in 2003 – that progress finally began to be achieved.

We will need a framework different from that for corporate debt to handle the huge volume of bad home mortgages. It will be politically important to take care of debtors likely to number in the millions, and new methods will be called for other than just the usual bankruptcy route. We will be monitoring the course of debate and policy regarding this issue in the months ahead.

Future market themes
The much-awaited earnings announcements by major U.S. banks in mid-April were within market expectations despite the continued vast scale of subprime-related losses. Investor reaction has been relatively muted, and the credit markets have been steady.

The next points of interest will be:

In addition, we believe another key theme will be discussions over a policy framework for public fund injections and mortgage debt disposal.

Japanese credit market trends and outlook
In our last Japan Credit Perspectives report in January, we predicted that Japanese credit spreads would continue to widen, led by CDS markets. Subsequent developments have consistent with our prediction from a directional standpoint, but the extent of the widening in CDS premiums has substantially exceeded our expectations under the influence of U.S. and European market trends. The premium for iTraxx Japan S8 (5-year), the benchmark index for Japanese CDS, hit 240 basis points at one point in mid-March, overtaking its counterparts in the U.S. and Europe (Chart 8). The CDS premium narrowed thereafter and now stands at around 100 basis points, but the fact that the Japanese level could actually surpass those elsewhere, even if only briefly, indicates that the credit markets, like the stock markets, have become increasingly linked to overseas market movements. This suggests the risk of an overshoot due to foreign factors.

Corporate bond spreads have also widened, though not to the degree of CDS, with spreads in some low-rated sectors opening to around 30-40 basis points since January (Chart 8). Looking forward, we expect CDS markets to continue following U.S. and European trends, but if the CDS premium (iTraxx Japan) should remain fixed at a high level, we would expect the impact to carry over gradually to corporate bond spreads as well, in the form of a similar widening.

Implications for credit market investment
Consequently, we maintain our cautious stance on corporate bonds and would recommend an approach based on a flight to quality.

Amidst the general broadening in spreads recently, the widening in low-rated sectors has been relatively large, so that they may appear attractive at first glance. However, given the ongoing downward pressure on fundamentals and the risk of a global market selloff, we would advise particular care regarding those sectors.

Samurai bonds have been issued actively by U.S., European and Asian financial institutions since the second half of last year, but most have been issued at spreads several dozen basis points tighter than dollar bonds, leaving them at rich levels. Samurai bondholders tend to be much more conscious of downside risk than dollar bond investors due to the high volatility from supply pressures and the deteriorating fundamentals. It is important to consider these bonds not just from the standpoint of absolute spreads but from a global relative value perspective.

On the other hand, we believe the CDS market presents a unique investment opportunity in light of the considerably cheap level of CDS premiums relative to the fundamentals.

For example, the average rating for iTraxx Japan S9 (5-year) is single A (Moody’s) with a cumulative five-year default rate of nearly 50 basis points. The index assumes a recovery ratio of 35%, so a theoretical (break-even) CDS premium corresponding to a five-year default rate of this level would come to 32.5 basis points [i.e., 50 basis points x  (1-35%)]. As a result, the current CDS premium deviates significantly from the theoretical premium as calculated from the actual corporate bond default rate history. Adding a liquidity premium of 20-30 basis points to this theoretical premium, we attain a fair value of 50-60 basis points. This is low from the standpoint of today’s CDS market.

At the same time, considering the various potential risks connected with the liquidity crunch in U.S. and European markets at present, we believe that the liquidity premium and short-term volatility could remain at fairly lofty levels until the markets stabilise. Also, while Japanese markets have not seen a corporate bond default since retailer Mycal in 2001, the economic slowdown could awaken the sensitivity of investors to the possibility of a major default, causing a sharp change in investor psychology. Investors should keep close watch over the environment and direction of U.S. and European markets as well as credit trends among Japanese corporations, and maintain a sufficient risk buffer in their investment activity.