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:
Traders in Tokyo have given warning that about $90 billion (£55billion) of complex foreign exchange products, sold mainly to Japanese households and institutions, are on the brink of falling “like a house of cards”.
A rescue effort by the product issuers – large Japanese, European and American investment banks – is expected to involve extensive hedging measures that will throw global currency markets into even deeper turmoil.
The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.
The products combine exposure to foreign exchange, interest rate differentials and domestic inflation and have formed a small but potent part of the so-called yen carry trade – the borrowing of yen to invest in currencies offering higher interest rates – a gambit thought to have financed huge amounts of global risk-taking in recent years.
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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.The warning on PRDCs coincides with a phase of unprecedented volatility for the yen, which this week soared to levels against the dollar and euro that are likely to hurt the country’s exporters. The yen traded at 97.65 to the dollar yesterday, close to levels not seen since 1995. Two months ago, the yen stood at 110 per dollar.
Foreign exchange traders have blamed the unwinding of the yen- carry trade for much of the upward pressure on the Japanese currency.
Also fuelling yen volatility has been speculation that the Bank of Japan (BOJ) may be preparing to cut interest rates this week – rumours that provoked a sharp reversal for the yen over the past two days. The speculation suggests that the BOJ could be about to trim 25 basis points from rates and bring them down to only 0.25percent.
At the same time, Japan’s “Big Three” banks – Mitsubishi UFJ, Sumitomo and Mizuho – are tallying mounting losses from Tokyo’s plunging stock market. Japanese banks have vast share portfolios that are bleeding red-ink.
When the Nikkei share index hit a 26-year low of 7,000 points this week, combined paper losses on the stocks held by the Big Three since March 2007 amounted to about $100billion.
Industry figures said that if the savaging of the Japanese banks’ huge stock portfolios continues, it could trigger a capital crisis among institutions recently viewed as among the safest and best capitalised in the world.
The stock losses suffered by Mitsubishi UFJ alone – $41 billion – are greater than the total sub-prime writedowns of HSBC, JPMorgan or Bank of America.
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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
“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
I previously was working as a junior in a multinational that valued these Power Reverse Dual Currency notes for our clients.
These things some of these were so heinously complicated to model that most companies (including japanes ones) avoided them. Perversely, as a junior, I ended up modelling them. These were a death trap.
They typically paid a coupon based on the USD/JPY FX rate according to a calculation or the sort:
10%-7%*105/FX
They usually paid around 3% but their payment profile was horrible. Many of them were forecast to stop paying coupons after only 4 years. And these were 20-30 year bonds!
Basically they were a bet that the carry would not unwind and the yen would stay undervalued. Oh, yeah and if things moved the other way most were issuer callable so their asses were covered!
“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.”
It’s a few days that I see the most hilariouses pieces of bad news.
It is like you are trying very hard to find new disasters as if we had not enough of them already.
Basically this article says that there may be losses for japan households ranging from 20 -30 Bn to 90 BN. “potential for havoc”? It does not seem as a huge news in an environment where all assets class have lost something like 5 trillions.
As I already said …. please get a life.
I would guess that the total losses from the 15 trillions of Japanese savings have a much higher price tag.
… at this very moment, the best all those sloshing cash can do is gyrating between ..
a) major equity market (thus, why it can fluctuate 5-9% in the blink of an eye every single day)
b)US T-bond,
c) USD, EURO, or yen.
d) maybe commodity.
I seriously doubt all those USD cash sloshing around will be put into emerging market. China is closed. so…
Now they really have to quickly stabilize the sloshing sea of liquid USD. It is truly a tsunami.
I just hope those cash doesn’t jack up commodity 20-80% across the board. Or we will be back to around time of Lehman collapse again.
If they allowed leverages of 20:1, it seems like the issuer is going to be the loser, not the investor.
“If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.”
John Maynard Keynes, as quoted in The Economist (13 February 1982), p. 11
Reporting and awareness of problem investments like PRDCs is important to avoid the same mistakes again.
With USD interest rates approaching zero and likely to remain locked down there for a decade – these types of leveraged-return instrument (USD carry-trade driven) will spring up like weeds. Is this another regulatory failing in the making? If they blow up en-masse when USD rates finally climb – will regulators be saying “ooh we didn’t see that one coming!”
I’ve lived in Japan for 12 years and I can explain a little of the reason why protection for the retail investor has weakened. When I first arrived in the mid 90’s, most Japanese people were still shell-shocked over the late 80’s stock and RE crash. Nearly everyone wanted 100% safe investments and there were high legal barriers to investing overseas (almost impossible for the non-super-rich). Ordinary people couldn’t even have accounts or investments outside Japan (a leftover of regulations designed to rebuild the country after WWII). But after nearly a decade of savings account and CD rates hovering around 0.2% to 0.35% (not a typo) there was pressure to find better investments. The Japanese government was also under pressure from other countries to open their financial markets. They instituted a widely hyped “Big Bang” liberalization of financial markets and removed many of the old restrictions while simultaneously allowing foreign financial firms into the retail investment market in Japan. In the first year, Japanese investors flocked to the superior yields offered by the foreign investment companies, but after about a year, the Japanese investment houses had caught up. The Japanese investment houses started offering more creative (and poorly documented) high-yield investment opportunities carefully tailored to local preferences and a large part of that vast pool of savings began to flow into these new investments. Advertising and peer pressure influenced a lot of people as they feared missing out on the new “hot opportunity”. Investing became “cool” and a lot of people jumped into things they didn’t really understand. They’re about to learn more about finance than they really wanted (but aren’t we all?).
a lot of unsophisticated japanese investors (small banks as well as households) got comfortable with punting on the market by buying principal protected structures, which is what i believe most of the prdc’s are. however, with yen rates so low, principal protection in yen is very expensive. so most of these products are very long dated (min 10 years), and they have a very very leveraged coupon structure.
as another example, i was involved in putting together a similar investment structure linked to emerging markets debt. like the prdc’s, these were long dated, with a leveraged coupon, this time linked to the underlying emerging markets risk. also like the prdc’s, thanks to market volatility, most of these have now turned into long-dated zero coupon bonds.
i feel very sorry for the clients that bought this product. i personally thought it was a good structure at the time – something i might have invested in myself. emerging markets debt is still a very good long term investment, but the amount of leverage built into the structure meant that it was simply not able to withstand such extraordinary market volatility.
i suspect prdc’s are a similar story. currency forward curves used for pricing these structures are based on interest rate differentials. forward curves said the yen would appreciate rapidly, but from an economic and geopolitical perspective this did not make sense (and indeed, still does not make sense). so “monetising” that forward curve via the carry trade is a sensible strategy, provided that you can stay in the trade for the long term. the problem is that when you build a lot of leverage into the investment structure, like prdc’s do, it becomes impossible to weather big storms like the one we have just seen, and you end up losing everything.
Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them …
The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.
The products combine exposure to foreign exchange, interest rate differentials and domestic inflation
US Reform
the above can go a long way toward a definition of the current crises to educate the public on what has happened to them and how.
US News media, if they understand it themselves, are useless -indeed, worse than useless because their skill is acting as if they know what they are talking about while people starved for financial news watch c-span and think they are being educated by congressional hearings that further exploit this absence of news with sensationalized history, pandering to the public, and more propaganda from witnesses.
every financial instrument including credit cards, mortgages and bank agreements sold to the public must feature language that can be understood by any high school student with an above B average.
CORRECTION for failure to put emphasis on quoted material:
“Japanese regulators were once hugely protective of retail investors and placed tough restrictions on what products could be sold to them …
The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.
The products combine exposure to foreign exchange, interest rate differentials and domestic inflation …”
Topic: Reform
the above can go a long way toward a definition of the current crises to educate the public on what has happened to them and how.
US News media, if they understand it themselves, are useless -indeed, worse than useless because their skill is acting as if they know what they are talking about and people starved for news who watch c-span think they are being educated by congressional hearings that further exploit this absence with sensationalized history, pandering to the public, and more propaganda from witnesses.
every financial instrument including credit cards, mortgages and bank agreements sold to the public must feature language that can be understood by any high school student with an above B average grade.
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
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.
ciccocicco,
Quit being a complete and utter jerk. The headline was a direct quote from the Times Online, And Yves’ intro was not alarmist, despite your efforts to depict it as such. The FX markets HAVE been hugely volatile, the yen made its biggest move in what, 26 years, the FED and IMF just created huge new facilities to stop the run on emerging markets. Or were you asleep while that was happening?
You dump on Yves yet come here to read. If you don’t like what is here, quit reading rather than making lame, nasty comments. You offer not ONE SHRED of data, this is fact free, useless bitching.
If you just want to pick fights, go to a political blog. I find your comment negative and pointless. No one is holding a gun to your head to make you read this blog. Yves presents information, all you do is complain.
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
what are the implications for the large japanese banks and the stock market? thanks