Commentary: Japan's Banks: Why Tokyo Is Crying Wolf

After blithely ignoring Japan's banking crisis for the best part of a decade, Tokyo officialdom is now talking of financial Armageddon. Finance Minister Kiichi Miyazawa recently warned Japan's Diet that a sudden bank failure in Tokyo would cause a global train wreck in the vast $40 trillion global derivatives market. That started to look prescient on Sept. 9 as the Tokyo stock market fell 1.1% on rumors that Fuji Bank had $22 billion in derivatives losses, though Fuji insisted its maximum possible losses were $117 million.

If a Japanese bank suddenly collapsed while holding huge outstanding derivatives contracts, the argument goes, it would have to close out its positions in a hurry. In turn, that could set off a cascade of defaults and tear apart a web of financial contracts used to hedge against changes in interest rates, currencies, commodities, and stocks. And if Japanese lenders fail to honor their sides of deals, aggrieved international banks in the U.S. and Europe will treat their Tokyo counterparts as pariahs for years to come.

To drive home its point about the dangers, the government leaked word that Japan's top 19 banks hold derivatives worth a staggering $17.5 trillion. That's well over three times Japan's gross domestic product.

A NIGHTMARE. Scary talk, but misleading. As with other aspects of its proposed workout of Japan's debt-burdened banks, the ruling Liberal Democratic Party isn't exactly telling it straight. Japan's banking titans are indeed big players in global derivatives markets. And if ailing Long-Term Credit Bank of Japan Ltd., which the LDP says holds $380 billion worth of outstanding derivatives contracts, suddenly collapsed, it would be a nightmare for Bank of Japan to unwind the deals.

But to reach the $17.5 trillion number, the authorities are using the deals' so-called contract value, or face value, which tells little about the real exposure or risk. For example, if an investor paid $500 for a warrant to buy, say, 10,000 shares of Toyota Motor Corp. in a year at $50 each, the contract value would be $500,000. If the shares actually shot up to $75, the investor would pocket the difference, some $250,000. But if the shares tanked instead, the investor would let the warrant expire--and be out of pocket all of $500.

So likely losses to Japanese banks are only a fraction of the contract value. True, a fraction of $17.5 trillion could still be a sizable sum. The government puts the potential losses for the top 19 banks on existing derivatives contracts at $180 billion. But to reach that total, every single counterparty to a derivatives contract would have to default at once, or market gyrations would have to be such that every single bet made by all Japanese banks went sour simultaneously.

What's going on here? In a word: politics. Some analysts think the LDP is using scare tactics to steamroller opposition parties and the public into accepting its "soft landing" bank bailout program. The plan would bail out banks with taxpayers' money on lenient terms. It would give soft new credits to LDP-favored companies in construction and real estate industries. And it also would clear the way for a speedy merger of LTCB with Sumitomo Trust & Banking Co. "They are trying to get the opposition to shut up," says J. Brian Waterhouse, a banking analyst with HSBC Securities Japan Ltd.

RISKY DEALS. There's no denying that big international banks, such as Barclays Bank, Bankers Trust, and most recently, J.P. Morgan, have been burned by derivatives bets gone bad. The same could happen to a big Japanese bank. Some derivatives deals are so risky that an open position can mean huge losses. It's also true that U.S. and European lenders are extremely edgy these days about doing derivatives deals with Japanese lenders.

But the anxiety has more to do with Japan's unwillingness to implement a painful banking industry overhaul to clear $1 trillion in problem loans that analysts say are on the books of Japanese banks. That was the result of sloppy lending made primarily to Japanese companies, and writing it off will mean a bruising workout for both lenders and borrowers. On Sept. 9, BOJ cut lending rates to a record low 0.25% and said it would flood the banking system with cash. But the real danger is that without serious restructuring, that won't do much good.

Peddling global meltdown theories about the little-understood world of derivatives may be shrewd politics for the LDP. But the real nightmare is that the Japanese public and opposition will be bamboozled into accepting a bailout plan that fixes nothing and merely prolongs the current agony well into the next century.

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