MW-38 -- Jasdaq: Less of a Winner than You Think

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Commentary on the week's music technology news
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Issue No. 38
Wednesday, August 6, 2003
Tokyo

++ Viewpoint: Jasdaq: Less of a Winner than You Think

The Bottom Line:

Top-Down

o For the Financial Services Agency and the Financial
Revitalization Program (FRP), it's been two steps forward, one
step back -- and on occasion, one step forward and two steps
back. But for all the criticism of the FSA under Heizo
Takenaka, his efforts to put teeth in the FRP have resulted in
a significant 7.7 trillion yen decline in the reported
nonperforming loans (NPLs) of the 13 largest banks, after
three years of continued deterioration.

o While this has left the weaker of these banks with extremely
thin to de facto nonexistent regulatory capital and depleted
profitability that goes beyond the downward distortion from
accelerated NPL liquidations, it is forward progress. Every
time the government has renewed its efforts to clean up the
banking system, large banks have effectively gone under.
Exactly one year after prime minister Ryutaro Hashimoto kicked
off Japan's "Big Bang" with much fanfare, Japan was staring at
a near meltdown and the failure of Hokkaido Takushoku Bank,
among others.

o On the very same day that a bank reform package passed the
Diet in October 1998, the Long-Term Credit Bank was
nationalized. Then Resona Bank was effectively nationalized a
few months following the inauguration of the FRP. How many
more "big bang," "financial reconstruction" and "financial
revival" programs and how many more bank
nationalizations/failures are needed before Japan can finally
put its banking problems behind it?

Bottom-Up

o The rising tide of the recent rally has lifted all boats,
especially the smaller, leakier boats. Those companies listed
on the Tokyo Stock Exchange First Section (TSE 1) that are
still trading at under 100 yen have surged 36.4 percent as a
group, compared to a 28.0-percent rise for those stocks
trading between 100 and 300 yen, a group which forms the
majority of stocks currently traded on the TSE 1 (some 841
stocks).

o On an aggregate basis, three-month performance declined the
higher the absolute value of stock prices went. For example,
the group of companies trading between 400-800 yen rose only
19.3 percent, and the group of stocks trading at 900 yen or
higher rose 19.1 percent during the same period.

o Money Watch is among those who believe that a more stable
stock market overall and continued abundant liquidity will be
most favorable for small cap stocks. However, the apparently
stellar performance of the Jasdaq and the J-Stocks in
particular has in reality been produced by less than five
stocks, the most prominent of which is Yahoo Japan. As Yahoo
Japan is now moving up to the TSE 1, its absence could well
mean more mundane Jasdaq performance.

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++ Viewpoint: Jasdaq: Less of a Winner than You Think

Top-Down: Two Steps Forward, One Back for FRP
Japan has had more than one grand plan to clean up its banking
system. In fact, it has had three. Problem is, none of the others
(i.e., Big Bang and Financial Reconstruction) have worked. Prime
minister Ryutaro Hashimoto first came up with Japan's version of "Big
Bang" reforms in November 1996.

The goal of these reforms was to rebuild Japan's financial sector
into "a strong and unshakable" competitive financial system and
to create an international financial market comparable to the New York
and London markets by the year 2001.

Exactly a year later, Japan came very close to a financial
meltdown, when Hokkaido Takushoku Bank, Sanyo Securities and
Yamaichi Securities all fell like dominoes in November 1997.

The Japanese government was not able to systematically respond to
this threat until almost a year later in October 1998, when a
package aimed at throwing a "safety net" under the financial
system (including the Financial Rehabilitation Law) was passed.

The goal of these measures was aimed at achieving a substantial
completion of disposition of the bad debt, at least at the
largest banks, by the end of March 1999, and to rebuild the
financial system into a strong, unshakably competitive system
during the period ending March 2001.

Neither of these goals was accomplished. On the very same day that the
banking package was passed, Long-Term Credit Bank (the current
Shinsei Bank) "applied" for temporary nationalization. Shortly
thereafter, in December 1998, Nippon Credit Bank was declared
insolvent.

These failures came after the government had injected its first
round of public money (2.1 trillion yen) to bolster the balance
sheets of nine city banks and first-tier regional banks.

In March 1999, the major banks received another injection of
public funds, this time worth over 7 trillion yen. By October 1999,
the government was claiming that "good progress" had been made;
the big banking groups were moving toward a series of "mega-
mergers." It was hoped that these mergers would be a catalyst for
industrial restructuring, and a breakdown of old zaibatsu group
alignments. Depositors in Japan were to be fully protected only
until the end of March 2001.

The Financial System Revitalization Program
But by 2002, it was becoming apparent that the banks were not
writing off/writing down NPLs as fast as they were accumulating.
Moreover, the merger of Mizuho Holdings will probably go down as some
of the worst in corporate history, with ongoing executive turf wars,
ATM network and settlement failures, a plunging stock price, and the
largest loss in Japanese corporate history in fiscal 2002.

Prime minister Junichiro Koizumi surprised observers by dumping then
FSA minister Hakuo Yanagisawa in September 2002 to show how "serious"
he was about cleaning up the bank NPL problem. Former FSA minister
Yanagisawa was staunchly opposed to using more public funds to bolster
bank capital. Without additional capital infusions, the banks were
restrained in how fast they could liquidate NPLs by the amount of
cushion they had in liquidating their portfolios of stocks to
offset these write-downs.

The new FSA minister, Heizo Takenaka, favored a more aggressive
NPL liquidation program as well as proactive infusions of bank
capital with public funds to accelerate the process. Bank stocks
first rallied when Takenaka was named to his new post, as
investors expected that an accelerated cleanup of NPLs would in
the long term be good for Japan's financial sector and economy.
Thereafter, bank stocks entered a tailspin that took the Nikkei
average to the 7,600 level as the FSA pushed the banks hard to
liquidate NPLs.

In addition, the major banks that received public funds in 1999
had failed to meet the earnings targets stipulated in their
revitalization plans. They continued to be plagued by excessive
NPLs, and substantial amounts of their Tier 1 capital was in fact
"vapor capital" in the form of deferred tax assets (DTAs). The
1999 government guidelines stated only that the government would
encourage banks to improve their earnings if profits fell by 30
percent or more from their target figures. There were no standardized
guidelines for auditors to calculate DTAs, and loan classifications of
the same borrower also differed according to the bank's relative
position, i.e., as a main bank or as a junior creditor.

Under Takenaka, the FSA's relationship with the major banks took a
much more adversarial tone, especially after the announcement of the
Financial Revival Program in October 2002. The six key points of the
FRP were:

1. Adoption of discounted cash flow valuation of NPLs
2. Harmonization of the diverse credit classification of the
same borrower by different lenders
3. Elimination of the discrepancy between self-evaluated NPL
amounts and official NPL counts
4. Better bank corporate governance
5. Implementation of an early warning system for bank
balance-sheet health
6. A new framework for corporate revival

Reading through the FRP, one gets the distinct impression that
becoming a "special support financial institution" was something
that bank management would want to avoid at all costs. Banks
would be subject to "special support" when:

1. Management conditions are such that emergency countermeasures
are required
2. The bank itself applies for public funding
3. The preferred shares held by the government and converted into
regular voting shares exceed a specific percentage of
outstanding shares

Reigning in the Banks
It remained to be seen whether the FSA and Takenaka could
achieve their goal of reducing the NPL ratio of major banks by half
(from a level of more than 8 percent), or in writing off by fiscal
2004 over 13 trillion yen of nonperforming loans. Despite virulent
resistance and hostility by the banks to the Financial Revival
Program, Takenaka and his program did get the banks' undivided
attention.

The Financial Revival Program and plunging values in bank stocks
jolted the banks into responding, albeit incrementally. At the
same time, the banks and their supporters within the LDP played
up the risks of Takenaka's so-called "hard-landing" scenario,
conjuring up all sorts of worst-case scenarios.

The quid pro quo for the FRP was the Industrial Revitalization
Corporation of Japan. But assuming that the Financial Revival Program
developed more or less as scheduled, while the Industrial Revival
Corp. might not (at least as regards fostering NPL write-offs and
revitalizing "recoverable" firms as opposed to merely propping up
zombie companies), the net result could be what the opponents of the
Financial Revival Program feared: exacerbated deflation, a rush of
bankruptcies and downward pressure on an already faltering economy.

Such a scenario was not good for stock prices. Indeed, the stock
market began to discount such a possibility nearly from the day
Takenaka assumed his post, plunging from over 9,300 on
the Nikkei to a new post-bubble low in the 7,600 range as
stock market participants speculated about yet another financial
"crisis."

There was (and is) intense pressure from Takenaka's political
opponents within and without the LDP, from the banks themselves,
and increasingly from the business community. The FSA was forced
to back away from the more contentious measures envisioned in the
FRP in deference to the plunging stock market and concerns over
the impact on the economy.

Still in the Heat of Battle
The banks won the first skirmish regarding the introduction of
stricter benchmarks for controversial deferred tax assets that
had swelled to account for a substantial portion of Tier 1 bank
capital ratios.

But they had by no means won the war, as was made very clear by
the government "rescue" of Resona Holdings, where the government
liberally interpreted Article 102 of the Deposit Insurance Law to
declare an "emergency" in order to proactively infuse capital
into Resona and effect a de facto nationalization of the bank.
It was necessary to evoke Article 102 of the Deposit Insurance
Law because an earlier provision for bank capital infusions with
public money -- "The Financial Function Early Strengthening Law" --
had already expired in March 2002.

The Financial System Council, which was supposed to have come up
with a new framework for proactive infusions of public money as
needed into the major banks, came out as predisposed to
introducing a new framework for bank capital infusions, but
remained hopelessly deadlocked on the issue of stricture DTA
requirements after seven months of deliberation.

This notwithstanding, the FSA and Takenaka have continued
struggling to make forward progress, following the basic game
plan as laid out by the FRP. The FSA has been forced to back off
of an earlier introduction of more stringent DTA measurement, but
the FSA is doing everything in its power to keep up the pressure on
the banks to improve their business operations.

This pressure is expected to continue as long as Takenaka remains in
charge of the FSA. While there has been speculation of his possible
removal, Takenaka's job appears assured as long as Koizumi remains in
power. Conversely, his replacement would represent a big step backward
in the ongoing effort to clean up Japan's banking system.

The FSA is now warning the banks that they will be issued
business improvement orders. In August, the affected banks would
be required to submit new revitalization plans that include
restructuring moves, job cuts and other measures to improve
earnings. The FSA can ask top executives to step down if they
fail to achieve earnings goals included in the plans. Heretofore,
the banks ignored such threats, but they cannot afford to
ignore them as long as Takenaka is in power.

One or Two Banks Could Still Be Nationalized
"There but for the grace of (political expediency?) goes Mitsui
Trust" was what more than a few observers were thinking when the
auditors tripped up Resona Bank and effectively forced the bank
to seek a government capital infusion.

But upon seeing the results of the de facto nationalization,
employees of other banks on the short list for similar action are
apparently sanguine. The thinking goes thus: Even if we are
nationalized, management will not be arrested and employees will not
be fired. What's wrong with that? In other words, the Resona bail-
out has fostered a sense of relief among the rank and file in
other troubled banks.

The usual definition for such a situation is called "moral
hazard." DTAs as of the most recent count were effectively 100 percent
of Mitsui Trust's Tier 1 capital -- i.e., the bank has no "real" Tier
1 capital. Why Resona and not Mitsui Trust? There are a couple of
possibilities:

1. The zaibatsu connections of the Mitsui Group are better than
the ex-Resona bank CEO's perceived connections with
politicians.

2. Since the Sumitomo Mitsui financial group has already been
formed, there has been speculation for some time that Mitsui
Trust would join that fold.

Thus the de facto nationalization was a watershed event, at least
regarding perceptions of the degree of systemic risk in the
financial system. Moreover, it forced a postponement of a
decision on the thorny issue of DTAs, at least from the policy
perspective.

Bottom-Up: Jasdaq Performance No Great Shakes
As Money Watch has previously pointed out, one of the features of the
current rally in Japanese stocks is that individual, semi-pro day
traders and the dealing desks of the smaller brokers have played
an active role, and this is reflected in the high trading volumes
in the lower quality "penny" stocks. To quantify this, we looked
at the performance of all TSE 1 listed companies and broke them
down by stock price.

On a simple average basis, the performance statistics bear this
out. Those TSE 1 listed companies still trading at under 100 yen
have surged 36.4 percent as a group, compared to a 28.0-percent rise
for those stocks trading between 100 and 300 yen, which forms the
majority of stocks currently traded on the TSE 1 (some 841
stocks).

On an aggregate basis, three-month performance declined as the
absolute value of stock prices rose. For example, the group of
companies trading between 400 and 800 yen rose only 19.3 percent, and
the group of stocks trading at 900 yen or higher rose 19.1 percent
during the same period.

What about the so-called high-priced technology/growth stocks
traditionally favored by foreign investors? Here was one
exception to the rule just described. The "tech stock" group
(which includes the electricals, precisions and the software
stocks listed under the "services" trading post) that trades at
stock prices of 900 yen or above rose by 33.2 percent during the three
month period. As a group, high-priced and lower-priced "tech" stocks
rallied 30.7 percent.

Jasdaq first bottomed out on March 11, 2003, and has rallied 48.7
percent since. The Nikkei average, on the other hand, didn't bottom
out until April 28, and while rallying just under 26% percent, has
failed to breach 10,000, even though supported by a rebound in bank
stocks and companies that were being priced to fail.

The Jasdaq J-Stock Index of a "Nifty 51 basket" of Jasdaq's best
has surged 71.9 percent since late March and continues to renew highs
while the Nikkei consolidates.

Yet the biggest winner, Thine Electronics, could not match the
204-percent rebound of Nikkei dogs like Nippon Yakuhin or Daikyo.
Moreover, a closer analysis of the J-Stock's market-cap-adjusted
surge shows that just four stocks -- Yahoo Japan, Rakuten, Aruze
and UMC -- accounted for 83 percent of the total market-cap-adjusted
return of the J-Stock index since the end of March, with Yahoo
Japan alone accounting for 66 percent of the return.

Excluding these companies, the J-Stock index would have returned
a more mundane 12.3 percent, versus a 39.2 percent return for Jasdaq
as a whole (which also includes the above four stocks) and a 16.3
percent return for the Nikkei 225 during the same period. Remove the
stars, and the "Nifty 51" hasn't been so Nifty.

Moreover, with Yahoo Japan -- Jasdaq's star performer and by far
the largest in market capitalization -- going to Tokyo's big board,
the J-Stock index's performance will be a lot duller.

-- Darrel Whitten

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Written by Darrel Whitten info@asianbusinesswatch.com

Edited by J@pan Inc staff (editors@japaninc.com)

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