Lehman Fall From Grace Taints Japan Inc.

"I begin to smell a rat."

M. De Cervantes

The collapse of Lehman Brothers has impacted Japan in many ways. Lehman had for many years been one of the elite I-banks that had thrown off many stock traders and M&A specialists that had gone on to set up hedge fund operations in the region; some of which had had books written about their early career exploits (e.g."Ugly Americans...") while others had been involved in audacious blow-ups.

The bank itself rode the wave of high profile and very profitable investor activist deals before that whole business model slowed down drastically a couple of years ago with the arrest of Murukami of MAC consulting fame.

In recent days, there had been strong rumors that Nomura had been interested in buying out Lehman's U.S. operation. The positives at the time had focused on the opportunity for the premier Japanese shop to flex its global muscle and pick up the recognized jewels of investment banking contacts toegther with a blue-chip investment management operation in Neuberger Berman.

The rest of the Lehman operations pretty much overlapped with Nomura's own global reach in Asia, London and to a limited extent the U.S. So the thought, together with an intense fear of the unknown on the balance sheet meant that Nomura pulled back from any serious discussion. The risk-reward was not attractive.

The Lehman Legacy is now looking ugly (like the famous book). Yesterday, the WSJ reported that a number of Japanese banks were sizeable creditors as Lehman bankrutpcy proceedings took shape in Japan. The extent of the exposure to toxic Lehman Legacy took the equity markets by surprise and banks stocks were punished on the TSE (as they deserve). The TOPIX and Nikkei 225 sank in unison.

It is funny how the banks criticize hedge funds for transparency when they themselves prove to be non-transparent time and time again!

This time around the list of tainted Japanese banks is long. Shinsei Bank and Aozora Bank were large Lehman creditors. Mizuho Financial lowered guidance on 3Q profits by US$113 million due to unrecoverable Lehman loans in the form of a credit-link loan and in senior corporate bonds issued by LB. Lehman itself offered that it owed US$289 million to Mizuho Corporate Bank (a subsidiary). Mizuho later laid this loan off of it's balance sheet, probably to many of Japan's smaller regional banks, with only half of it backed up by collateral.

SMFG, one of the biggest money-center banks admitted to LB loans (and losses) to the tune of US$980 million, with US$880 million secured by collateral. It also held US$500 million in LB corporate bonds.

Mitsubishi UFJ Financial Group, the other money-center behemoth admitted to US$275 million in exposure.

This is where the tire hits the road. As in a lot of recent business in Japan, banks were hungry for "good quality" high yielding names to buff-up their balance sheets. Due to Basel II Regulations many had taken the route of pulling back from exposure to hedge funds over the last couple of years.

In its place it was taking on this paper onto its own balance sheet, selling it on to other institutions in Japan (probably including pension funds who do not care so much about mark to market) but also in structures which may have been sold through the broker networks to retail clients as "safe fixed income investments". The Bank of Japan will probably be looking very carefully into this issue.

In Japan, like in Italy and Germany, many institutional investors hold the coporate bonds of U.S. financial institutions. The latest collapse of these brand names is likely to have very harmful brand damage on the distributors and on the retail masses who ultimately lose out in poorer then anticipated performance.

So while Nomura and others did not step into the LB mess directly, one will probably be hearing in coming months just how disperse the collateral damage will be. Of course, many of Japan's pension funds will not speak too loudly about their performance but all indications suggest that the Lehman collapse and deterioration in financial corporate bond holdings will represent yet another "kick in the portfolio ankles" for Japan's banks, regional banks, agricultural banks, credit institutions and pension funds. Mahalo!