Battle Over Japan's Mortgage Market Raises Default Risks

Battle Over Japan's Mortgage Market Raises Default Risks Global Fixed Income Research Naoko Nemoto Managing Director Tokyo (81) 3 4550 8720 naoko_nemoto@ standardandpoors.com Standard & Poor's 55 Water Street 39th Floor New York, NY 10041 September 2005

Naoko Nemoto, Managing Director +81 3 4550 8720 naoko_nemoto@standardandpoors.com Battle Over Japan's Mortgage Market Raises Default Risks The bursting of Japan's bubble economy in the early 1990s triggered an economic slump that has sometimes been called the "lost decade." The Nikkei stock index declined by more than 70%, and commercial land prices in large cities fell 82% from their peak, creating stockpiles of nonperforming loans. Throughout the crisis, the mortgage market was comparatively stable, as fear of home repossession kept default rates relatively low. In recent years, as corporate borrowing has fallen off in the wake of companies' financial restructuring and growing disintermediation, Japanese banks have come to rely more heavily on housing loans, which offer relatively wide margins. Over the last three years, housing loans have surged to 23% of major banks' total lending from 16%. But if the Bank of Japan (BOJ) departs from its zero-interest-rate policy, as it s expected to do at some point, rising rates could have a significant impact on marginal borrowers, resulting in higher defaults. With intensifying competition driving banks to lower their rates and loosen their lending criteria, this shift to home loans could translate into another bad loan burden in three or four years. Mortgage Loans Stronger Than Commercial Loans Defaults on mortgage loans underwritten in the bubble years did rise, but even at their peak they remained moderate. Typically, defaults on Japanese housing loans spike three to five years after origination. Sure enough, this happened around 1993, as the country s economy deteriorated. For instance, the accumulated default ratio of home loans originated in the 1970s and early 1980s was 1%-1.5%, and the net default ratio (which factors in collections on debt) was about 0.2%. For loans extended in the late 1980s, the accumulated default ratio rose to 2%-3%, and the net default ratio was 1%- 2%. In the 1990s, as interest rates fell default ratios did, too to 0.6%. By comparison, commercial loans were a disaster. In 2001, nonperforming loans at all banks amounted to 7.5% of total loans. Annual credit losses for all banks were 2.6% of total loans in 2002. Battle Over Japan's Mortgage Market Raises Default Risks Page 1

Housing loans performed relatively well for several reasons: Although the unemployment rate rose and wages fell in the post-bubble years, the impact was moderate and slow, allowing obligors to continue making loan payments. Japanese traditionally place significant importance on home ownership, and thus work hard to avoid foreclosure. Household savings rates in Japan are relatively high compared with those of other developed countries, providing a cushion for mortgage holders. In some cases, retirees transferred financial assets to their children to aid in paying off debt. The BOJ started to loosen its monetary policy in late 1991, and average mortgage rates declined to 2.4% from 8.5%. The lower rates benefited borrowers with variable mortgage rates and allowed others to refinance at lower cost. Government Housing Loan Corp. (GHLC), which had more than a 40% share of the mortgage loan market, applied relatively strict lending criteria, as it was not seeking profits. For example, GHLC granted no mortgages with a loan-to-value (LTV) ratio of more than 80%. Given GHLC s strong market presence, its criteria became the market standard. Though overall mortgage defaults remained low, they were higher for apartment loans and mortgages made for investment purposes. Banks advanced apartment loans mostly to high-net-worth individuals wanting to build income-producing properties, primarily to achieve tax savings. At the same time, speculators purchased condominiums hoping to sell at higher prices. Both types of borrowers had high leverage ratios and fewer incentives to continue debt payment compared with ordinary mortgage holders. Falling Home Prices Not A Deflation Trigger By any measure, Japan s real estate market has calmed considerably since those tumultuous days. In the 1980s, lenders granted home loans at an unprecedented pace while stock and land prices soared. The residential land price index reached 269 (1985=100) before falling to 90 as of March 2005. The commercial land price index hit 374 in 1991, before crashing to 48 by March of 2005 (see Chart 1). 400.00 Chart 1 Comparison Of Land And Stock Price Indexes (1985=100) 350.00 300.00 250.00 200.00 150.00 100.00 50.00 0.00 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Commercial land Residential land Nikkei stock index Battle Over Japan's Mortgage Market Raises Default Risks Page 2

The housing market has been less volatile because, in most cases, sales of residential land have been based on real demand. In the bubble era, many large corporations speculated on real estate. As the value of land increased, these companies borrowed more from banks, leveraging higher collateral values, then used the borrowed funds to purchase more real estate. By contrast, it was and is normally difficult for homeowners to realize gains from land appreciation. Moreover, individual borrowers were less overextended, because, at the time, Japanese banks didn t offer home equity loans or other risky financing. The fall of residential real estate prices during the 1990s hurt Japan s economy, but the overall effect was relatively minor. Housing starts declined in 1992 following the downturn of prices in 1991, but housing investment recovered quickly in 1993 due to tax incentives and lower interest rates. During the recession of the 1990s, housing investment moved counter-cyclical to the macro-economy, mitigating the downward trend. The direct impact on consumption was minor compared with the influence of other factors, such as rising unemployment. When the bubble economy burst, in fact, the most immediate effect was on business confidence and fixed investments. Companies lowered production and their earnings fell, so they cut working hours, salaries, and employment, which resulted in lower household income and consumption (see Chart 2). 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 (1.0) (2.0) (3.0) (4.0) Chart 2 Land Prices and Economic Indicators 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1Q GDP Employee expenditures In 1998, Japan recorded its first negative GDP growth since the oil shock of the early 1970s, and at the same time experienced negative consumption growth for the first time since such statistics had been gathered. Triggers for these events included the failures of large financial institutions, such as Yamaichi Securities and Hokkaido Takusoku Bank in November 1997, and the ensuing weakness and instability in the country's financial system. Battle Over Japan's Mortgage Market Raises Default Risks Page 3

Trends And Risks In Today's Mortgage Market Since 2002, Japan s economy has been on a slow, upward trend, supported by robust exports and the high growth of other Asian economies. Also, the corporate and banking sectors have largely cleaned up their balance sheets and improved earnings. Depreciation of land nationwide has slowed, and prices are rising in some areas of Tokyo, where office vacancy rates are declining, the population is rising, and there are large development projects. On the other hand, land prices are still dropping in some prefectures. And even in large cities, variations in land prices are widening, reflecting differing prospects for cash flow. Whereas land in Japan was previously regarded as a scarce resource, in fact, many now predict an oversupply, as the nation's population will start to decline starting in 2006, thanks to the country s falling birth rate. Housing investment is lower than at its peak in the 1990s, but has remained relatively stable, due to low interest rates and favorable tax policies. In addition, changing demographics have resulted in growing demand for home improvement loans, as older Japanese make changes to their homes before they retire. Of course, this wouldn t be Japan s economy unless dangers lay ahead. Recently, banks have placed greater emphasis on expanding their portfolios of home loans. That s partly because public corporations, in particular GHLC, will terminate new financing and concentrate on loan guarantees starting in 2007, leaving more room for private banks to step up. Already, commercial banks' market share of newly generated loans has increased to 97% from 70% over the past three years (see Chart 3). Chart 3 Home Loans And Commercial Bank Market Shares (Tril. ) 40 (%) 120 35 100 30 25 80 20 60 15 40 10 5 20 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1Q 0 Value of new home loans (left scale) Market share of private banks (right scale) For the moment, corporate loan demand is weak, limiting lending opportunities. So home loans are comparably attractive, as they have higher spreads and lower risk weights under Basel rules. Problem is, the mortgage market's stability and easy margins have also invited intense competition among banks, which has resulted in looser lending criteria and deep discounting. Battle Over Japan's Mortgage Market Raises Default Risks Page 4

Many banks have begun to extend loans that do not meet internal requirements for LTV or debt payment to income (DTI). In 2001, Bank of Tokyo-Mitsubishi Ltd. (A/Stable/A-1) offered 1% three-year fixedrate mortgage loans, and other banks followed suit, offering loans with 0.9%-0.7% interest rates. These terms are not very profitable in the short term, but banks contend that the loans will make money over the long term, as mortgage rates rise in line with higher interest rates. However, borrowers could pre-pay their loans in less than three years and take out mortgages at other banks to avoid such adjustments. Alternatively, if interest rates rise, borrowers' payment burdens will jump and DTI ratios will deteriorate. Borrowers in Japan have become so accustomed to low interest rates that many may not have fully considered the ramifications of a rise in rates. And the proportion of long-term, fixed-rate mortgages is small compared to other countries, leaving borrowers more exposed to interest rate changes (see Chart 4). 100% Chart 4 Housing Loans By Interest Rate Type (Flow Base) Variable rate 80% 60% 40% Initial fixed-rate period of five years or less Initial fixed-rate period over five years and up to 10 years Full-term fixed-rate or initial fixedrate perio d o f o ver 10 years 20% 0% Japan U.S. U.K. Germany France Sources: Japan, Survey by GHLC (fiscal 2002). U.S., Federal Housing Finance Board and Loan Performance 2004 (categories two and three are combined). European M ortgage Federation and national sources used for Germany (2004), U.K. (2004), and France (1999). The mortgage loan spread in Japan is now 1%-2%, which is high compared to typical spreads of 20-50 bps on loans to blue chip firms. On the other hand, the profitability of mortgage loans likely will fall over the longer term, as they have terms of 20-35 years. The ultimate returns will depend on factors such as future credit costs and prepayment rates. But unless banks enhance their risk assessment methods and price their mortgages wisely, there is a tangible risk that they ll find themselves burdened with another bad loan problem perhaps sooner than they think. Free Subscription to Global Fixed Income Research We recently changed our e-mail distribution method for our Research to a new format called Capital Market and Economic Research. Going forward, all complimentary Global Fixed Income Research will be distributed under this heading. Once you register, you will automatically receive the articles for topics that you have opted. If you are interested in continuing to receive our complimentary research reports, please be sure to register for Capital Market and Economic Research by clicking on the link below: http://www.standardandpoors.com/gfir/register Copyright 2005 by Standard & Poor s, a division of The McGraw-Hill Companies. Reproduction in whole or in part prohibited except by permission. All rights reserved. Information has been obtained from sources believed to be reliable. However, because of the possibility of human or mechanical error by our sources or others, Standard & Poor s does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or the result obtained from the use of such information. Battle Over Japan's Mortgage Market Raises Default Risks Page 5