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Japan Bank's Foray Into Risky U.S. Debt Ends With $3.7 Billion Loss -- WSJ

05/28/2020 | 02:48am EST

By Megumi Fujikawa and Cezary Podkul

The Japanese bank that was the biggest buyer of debt used to fund private-equity buyouts suffered a Yen400 billion ($3.7 billion) hit and said it would stop investing in that market.

Norinchukin Bank owns about 10% of the $700 billion market for corporate debt that was packaged into securities called collateralized loan obligations. Other big buyers include Wells Fargo & Co. and JPMorgan Chase & Co., which each owned about $30 billion worth of CLOs at the end of the first quarter.

Losses on these investments could hamper the banks at a time when bad loans are rising. They could also sour investors on CLOs, which bought roughly 60% of the debt that private-equity companies used for deals in recent years, according to the International Monetary Fund.

"We will limit making new investments" in CLOs, Chief Executive Kazuto Oku said.

Norinchukin's Yen7.7 trillion ($71 billion) portfolio of CLOs was invested in the triple-A slices of these securities, and the loss dates back to the end of its fiscal year on March 31. The bank, which serves Japan's farmers and fishermen, said the unrealized losses were offset by gains elsewhere in its portfolio.

The market has rebounded since the end of March, so its losses on CLOs have likely shrunk since then. Prices for the type of securities the bank owns were trading at 95 cents on the dollar March 31 and were nearly 97.5 cents in mid-May, according to data from Barclays. Neither JPMorgan nor Wells Fargo announced losses on their CLO holdings.

Until last year, Wall Street veterans had marveled at the outsize role played by the large but little-known Japanese bank in the market for CLOs. It was a sign of how Japanese financial institutions, faced with negative interest rates on their own government's bonds and limited opportunities to lend, were searching ever farther afield for high-yielding investments.

Like most investors in the safe parts of CLOs, the banks are seeking extra yield for the same level of risk. That strategy blew up in the financial crisis when supposedly safe securities backed by mortgages caused big losses for banks.

CLOs have performed better, but as the market boomed, lending standards loosened. When the coronavirus pandemic hit, U.S. companies were carrying significant amounts of debt. What followed were bankruptcies of companies like Hertz Global Holdings Inc. and J.C. Penney Co. Moody's Investors Service in April placed ratings on 859 securities from 358 U.S. CLOs, worth some $22 billion, on review for downgrade.

An important risk right now is that the mathematical models that created the safe securities didn't take into account a scenario like the coronavirus pandemic, according to Rod Dubitsky, who headed U.S. asset-backed securities research at Credit Suisse until 2009.

Mr. Dubitsky argued back then that subprime mortgage-backed securities were due for a wave of downgrades, and he recently issued the same warning for triple-A rated CLO bonds. He argued in a recent paper that the securities don't deserve such high ratings because of the impact of the pandemic on the economy.

"The entire concept of triple-A CLOs goes out the window because there is not much diversification left when the entire portfolio is subject to a global economy that is in deep recession," Mr. Dubitsky said in an interview.

In recent weeks, ratings firms Moody's, S&P Global Inc. and Fitch Ratings have collectively placed more than 1,600 bonds from mostly lower rated CLOs on review for possible downgrades.

The rising risks in CLOs threaten to limit the biggest source of funding for private-equity buyouts and a source of funds for struggling companies that are owned by PE firms. If too many loans held by the funds are downgraded to the lowest levels, the funds may not be able to buy new loans, further tightening the lending markets.

Mr. Oku, the Norinchukin chief, sounded only slightly chastened by the losses, saying it was his job to extract return from the bank's portfolio and pass it on to members.

"It is difficult to disagree with the opinion that we have to use member banks' money more effectively instead of investing in overseas CLOs," he said. "But we have to steadily try to make investments that are profitable."

Mr. Oku didn't say what specifically caused losses in his bank's portfolio, but he held out hope that his holdings might keep their value even in a bad situation. The bank was stepping away from new investments in that market, he said.

"We will have to examine risks in two stages: how many U.S. companies will go bankrupt or file for chapter 11, and after that, in how many of these cases we will see AAA-rated CLOs being affected," he said at a news conference.

For now, Norinchukin isn't reflecting the CLO losses on its bottom line. Mr. Oku said the bank still had much larger unrealized gains in other parts of its portfolio and planned to hold the CLOs to maturity.

Norinchukin acts as a central pool for funds gathered by local farming and fishing cooperatives throughout Japan, and it holds about $600 billion in deposits from member cooperatives. It can use the money to make loans to companies in farming, forestry or fisheries, or it can simply invest it in global markets like any money manager, seeking returns to distribute to members.

Its problem for years has been a shortage of loan opportunities, leaving the money-management side of the business as the dominant one. The number of people working in agriculture as their main job has fallen 35% during the last decade, and those who remain are mostly over 65.

--Paul J. Davies contributed to this article.

Write to Megumi Fujikawa at megumi.fujikawa@wsj.com and Cezary Podkul at cezary.podkul@wsj.com


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