Consumer Finance in Japan - a new Sub-Prime Debacle or a Positive Opportunity?

Note: This is an edited version of an analysis I wrote as a Council Member with Gerson Lehrman Group (http://www.glgroup.com) and posted to GLG members on October 17, 2007.

The $170B Consumer Finance industry in Japan is undergoing significant change, which has potential to affect both consumer lenders as well as the broader economy. A new law passed in December 2006 eliminated so-called "gray zone" lending at interest rates up to 29.2%. Prior to the new law, consumer loans could be offered above the maximum 20% legal rate, so long as the customer formally agreed to pay a higher rate after receiving a full explanation of the costs. The new law eliminates this gap by 2010. But even now the impact is being felt. Additionally, a recent Japan Supreme Court ruling allowed borrowers to recover payments of excess interest, forcing consumer lenders to set aside large reserves. The industry was also rocked by scandal when some major players were admonished by regulators for inappropriate and in some cases illegal loan collection techniques. The new law also restricts the total loans that may be offered to an individual, requiring the aggregate across all loans to be less than a set proportion of annual income. Additionally, rates lower than 20% are required depending on the size of the loan.

Indeed the entire industry is somewhat curious in a country where home mortgages can be had for a 2% or less, and savings deposits routinely pay barely 0.1% interest. The history of the industry would be an essay of its own, but for now suffice it to say that it is driven by two things: 1) It is notoriously difficult to get any other form of loan. Traditional lenders, such as banks, are very risk adverse having been burned badly in the real-estate and stock-market bubbles of the late 1980's, which resulted in over a decade of industry consolidation and bad-loan restructuring. Even then, a loan typically requires a family member or some other affluent party to co-sign the loan as a "guarantor". 2) The concept of "saving face" is as important in Japan as elsewhere in Asia, and it is often considered shameful to need to borrow money. The relative anonymity, including in some cases the absence of the requirement for a guarantor, that consumer loan business provides is one of its attractions.

So to the question, is there a real problem? In the short-run, there are certainly several warning signs. The major Japanese firms Aiful, Promise, Acom, and Takefuji have all suffered of late. Most reported losses in 2006 and many will also report losses or much lower profitability in 2007. The recent FT article cited as a lead-in to this analysis also highlights difficulties in raising capital from Asset Backed Securities, which can be as much as 46% of the capital source for the major firms. The ABS market has essentially dried up. A smaller firm, Credia, defaulted when its banks pulled credit lines despite an investment grade rating. Additionally, the spreads between short-term and long-term Credit Default Swaps have gone to nearly zero. Major banks such as Sumitomo Trust and Aozora have also been reported as having reduced their exposure to ABS and CDS markets and as lenders to consumer finance firms.

Among the major foreign players, Citigroup, which operates under Citifinancial's DIC brand in Japan, took a charge in late 2006 and reduced the number of manned DIC branches by 80% to about 50. This came after several years of tuning the DIC operation to better automate the business end-to-end with better standardized processes for all aspects of loan origination, credit scoring, and collections in a division that had consistently been the most profitable Citigroup business in Japan (and indeed a major earnings source for Citifiancial International overall). General Electric has been reported to be considering exiting the Japan consumer finance market altogether by selling its local Honobono Lake branded business. GE has already cut 60% of its 115 manned branches.

Will these legal and regulatory changes, and resulting impact to consumer loan companies have a broader economic impact? Some analysts have presented doomsday scenarios. For example, respected economist Jesper Koll forecast that a full 1% impact on GDP could be possible (in an economy where the central bank is forecasting only 2.4% GDP growth) as a result of the impact reduced credit access to certain sectors of the economy may have on consumer spending and other parts of the current tentative recovery. The fear is that this change will be as bad as the increase in consumption tax from 3% to 5% that occured in 1997 and tipped the economy into years of deflation and low growth. Another worst case scenario is that entire sectors of the economy no longer have access to credit, and thus go to illegal loan-sharks at usurious rates for money, resulting in a variety of social ills.

However, the industry itself is not so pessimistic. Promise is purchasing Shimpan Finance in an effort to gain market share. Aiful is also forecasting a return to profitability in 2008. These firms, as well as Citigroup, are working to diversify into credit cards, home loans, 2nd mortgages, and small business loans. Equally, major banks also have consumer finance divisions that are diversifying across the entire range of consumer credit products.

Overall, we must remember that credit markets in Japan are relatively underdeveloped. Additionally, land and property values are recovering, unemployment remains low, and consumer and business sentiment is improving. The deflationary spiral appears to have largely ended, and the Bank of Japan is taking tentative steps to raise interest rates overall. This is very different from the sub-prime mortgage debacle in the US, which resulted from over-extension of credit with built-in rate increase triggers coinciding with and the bursting of a property bubble in much of the US. It is also unlike the sub-prime credit card concerns of 2005 and 2006, which equally resulted from over-extended lending to borrowers with poor credit histories. Even the $170B consumer loan business in Japan is relatively small as a part of the overall economy. Average top rates are around 23%, thus the gap to 20% is perhaps not as bad as it might seem. Additionally, much of the economy is still based on cash, with credit cards still relatively rare.

On the political front, the resignation of Prime Minister Abe and replacement with the new Prime Minister Fukuda would seem to portend a return to a safe pair of hands. This doesn't mean the government of Japan couldn't still derail a nascent recovery, but there is certainly a sense of "back to basics" in the local political landscape.

The stock market is also showing a recovery. As deflation has ended, the Nikkei index is back in the 17,000 range. Then yen continues to range between 115 and 118 to the US dollar, driven more by the carry-trade which drives the yen up when things are uncertain, and down when things look more certain and encouraging investors to take on the risk of profiting from interest rate differentials between the yen and other currencies. The next phase of the Nikkei bull market will occur when bond investors start moving back into equities, which hasn't really happened yet but will occur when Japan interest rates start increasing.

Naturally the spreads between borrowing money and lending it out to consumers will squeeze consumer finance companies, but this, perhaps ironically, could have a positive impact at several levels:
1) First, the under-developed lending markets will naturally be driven to a more developed state, sophisticated risk management and credit scoring, improved automation for low cost processing, and sophisticated product development. Already new entrants such as Shinsei bank are offering home loans more aggressively than has been seen in the recent past.
2) Further consolidation in the entire consumer finance industry will shake out the weaker players and drive further improvements as mentioned above. One estimate suggests that the current 10,000 total money lenders will reduce to about 3,000 overall with the weakest systematically absorbed by the strongest.
3) Credit Cards and more traditional credit products are now more widely accepted and more mature are a credit instrument, and will likely continue to mature.

There are still 2 years before the new law takes full effect, but already lenders and banks are working to prepare, with very few new loans being given out at the highest rates, and with a clear eye on the credit worthiness of borrowers. Consumer loan advertising, which is visible just about everywhere, clearly points out the lower rates and advantages to credit-worthy customers.

It is also worth noting that something similar happened before, when the top rate was reduced from nearly 40% to 29.2%. At that time, similar things happened in that lenders had to adapt or die, with the weakest lenders shaken out of the market. There was little adverse impact to the overall economy, and overall borrower disciplines arguable improved with borrowers better able to spend and invest in the general economy instead of financing high interest payments.

In the short run there may indeed be some turmoil, and lenders will certainly need to adapt. Nevertheless, there is room for cautious optimism that in the long run the changes will have a net positive impact on the world's second largest economy.

Update: The US sub-prime problem is taking longer to resolve itself than I expected last October. This is putting pressure on the Japanese stock market (the Nikkei 225 index fell below 15,000 yesterday), and is also resulting in a reduction in the so-called "carry trade" and thus a stronger Yeh to the dollar (now about 108, vs. 115 when this was written). There are also rumors that Citi may sell off its consumer finance business in Japan. But the crux of the analysis remains valid, i.e. that Japan credit markets will mature and the consumer loan industry will adapt, which is a net positive overall despite that government intervention to dictate what rates and risks are acceptable businesses for these lenders.