How Wall Street Is Exporting Toxic Junk Loan Waste To Japan

What gets stuffed into the Wall-Street sausage maker on the American side are dollar-denominated risky “leveraged loans” – loans issued without collateral by over-indebted junk-rated companies. Banks slice and dice these leveraged loans, lumped them together into Collateralized Loan Obligations, and sell them to other financial institutions. These CLOs are then repackaged and peppered with derivatives to hedge against currency fluctuations.That’s what goes into the sausage maker.

What comes out of the sausage maker on the Japanese side are plump-looking, yen-denominated, highly rated bonds.

Blame the Bank of Japan. Where there’s enough demand, there will be supply. The BOJ, as part of its mega-QE program, is buying every Japanese Government Bond that hasn’t been nailed down. It has been telling banks, insurance companies, and pension funds to dump their vast holdings of JGBs. It pushed 10-year yields to 0.33%. And it’s strangling the JGB market.

Conservative Japanese pension funds, and even the Government Pension Investment Fund with ¥137 trillion ($1.14 trillion) in assets, long reliant on these JGBs, are dumping them into the lap of the central bank to replace them with a variety of goodies that provide some visible yield, including the latest Wall Street sausage.

It’s logical in our absurd world. Corporate America is already racing to sell euro-denominated junk bonds in Europe where the epidemic of negative yields in government bonds has suppressed yields across the corporate spectrum as well, to where junk bonds yield about 200 basis points (2 percentage points!) less than in the US. Low-cost money for high-risk US issuers, the new nirvana [read… Dumping American Junk in Europe, Draghi Asked for it].

But the deal with Japan is vastly more glamorous. These aren’t junk-rated US corporations going to Japan to sell yen-denominated bonds directly. This is Wall Street offloading murky, risky products at a high price.

These leveraged loans that form the base for the CLOs have long worried US banking regulators. Yellen personally warned about them. So they’ve fallen out of favor with banks. Issuance in the first quarter dropped 52% from a year ago. Retail investors have soured on them too, and they’ve been yanking their money out of leveraged-loan mutual funds for 12 months in a row.

The other option for banks to offload their leveraged loans is to slice and dice them and repackage them into highly rated CLOs. That too worries regulators because banks retain some risks. But never mind. Investors are clamoring for CLOs. So year-to-date, US issuance jumped 22% from a year ago, to $30.4 billion, with March issuance setting a new all-time record – though investors suffered “dismal” returns.

Where does this demand for CLOs come from? From all kinds of directions, including from across the Pacific. Now it’s time to turn these dollar-denominated CLOs into yen-denominated bonds for desperate Japanese pension funds – and thereby retirees. “To make it easier for Japanese investors to get to this US debt,” as Bloomberg put it. And it’s in the true spirit of sausage:

The Repackaged CLO Series GG-A1 Ltd., for example, “consists of a special-purpose entity that will issue Japanese yen-denominated notes and is backed by the U.S. dollar-denominated notes” issued by Kitty Hawk CLO 2015-1 LLC, according to a Standard & Poor’s March 24 pre-sale report.

Essentially, it transforms $249 million worth of a $331 million U.S. CLO managed by Guggenheim Partners Investment Management into highly-rated Japanese-yen denominated bonds, according to an April 15 Moody’s Investors Service report.

The deal was finagled by Mitsubishi UFJ Financial Group, which, as Bloomberg reported – I had to hold my nose as I was writing this – “is also the counterparty on the currency swap that mitigates the risk of losses from changes in the yen-dollar exchange rate.”

Japanese institutions that turned their JGBs over to the BOJ have other options to use their freshly printed cash and obtain a visible yield. They can buy US Treasuries, for example. And they’re doing that. They can buy US corporate bonds directly which are a lot less murky than the sausages they’re buying from Mitsubishi. And they’re doing that too. They’re buying everything in sight that has a measurable yield. Right now, there isn’t much in Europe to fit that strategy, outside of Greek bonds. As far as a large market is concerned, the US is it.

The bitter irony of QE in Europe and Japan? The ECB and the BOJ are repressing yields to absurdly low levels, to levels where borrowers make money on their liabilities while lenders are losing money on their assets – by design! They’re doing this even while the cacophony emanating from the Fed has been evoking interest rate increases in the US.

The ECB and the BOJ are encouraging Wall Street and Corporate America to head to their shores and dump even the riskiest US securities for the juiciest price. And they’re motivating their hapless folks to buy even inscrutable and potentially toxic American securities at ludicrously low yields to obtain a feeble illusion of income.

But it’s great for America. We get to export breath-taking risks, nicely packaged and relabeled as “safe,” to other countries and let them take the losses when they come due. By the looks of it, this risk-dumping is going to be a huge trend. Until it blows up. But this time, it’ll blow up in their faces, rather than in our faces. And they can thank their central bank.

These junk-rated US corporations are already showing what material their debts are made of. Read…  Bankruptcies Suddenly Soar Across Corporate America, Worst First Quarter Since 2009

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  13 comments for “How Wall Street Is Exporting Toxic Junk Loan Waste To Japan

  1. Dave Mac says:

    Once again the BOJ manages to snatch defeat from the jaws of success.

    Don’t they ever learn?

  2. Mike R. says:

    Wow! Fascinating analysis of unintended consequences. Or maybe they are intended?

    • Dan Romig says:

      I have to believe that they are intended. For the most part, those who pull the strings don’t get to where they can be the puppet-master by mistake.

      There’s a whole lot of capital out there on planet earth looking for somewhere to go, and Wall Street is happy to take home as much as possible.

  3. Julian the Apostate says:

    To echo an earlier poster, I believe the precise military term is cluster fuck. The Neo-Keynsians have created a perfect Kantian noumenal world for themselves that allows them to believe their minds create reality. Ayn Rand explains all this in her magnum opus. These types are not long range planners. When moochers can no longer find willing marks they reach for a gun. In an ostensibly “free” country they need an excuse to reach for the gun. The Looter-in-Chief has been layering 80,000 pages a year to the regulations businesses must conform to-no one person can possibly do business without violating one or more of them. When they feel the need they can use these “violations” to crush anyone. Hence the rise of the police state we’ve all come to know and love. These sausages they’re selling the Japanese are economic version of Schrödinger’s cat – so far every time they’ve looked in the box the cat is still alive. It is ironic that the protectionist Japanese have allowed this financial atomic bomb into their country. And as we all know the thing ‘blowing up in their faces instead of ours’ will not save us. MAD only works as long as the first nuke doesn’t go off. When it does then it really is Mutualy Assured Destruction.

  4. Mel says:

    Sorry, point of information.

    What is a “leveraged loan”? Is this simply a loan covered by insufficient collateral? I haven’t found an answer in Wikipedia or the ususal places.

    Question 2: Don’t they have newspapers in Japan? We’ve seen this mess play out to the end once already.

    • Wolf Richter says:

      A “leveraged loan” is a loan that a bank extends to a highly leveraged company with a junk credit rating. They’re not based on collateral. Banks normally don’t hang on to these loans. They’re too risky. They try to sell them to mutual funds. Or they combine many such loans from different companies into Collateralized Loan Obligations (CLO), which they then sell to institutional investors, such as mutual funds. Either way, banks try to get rid of them.

      • Mel says:

        Many thanks.

      • a Texas libertarian says:


        This paragraph is gold. I’ve never heard the sausage analogy, and it is oh so perfect!

        “What gets stuffed into the Wall-Street sausage maker on the American side are dollar-denominated risky “leveraged loans” – loans issued without collateral by over-indebted junk-rated companies. Banks slice and dice these leveraged loans, lumped them together into Collateralized Loan Obligations, and sell them to other financial institutions. These CLOs are then repackaged and peppered with derivatives to hedge against currency fluctuations. That’s what goes into the sausage maker.”

        As always, thanks for another great article.

    • MC says:

      “Leveraged Loans” refers to loans extended to individuals or companies that already have high levels of debt. In a normal world they are considered far higher risks than the norm and hence they carry far higher interest rates than a usual. In a world where BB- rated banks can issue bonds yielding 1.40-1.60% the difference is often academic.

      Newspapers in Japan? They could have people like Wolf Richter and David Stockman writing daily and it wouldn’t change a thing. Japan and Europe are far more starved for yield than the US. Just look at 10-years sovereign bonds. Japanese bonds yield 0.3%. German bonds 0.08%. French bonds 0.34%. US bonds by contrast yield a massive 1.89%. Yes Virginia: US bonds yield more than Spanish (1.35%) and Italian (1.39%) ones.
      When horses are dying of thirst, they go mad. They’ll do whatever it takes to find water. If one smells water, the rest of the herd will stampede behind it.
      When investors, such as Japanese retirees and young German couples, are denied yields on safe investments, they go mad…

    • a Texas libertarian says:

      A leveraged loan is a loan made to a borrower who already has a high level of debt. I think someone can have plenty of collateral but can still be considered leveraged, if they have high levels of preexisting debt to service (I could be wrong about this though).

      Since the risk of default is higher for a borrower with a high level of debt already on their balance sheet, the lender charges a higher interest rate, and this translates to more yield or “juice” to investors desperate for yield in an interest rate repressed environment like ours. The Federal Reserve does its best to remove risk from the system, by implicitly guaranteeing monetary intervention if stock prices fall (the “put”) or if “important” businesses fail, so investors looking for yield see no reason to avoid these “juicy” sausages.

      One thing is for certain though, when you fight the laws of economics, like central banks do by definition, you lose. It’s only a matter of time.

    • d says:

      2 A.

      Japan is one of those states that is still conformist, when the BOJ and MITI say to the funds and Corporate japan “Do X”. They dont argue, they do.

      Sounds absolute lunacy, in a democracy in the 21St century, but thats how it is, in that country.

  5. Petunia says:

    Guggenheim Partners = Bear Stearns in Drag

    That should tell you how this deal lands up.

  6. rjohnson says:

    People must make decisions to hold their jobs. The wonderfully manipulated economic stats and relative economic strength of the US give the Japanese the necessary cover (face saving) to buy these things. I can hear the whispers, see the nodding, the placid smiles. They’re buying a model, not the real thing (kinda like how Hollywood works today).

    They know they’re garbage, but decisions must be made, and when you’re falling you’ll grab any branch, however frail. It’s probably the least toxic stuff on their table (beside the puffer fish sushi).

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