Shinsei and Aozora ponder merger

Shinsei and Aozora continue to fascinate and horrify in equal measure. The two banks, formerly known as Long Term Credit Bank of Japan and Nippon Credit Bank, are the only two Japanese banks to ever become foreign-owned and foreign-run as a result of the Japanese banking crisis in the 1990s (JC Flowers owns one-third in Shinsei and Cerberus holds 50% of Aozora). As such, they represent an ongoing experiment in the ability of Wall Street superstars to turn the two ugly sisters into beautiful Cinderellas. But so far, neither bank looks likely to be marrying a prince. On the contrary, it looks as if they may be forced to live together unhappily ever after, if rumours of a pending merger between them are true. Neither bank is commenting on the speculation.

One analyst at a major US bank in Japan says that the two banks are pondering a one-for-one share swap, which would leave them each holding 50% of the new venture under a holding company structure. Combined assets would reach ¥18 trillion ($185 billion).

The venture would theoretically combine the retail and consumer finance expertise of Shinsei, with the wholesale banking orientation of Aozora bank.

However, says Masahiko Watanabe of Fitch Ratings in Tokyo, "there are few apparent synergies between the two -- which means that cost-savings are absent. And the counter argument that the operations are 'complementary' is weakened by the fact that the two stand-alone businesses are too small to generate economies of scale on their own".

In other words, the two banks should merge with other banks engaged in the same line of business, thereby gaining synergies (cutting costs) and acquiring economies of scale. However, a financial consultant in Japan who prefers to remain anonymous says that "the amount of toxic assets in Shinsei is still not clear. This is scaring off the Japanese banks".

Japanese news reports on Thursday stated that the two private equity funds are reluctant to do the deal, while Shinsei's CEO and chairman, Masamoto Yashiro, who was re-appointed in June 2008, is in favour.

Yashiro is the semi-legendary chairman who first ran the bank after it was invested in by Ripplewood in 2000. He did a pretty good job, according to the consensus, of steering the bank to a more retail-friendly format. In particular, he moved the bank towards internet banking, which attracted a lot of young people.

Analysts believe Yashiro is keen to push the bank away from its current direction. "Yashiro is keen to disengage Shinsei Bank from its overseas investment banking activities. Yashiro wants to return to a more Japan-centric organisation, based on institutional lending, consumer finance and retail banking," says Maki Hanatate, banking analyst at Moody's ratings agency in Tokyo. 

However, this may not be the direction the private equity funds want to take. "The PE investors want to get involved in highly profitable activities and exit their investment as soon as possible. They may therefore be reluctant to focus on low-risk, low-return activities," says a financial analyst who is giving his private view and prefers to stay anonymous.  

Yashiro's move would imply a reversal of the course taken by Shinsei under former CEO and investment banker Thierry Porte, who took over in 2005. Under Porte, the bank moved more strongly into overseas investments in real-estate derivatives in order to boost earnings. The move exposed Shinsei to losses when the financial crisis hit. In March 2008, Porte even had to engineer the emergency sale of the bank's headquarters to counter the black hole created by collapsing US mortgage assets.

Some analysts see Yashiro's 'retro' move as evidence the foreign presence has failed to benefit the banks. "After all the hype about how foreign management and new thinking would radically change these banks, the new business model is essentially to do what the old long-term banks did best: viz, plain vanilla-flavoured, collateral-based financing -- which was ridiculed in the past by foreign bankers as being way behind the curve," points out J. Brian Waterhouse, senior bank analyst at Japaninvest.

Waterhouse adds that both banks have run down their trading desks and fired a lot of expensive gaijin (foreign) traders. Aozora is going back to basics, issuing loans backed by real estate collateral, while Shinsei is trying to move further away from reliance on institutional lending and more towards retail.

Unfortunately for this strategy, Waterhouse goes on to say, "Shinsei's commercial and consumer finance division has only recently broken into the black, and their pure retail internet operation is not profitable, so institutional business (i.e. what Shinsei did before it was nationalised and taken over by the PE funds) is around 90% of their total operating revenue before charge-offs."   

Shinsei is due to declare its full-year financial 2008 results on May 13. It is forecasting a consolidated cash basis net loss of ¥31 billion for financial 2008. Aozora is estimating a net loss of almost ¥196 billion for the year. In February this year, Aozora fired its CEO, Federico Sacasa, and replaced him with Brian Prince -- a former Shinsei man.

The above results are a scant reward for Shinsei's efforts to break the mould of Japanese banks, which traditionally favoured corporate banking over retail banking. Shinsei's strategy, after it was taken over by the Americans, was to offer retail services with all the bells and whistles that Citi or HSBC offer. There was a crucial flaw in this plan, namely Shinsei's lack of scale. Lacking a major retail branch network in the first place, Shinsei had to build one from scratch -- a fruitless task in a country dominated by the gigantic networks of the Mitsubishi, Mizuho and Sumitomo banks. Shinsei rolled out an excellent internet banking substitute, but analysts say banks 'need clicks as well as bricks' to sell high-margin products. After all, a bank needs a face-to-face meeting with clients to discuss and sign the documents. (Some banks have tried to automate the whole process, using 24-hour ATMs, but the results veered from the farcical -- drunken salarymen trying to get million yen loans at 4am -- to the tragic.)

Shinsei's efforts in consumer finance have been well documented. It all looked so good on paper, with consumer finance companies (CFCs) making returns on equity of 30% plus from super-high margin loans. Shinsei bought three CFCs, namely Shinki, Aplus and Lake, the latter off GE in 2008. Shinki is being folded into Lake, while Aplus is being restructured. Shinsei's consumer finance unit is profitable -- but likely not for much longer. The Japanese government has introduced legislation to clean up the money-lending business, in which many outfits were run by Yakuza-related loan sharks. Starting in 2010 (i.e. affecting the Japanese 2009 fiscal year, which starts on April 1, 2009) government legislation caps interest rates at 18% (rates of 40% per year were common in the past). In addition, the government has rescinded a law legalising mutually-agreed loan agreements, with the added provision that the loan companies must repay all interest on loans for the past five years which exceeded the 18% ceiling. This has caused CFCs to haemorrhage funds.

A merger between Shinsei and Aozora does have some advantages, say analysts. Fitch's Watanabe points out that Shinsei has a lower tier-1 ratio than Aozora, so it would benefit from a merger. Shinsei has a tier-1 ratio of 6.64%, while Aozora is on 14.81%, giving the combined entity an average ratio of 10.8%.

In addition, analysts note that the merged entity would be the sixth-biggest bank in Japan. That would make it more likely to receive government support in hard times.

Nevertheless, with the US yield-driven model apparently broken, and the Japanese banks struggling to make money from old-fashioned lending due to the rock-bottom interest rate environment, Shinsei and Aozora seem to have few options left to them.