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represented Kidder in an arbitration case against Joseph Jett), it was concluded that there was lax oversight and poor judgement by Mr Jett’s superiors, including Mr Cerrullo (former fixed income head) and Mr Mullin (former derivatives boss). The report suspiciously supports Kidder’s claim that no other person knowingly acted with Mr Jett. Kidder’s top managers should have been suspicious because Mr Jett was producing high profits in government bond trading – never a Kidder strength. Some of the blame can be attributed to the aggressive corporate culture of Kidder. At an internal Kidder conference, Jett was reported to have told 130 of the firm’s senior executives ‘‘you make money at all costs’’.

However, from details that have been revealed in the prepared reports, it is evident that there were problems at Kidder long before the Jett affair, indeed, even before Jett arrived. For example, in December 1993 Kidder had the highest gearing ratio of any bank on Wall Street, at 100 to 1. Mr Jack Welch of GE attempted to restore the reputation of GE by disciplining or dismissing those responsible. Mr Michael Carpenter was pressurised into resigning; both Mr Mullin and Mr Cerrullo were fired.

On 17 October 1994, GE announced GE Capital was to sell Kidder Peabody to Paine Webber, another investment bank. The sale included the parts of Kidder that Paine Webber wished to purchase. GE Capital also transferred $580 million in liquid securities to Paine Webber, part of Kidder’s inventory. In return GE Capital received shares in Paine Webber worth $670 million. Thus GE received a net of $90 million for a firm that it had purchased for $600 million in 1986, though GE also obtained a 25% stake in Paine Webber.

Questions

1.How might a conglomerate go about assessing the real worth of an investment bank when so many of the assets are intangible?

2.Identify the areas of potential ‘‘synergy’’ for Kidder and GEFS. In this context, explain the differences between synergy and economies of scale/scope.

3.Was the emphasis on developing investment banking and corporate finance rather than the use of Kidder’s retail outlets a wise decision?

4.Given Mr Cathart’s mission of restoring Kidder to profitability, what advice might Alan Horrvich give? What are the implications for each strategic alternative?

5.What in fact happened after 1987?

6.Summarise the various scandals associated with Kidder Peabody. What factors made this firm prone to scandals?

7.In 1994, GE divested itself of Kidder Peabody. The extent of the failure of this ‘‘match’’ is illustrated by the sale of Kidder to Paine Webber for a net of $90 million, compared to the $600 million price tag for Kidder in 1986.

(a)Did GE pay too much for Kidder in 1986? Why?

(b)How much is GE to blame for the subsequent problems at Kidder? Could these problems have been avoided?

8.Was GE wise to take a 25% stake in Paine Webber?

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Japanese firm or to change those in authority. But the announcement, in April 1992, that the merged bank was ready to use its new name, Sakura, suggested these difficulties had been overcome, and well inside the 3 years management originally announced it would take.

10.4.1. Background on the Japanese Banking System

The Japanese banking system is described in Chapter 5 of this book. For many years it was characterised by functional segmentation and close regulation by the Ministry of Finance and the Bank of Japan. During the 1970s Japanese banks experienced a period of steady growth and profitability. The Japanese are known for their high propensity to save, so banks could rely on households and corporations (earning revenues from export booms) for a steady supply of relatively cheap funds. The reputation that the Ministry of Finance and Bank of Japan had for casting a 100% safety net around the banking system meant, ceteris paribus, the cost of capital for Japanese banks was lower than for major banks headquartered in other industrialised countries.

The global presence of Japanese banks was noticeable by the late 1970s, but in the 1980s their international profile became even more pronounced because of the relatively low cost of deposits, surplus corporate funds, and the increased use of global capital markets. Lending activities increasingly took on a global profile. Japanese banks were sought out for virtually every major international financing deal. For example, in the RJR Nabisco takeover involving a leveraged buyout of $25 billion, Japanese participation was considered a crucial part of the financing. The combination of rapid asset growth and an appreciating yen meant that by 1994, six of the top 10 banks, ranked by asset size, were Japanese. By the late 1980s, Japanese banks had a reputation for being safe and relationship-oriented, but nothing special if measured by profit or innovations.

The reputation for ‘‘being safe’’ was partly due to the MoF’s determination not to allow any banking failures in Japan – there had been no bank failures in the post-war period. It was also known that Japanese banks had substantial hidden reserves. Furthermore, banks held between 1% and 5% of the common stock of many of their corporate customers; these corporates, in turn, owned shares in the bank. The cross-shareholding positions had been built up in the early post-war period, before the Japanese stock market had commenced its 30-year rise. These shareholdings and urban branch real estate were recorded on the books at historic cost, and until the 1990s, the market value was far in excess of the book value.

The Japanese banks’ ratio of capital to assets in the late 1980s appeared to be low compared to their US or European counterparts, but such ratios ignored the market value of their stockholdings and real estate. Also, Japanese banks were less profitable than banks in other countries for three reasons:

1.The emphasis on ‘‘relationship banking’’ obliged these banks to offer very low lending rates to their key corporate borrowers, especially the corporates which were part of the same keiretsu.

2.Operating costs are relatively high.

3.The Ministry of Finance discouraged financial innovation because of the concern that it might upset the established financial system.

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Japanese banks appeared prepared to accept the relatively low profitability, in exchange for the protective nature of the system.

As Japanese banks became more involved in global activities, either through international lending, through the acquisition of foreign banks, or by multinational branching, they began to learn about the financial innovations available by the early 1980s. At the same time, the MoF accepted the reality of imported deregulation, that is, the financial sector would have to be deregulated to allow foreign financial firms to enter the Japanese market. The pressure for this change came from the mounting trade surplus Japan had with other countries and a new financial services regime in Europe that would penalise countries that did not offer EU banks ‘‘equal treatment’’. The MoF agreed to the gradual deregulation of domestic financial firms, and to lower entry barriers for foreign banks and securities houses. The MoF lifted some of the barriers separating different types of Japanese banks and between banks and securities firms, and began to allow market access to all qualified issuers or investors. The tight regulation of interest rates was relaxed. Though the full effects of the reforms were not expected to be felt until after 1994, Japanese banks and securities firms realised they would have to adjust to the inevitable effects of deregulation. However, these reforms were relatively minor compared to what was coming (Big Bang in 1996) and, as can be seen in Table 5.8 (Chapter 5), the big changes in the structure of the Japanese financial system did not occur until close to the turn of the century.

10.4.2. Zaitech and the Bubble Economy

As was the case in the west, by the mid-1980s, large Japanese corporations realised that issuing their own bonds could be a cheaper alternative to borrowing from Japanese banks. Also, an investment strategy known as zaitech was increasing in popularity: it was more profitable for a Japanese corporation to invest in financial assets rather than Japanese manufacturing businesses. Early on, these firms borrowed money for simple financial speculation, but over time the process became more sophisticated. Non-financial firms would issue securities with a low cash payout and use the money raised to invest in securities that were appreciating in value, such as real estate or a portfolio of stocks, warrants or options.

The heyday of zaitech was between 1984 and 1989 – Japanese firms issued a total of about $720 million in securities. More than 80% of these were equity securities. Japan’s total new equity financing in this period was three times that of the USA, even though the US economy was twice the size of Japan’s and it too was experiencing a boom. Just under half of these securities were sold in domestic markets, mainly in the form of convertible debentures (a bond issue where the investor has the option of converting the bond into a fixed number of common shares) and new share issues. The rest were sold in the euromarkets, usually as low coupon bonds with stock purchase warrants attached (a security similar to a convertible debenture but the conversion feature, as a warrant, can be detached and sold separately). The implication of a convertible debenture issue is that one day, new shares will be outstanding, thereby reducing earnings per share. But shareholders did not appear concerned, and share prices rarely declined following an issue.

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Japanese banks were keen supporters of zaitech financing, because:

žThey could underwrite the new corporate issues.

žThey acted as guarantors of the payment of interest and principal on the bonds being issued.

žThey could buy the warrants to replace stock in customer holdings, which allowed profits from a portfolio to be freed up, to be reinvested on a more leveraged basis.

žOnce the warrants were detached, the bonds could be purchased at a discount of 30% to 40%.

The bonds could then be repackaged with an interest rate swap, and converted into a floating rate asset to be funded on the London deposit market, and held as a profitable international asset.

Zaitech became extremely popular among banks, corporations and investors alike, for different reasons. The late 1980s came to be known as the ‘‘bubble economy’’ in Japan because of the frequency with which financial market speculation, usually financed by margin loans, occurred. The prices of all financial assets, especially real estate and stocks, rose at rapid rates, encouraging yet more speculative behaviour.

As a result of zaitech and financial surpluses, Japanese companies were no longer dependent on extensive amounts of borrowing. Bank borrowing was not attractive if firms could issue bonds, which would be redeemed by conversion into common stock in the future. The ratios of long-term debt to equity (book value) began to decline for companies listed on the Tokyo Stock Exchange, from more than 50% in 1980 to about 39.6% at the end of 1990. By 1990, only 42% of corporate debt outstanding, or 17% of total capitalisation, was provided by bank loans. Bank loans that were negotiated often supported zaitech corporations or investment in bank certificates of deposit, which, because of relationship banking, the borrower could maintain at virtually no cost.

The fall in the leverage or gearing of Japanese firms was far more pronounced if equity is measured using market prices. By 1989, Japanese debt to equity ratios were half those of their US counterparts. But although many companies used surplus cash flows to repay debt, others engaged in zaitech – increasing debt to invest in other securities.

Thus, the real measure of leverage (gearing) was the ratio of net interest payable (interest received minus interest paid) to total operating income. By this measure, Japanese manufacturing companies, in aggregate, fell from 30% in 1980 to −5.3% in 1990. Thus, the manufacturing sector had become deleveraged or degeared: if zaitech holdings (based on December 1989 prices) were sold, they would have no debt at all.

10.4.3. Problem Loans and the Burst of the Bubble

Japanese banks had entered the global lending markets in the early 1980s and, determined to capture market share, competed on interest rates. The competition was not only with foreign banks, but other Japanese banks. Japanese banks became highly exposed in foreign loans, beginning with Latin American debt – they held portfolios of Third World loans which they had lent at below market rates. The MoF discouraged banks from writing off this debt after the Mexican crisis of 1982 – it wanted them to learn from their mistakes and

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exercise more discipline, and also, to limit tax credits taken by these write-offs. If banks were to write off loans, they had to do it off the books, by using the capital gains from the sale of securities and applying them against bad debt. Effectively, the banks’ hidden assets became their loan loss reserves.

The Nikkei index peaked in December 1989 having risen sixfold since 1979, and then fell steadily to less than 15 000 in 1992, a 62% drop from its high. The real estate market followed, resulting in large losses for many zaitech players. The value of their zaitech holdings declined, but there was no change in their loan obligations. By the first half of 1991, bankruptcies in Japan had risen dramatically, with liabilities of $30 billion, six times that of 1989.

As the problems escalated, companies were compelled to sell off relationship shareholdings, which forced down share prices still further and led to expectations of future falls, which, in turn, caused further falls in share prices. The share price of companies known to be deep into zaitech dropped even further. For some they were well below the exercise prices of the outstanding warrants and convertible bonds that had been issued. The expectation had been that these bonds would be repaid through the conversion of the securities into common stock. If the conversions did not take place when the bond matured, the companies would have to pay off the bondholders. Over $100 billion of warrants and convertibles maturing in 1992 and 1993 were trading below their conversion prices in late 1991.

When the bubble burst, the number of problem loans to small businesses and individual customers increased dramatically. The shinkin banks were the most highly exposed, and it was expected that few would stay independent – the MoF would force troubled banks to merge with healthy ones. The big banks were also in trouble, but the degree of their problems was difficult to assess because banks were not required to declare a problem loan ‘‘non-performing’’ until at least one year after interest payments had ceased. However, it was the long-term banks which were the most affected, because they had been under the greatest pressure to find new business as borrowing by large corporations began to fall. Two key rating agencies downgraded the bond ratings of 10 major Japanese banks in 1990, though most remained in the Aa category. The rating agencies noted Japanese banks were a riskier investment with questionable profitability performance, but were also confident the MoF would intervene to prevent bank failures or defaults on obligations.

10.4.4. Application of the Basel Capital Assets Ratio

International banks headquartered in Japan were required to comply with Basel 1. Banks had to meet these capital adequacy standards by the beginning of 1993. Subsequently, the banks would have to comply with the market risk amendment approved in 1996, to be implemented by 1998 (see Chapter 6).

The interpretation of what counted as tier 2 capital was partly left to the discretion of regulators in a given country. The MoF allowed Japanese banks to count 45% (the after-tax equivalent amount) of their unrealised gains as tier 2 capital, because these banks had virtually no loan loss reserves. As share prices escalated in the 1980s, the value of the tier 2 capital increased, and many banks took advantage of the bubble economy to float new

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issues of tier 1 capital. But after December 1989, stock prices fell, and so did tier 2 capital, thereby reducing the banks’ risk assets ratios. Japanese banks came under increasing pressure to satisfy the minimum requirements.

10.4.5. Sakura Bank in the 1990s

Sakura was one of the weakest performers of all the major Japanese city banks in 1991 because of high interest rates, small net interest margins, and rising overhead costs. The bank’s stated risk asset ratios were, in March 1991, 3.67% for tier 1 and 7.35% for tiers 1 and 2. The average for Japanese banks was, respectively, 4.35% and 8.35%. Sakura’s general expenses as a percentage of ordinary revenues were, on average, higher than for other city banks in the period 1988 – 90. Its net profits per employee were lower.

In its 1992 Annual Report, Sakura Bank acknowledged the new pressures of the Basel capital adequacy requirements, and noted that in the current environment it would be difficult to rely on new equity issues to increase the numerator of the risk assets ratio. Sakura intended to raise capital through subordinated debt and other means, and to limit the growth of assets. The bank’s strategy was to focus on improving the return on assets and profitability. In anticipation of deregulating markets, Sakura wanted to increase efficiency and risk management techniques.

At this time, analysts believed the positive effects of the merger were just beginning to be felt, with additional benefits expected to be realised over the next 3 to 5 years. The benefits would be created through integration of merging branch networks and computer systems, and a reduction in personnel. Though operating profits were recovering, they remained depressed.

Unfortunately, this was not to be, and like all money centre banks, Sakura faced problems with mounting bad debt throughout the 1990s. With the announcement of Big Bang in 1996 (see Chapter 5), it was clear all banks would have to adjust to a new regulatory regime and could no longer rely on ‘‘regulatory guidance’’, whereby the banks effectively did what was asked of them by the MoF in return for an implicit safety net and protection in the form of a segmented market that stifled competition. Recall that Sakura itself was created from the merger of two banks, after pressure from the MoF. As has been noted, the MoF, fearing corporate bankruptcies, discouraged Japanese banks from declaring bad loans (and making the necessary provisioning) in the early years after the collapse of the stock market in 1989. Failure to write off bad debt in the early 1990s contributed to an ever-growing debt mountain throughout the decade.

Since its creation in 1991, Sakura Bank has been largely focused on retail banking, with the largest number of branches among the commercial banks, and an extensive ATM network. For example, it frequently topped the mortgage league tables, though with a slump in property prices, a large portfolio of housing related assets is less than ideal. The bank has comparatively small operations in the fields of asset management and investment banking.

Sakura’s retail operations compete head on with the Japanese Post Office (JPO), which has been subsidised for years. The JPO is the traditional means by which the government raises cheap funds to finance public institutions. Until 1994, deposit rates were regulated