Zen carry trade second locus of Default

Fears mount in Japan over complex yen products
Leo Lewis in Tokyo

Traders in Tokyo have given warning that about $90 billion (£55billion) of complex foreign exchange products, sold mainly to Japanese households and institutions, are on the brink of falling “like a house of cards”.

A rescue effort by the product issuers - large Japanese, European and American investment banks - is expected to involve extensive hedging measures that will throw global currency markets into even deeper turmoil.

The products, which are known as power reverse dual currency notes (PRDC), were sold to Japanese households as simple products offering higher yields than regular savings but the bonds were in reality hugely complex structures “with 15 moving parts and multiple points of pain”, derivatives experts at RBS in Tokyo said.

The products combine exposure to foreign exchange, interest rate differentials and domestic inflation and have formed a small but potent part of the so-called yen carry trade - the borrowing of yen to invest in currencies offering higher interest rates - a gambit thought to have financed huge amounts of global risk-taking in recent years.

The PRDC's complexity disguised from the buyers the fact that they were taking on the same big foreign exchange risks as the regular carry trade but with additional exposure to global interest rate volatility.

The warning on PRDCs coincides with a phase of unprecedented volatility for the yen, which this week soared to levels against the dollar and euro that are likely to hurt the country's exporters. The yen traded at 97.65 to the dollar yesterday, close to levels not seen since 1995. Two months ago, the yen stood at 110 per dollar.

Foreign exchange traders have blamed the unwinding of the yen- carry trade for much of the upward pressure on the Japanese currency.

Also fuelling yen volatility has been speculation that the Bank of Japan (BOJ) may be preparing to cut interest rates this week - rumours that provoked a sharp reversal for the yen over the past two days. The speculation suggests that the BOJ could be about to trim 25 basis points from rates and bring them down to only 0.25percent.

At the same time, Japan's “Big Three” banks - Mitsubishi UFJ, Sumitomo and Mizuho - are tallying mounting losses from Tokyo's plunging stock market. Japanese banks have vast share portfolios that are bleeding red-ink.

When the Nikkei share index hit a 26-year low of 7,000 points this week, combined paper losses on the stocks held by the Big Three since March 2007 amounted to about $100billion.

Industry figures said that if the savaging of the Japanese banks' huge stock portfolios continues, it could trigger a capital crisis among institutions recently viewed as among the safest and best capitalised in the world.

The stock losses suffered by Mitsubishi UFJ alone - $41 billion - are greater than the total sub-prime writedowns of HSBC, JPMorgan or Bank of America.