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New financial instruments ?such as structured financial products and exchange-traded funds ?and new financial institutions ?including hedge funds and private-equity funds ?present opportunities as well as policy and regulatory challenges in U.S. and Japanese financial markets. This book presents cutting-edge research from experts in academia and the financial industry on new instruments and new institutions while contrasting their developments in the different countries.
New financial instruments —such as structured financial products and exchange-traded funds —and new financial institutions —including hedge funds and private-equity funds —present opportunities as well as policy and regulatory challenges in U.S. and Japanese financial markets. This book presents cutting-edge research from experts in academia and the financial industry on new instruments and new institutions while contrasting their developments in the different countries.
The contributors highlight the innovative way in which Japanese financiers and government officials have learned from the U.S. regarding the introduction of new instruments into their market. New Financial Instruments and Institutions continues the productive collaboration between the Brookings Institution and the Nomura Institute of Capital Markets Research in examining current issues in capital and financial markets.
Contributors include Jennifer Bethel (Babson College),Todd Broms (Managed ETFs, LLC), Frank Edwards (Columbia Business School), Allen Ferrell (Harvard Law School),Yasuyuki Fuchita (Nomura Institute of Capital Markets Research), Gary Gastineau (Managed ETFs, LLC), Ken Lehn (University of Pittsburgh), Josh Lerner (Harvard Business School), Frank Partnoy (University of San Diego Law School), Adam Posen (Institute for International Economics), Ken Scott (Stanford Law School), Steve G. Segal (Boston University, J.W. Childs Associates),Yuta Seki (Nomura Institute of Capital Markets Research, New York), Erik Sirri (Babson College), and Randall Thomas (Vanderbilt Law School).
One of the most important characteristics of financial markets and institutions is change. The industry, and the products and services it offers, is constantly evolving in response to financial innovations developed by entrepreneurs within existing and new institutions and the ever-changing needs of users and suppliers of funds.
This book is about some of the recent innovations-especially new financial instruments-and new institutions that are changing the financial sectors in the United States and Japan. It contains the papers presented, and the formal remarks of discussants, at the third annual conference of financial issues of mutual interest to the two countries held at the Brookings Institution on September 12, 2006, and cosponsored by Brookings and the Tokyo Club Foundation for Global Studies.
As in the volume produced for the second annual conference, which focusedon the "financial gatekeepers," the third annual conference highlighted some interesting contrasts and commonalities in finance in the two countries. For one thing, it will be clear from reading the papers on Japanese finance that financial innovation in Japan has taken its cue from the United States and is proceeding more rapidly than many in America (and possibly in other countries) may realize. For another, in at least one important market-the secondary market for residential mortgages-Japan shows evidence of learning from the United States, specifically what features are best to adopt and those that are best to avoid.
As for the U.S. financial market, this volume focuses on the growth of two relatively new, and in some circles controversial, financial institutions: hedge funds and private equity funds. The two main financial instruments of interest are structured products-investment vehicles whose performance depends on the performance of some other underlying instrument (and thus are analogous to derivatives)-and exchange-traded funds, or EFTs, increasingly popular means of asset diversification that are alternatives to mutual funds. All of these institutions and products illustrate the seemingly never-ending ingenuity of the financial services industry to come up with new methods for financing or hedging risks-but at the same time each raises novel legal and policy issues, or in some cases, risks. If Japan's history in adapting U.S. institutions and financial instruments continues to repeat itself, then surely at some future conference we will be considering how Japan has adapted and refined the more innovative U.S. institutions and instruments that we feature here.
Meanwhile, we believe the chapters that follow provide an excellent overview and introduction to some of the more innovative developments in finance today-for the benefit of investors, policymakers, and regulators who may not have the time to keep up with the seemingly dizzying pace of change in the financial markets.
This volume begins with two chapters analyzing recent innovations in the Japanese financial market. Chapter 2, by Yuta Seki, addresses the development and increased use of two types of financial securities first introduced in the United States: exchange-traded funds (ETFs) and real estate investment trusts (REITs). Both securities are collective investment vehicles, offered to both retail and institutional investors. Both are also relatively recent in Japan, having been introduced in that market in 2001, although each had a very different history.
In reviewing the history of investment trusts in Japan, Seki notes that collective investment vehicles of all types (beginning with mutual funds) always have accounted for a much lower share of household financial assets in Japan than in the United States (the same is true of stockholdings). Japanese consumers have been more comfortable with lower-risk investments in bank accounts, especially at the country's Postal Savings Banks. Stocks grew in popularity during the boom of the 1980s, but growth halted after the stock market bubble burst in 1989.
In an effort to boost the flagging stock market in the mid-1990s, the Japanese government eased several restrictions aiming to encourage the growth of mutual funds. In 2001 defined contribution pension plans were first introduced in the country, which also encouraged demand for mutual funds. An additional boost came in 2005, when Postal Savings Banks for the first time began selling investment trusts. By 2006 net assets in such trusts reached a record level of 60 trillion yen. Still, however, the mutual fund market in Japan remains small relative to that of the United States, composing roughly 3 percent of household financial assets compared with 13 percent in the United States.
By 2001 the stock market was still languishing, as were the fortunes of Japan's banks, which still held significant corporate shares on their balance sheets. In an effort to bolster the stock market, and thus indirectly its banks, the Japanese government borrowed an idea from Hong Kong, where the government purchased shares in companies listed on the Hong Kong exchange. Essentially, the Japanese government did something similar, authorizing an organization capitalized by the banks themselves and other parties to buy Japanese stocks, but through a new index vehicle for the Japanese market, the ETF. But unlike the United States, which allowed exchanges and entrepreneurs to innovate with new indexes to serve as benchmarks for ETFs, the Japanese government strictly limited the indexes to which Japan's ETFs could be linked, ostensibly to "maintain balance in price formation and to prevent price manipulation."
Since 2001 ETFs have grown in Japan, but not at the rapid pace seen in the United States, where by 2006 the outstanding volume of such instruments (roughly $335 billion) outstripped the volume in Japan by a factor of roughly 10 (at $35 billion). Given the greater popularity of mutual funds-the ETF's main rival-in the United States, this is not surprising. In addition, Seki points out that the first Japanese ETF was based on a relatively new index, the Nikkei 300, which was not well known to Japanese investors.
Further, after an initial increase in their number, some ETFs in Japan have been delisted in recent years, giving Japanese investors less choice than is available to American investors.
Seki is cautious in predicting the future growth of Japanese ETFs but offers several recommendations for increasing their popularity, including expansion in the number of ETF products, efforts to improve understanding and to promote the purchase of ETFs by Japanese investors, and diversification of distribution channels (primarily in defined contribution pension plans, a step he suggests is also needed in the United States).
Seki next turns his attention to another collective investment vehicle pioneered in the United States and later copied in Japan: the real estate investment trust (REIT). REITs are securities backed by estate holdings and pass through their returns (minus fees of their managers) to investors. They were first introduced in the United States in 1960 and became especially popular for investors with high fixed returns (with some prospects for capital gains) after the Tax Reform Act of 1986, which among other things also allowed REITs to manage as well as own real estate. Initially REITs were issued as initial public offerings (IPOs), but by the mid-1990s many established REITs were raising funds through secondary offerings. Over time, the investor base for U.S.-issued REITs expanded, especially as pension funds and foreign investors grew interested in the securities as a way to invest in U.S. real estate in an efficient, diversified manner.
REITs were introduced into Japan in 2001, through a vehicle popularly known as the J-REIT. That they were not introduced earlier was due to the absence of securitized loan and other investment products in Japan. This began to change in 1998, when the Japanese Parliament enacted legislation authorizing the issuance of corporate bonds and preferred stock backed by leasing credit receivables and revenue from commercial real estate. The legalization of the J-REIT came several years later.
The J-REIT is legally defined in Japan as an investment trust, in contrast to the corporate structure (with pass-through tax features) common in the United States. Seki describes other features of the J-REIT, concluding that it is more complicated from a legal point of view than its U.S. counterpart.
J-REITs have become relatively popular investment vehicles in Japan for several reasons according to Seki. First, they have offered higher yields than have been available on low-interest Japanese government bonds. Second, the low interest rate environment has enabled J-REITs to finance their real estate acquisitions at low cost. Third, Seki argues that the strong disclosure in the prospectuses of the J-REITs, including announcement of the expected amounts of dividends, encourages investors to buy them.
Banks and investment trusts (investment vehicles that purchase shares in as many as 10 to 15 individual REITs) have become the dominant purchasers of J-REITs, although retail investors also have been important purchasers. In the process, J-REITs have lowered the cost of capital (or capitalization rate) for real estate properties, while making the Japanese real estate market more liquid and transparent. Still, as with equity collective investment vehicles, the total REIT market in Japan is about one-tenth as large as that in the United States.
Looking ahead, Seki suggests that in the future it is likely that Japanese policymakers will have to wrestle with how to deal with conflicts and possibly other problems posed by having outside managers oversee the real estate held by J-REITs. In particular, there has been some concern about J-REITs investing in buildings that are not built according to seismic codes (and thus are technically illegal). Meanwhile, the existence and growth of both ETFs and REITs in Japan should continue to offer global investors a way of investing in Japan through diversified financial vehicles.
Yasuyuki Fuchita in chapter 3 discusses how Japan has successfully adapted, and arguably improved upon, yet another American financial innovation: the securitization of mortgages. The importance of this financial innovation cannot be overstated. The notion has been that individual mortgages can be pooled together in a trust and securities sold to the broader public representing proportionate interests in the trust. Agencies directly or loosely affiliated with the U.S. government-Fannie Mae, Freddie Mac, and Ginnie Mae, in particular-have guaranteed the interest and principal of these securities, giving comfort to a wide class of retail and institutional investors. Today, about 70 percent of all U.S. mortgages are guaranteed in this way. This securitization process has enabled global capital markets, and not just the U.S. financial institutions originating the mortgages, to finance the construction and sale of residential real estate.
Fuchita documents how Japan is in the process of catching up to the United States in the securitization of its residential mortgages. Still, however, the Japanese market in such securities-residential mortgage-backed securities (RMBS)-is small by comparison with that of the United States. But this is rapidly changing, and Fuchita documents how.
In particular, historically Japan encouraged residential ownership largely through government-provided subsidies on mortgage loans. At times, such subsidized loans, extended by the Government Housing Loan Corporation (GHLC), have accounted for over half of new mortgages. In recent years, however, the GHLC has essentially ended its subsidy program, substituting instead a system of securitizing loans originated by private lenders. For example, from roughly 0.5 trillion yen in 2001, the Japanese RMBS market increased to 5.0 trillion yen in 2005. Fuchita describes the institutional arrangements under which GHLC operated during this period, as well as the nature of the subsidies it provided in previous years.
But reform has not stopped there. Writing in late 2006, Fuchita reports that as of April 2007, the GHLC will be dissolved and will be replaced by a new independent housing agency, the Japan Housing Finance Services Agency (JHFSA). The primary task of the new JHFSA will be to provide support for the securitization of residential loans originated by private lenders. The JHFSA will be modeled on the operations of Fannie Mae in the United States-but with one notable exception. Unlike Fannie Mae, which both securitizes loans and also purchases loans and holds them in portfolio, the JHFSA will concentrate only on securitization and will not hold mortgages. Thus the JHFSA should not be subject to the "interest-rate" risk-the risk to shareholder capital arising from the difference in maturity of assets and liabilities-that has been a lightning rod for criticism of Fannie Mae. Much of Fuchita's chapter is devoted to explaining how the new JHFSA will operate and the nature of the guarantees it will provide.
Over time, the JHFSA and the new securitization process should change mortgage finance in much the same way securitization changed housing finance in the United States. Currently, about 25 percent of Japan's residential mortgages are securitized, far short of the nearly 70 percent in the United States. One can reasonably expect this differential to narrow. At the same time, given the rapid aging of the Japanese population, the demand for new housing will not grow as fast as in earlier periods. This will reduce the relative importance of housing in the Japanese economy over time.
Fuchita concludes his analysis by pondering several possible futures for the JHFSA in this environment: It may stay as a government agency, or eventually it may be privatized in some form (as has been the case in the United States with Fannie Mae and Freddie Mac). One potentially heretical possibility if the agency is privatized is that it will merge with another large, private Japanese financial institution.
In sum, Japanese financial markets continue to evolve, as have those in the United States. Japan's private institutions and its policymakers learn from developments in the United States and adapt them to their market. It is hoped that the learning process will entail fewer difficulties that seem inevitably to come with financial market leadership.
The next two chapters focus on the U.S. financial market and two financial institutions offering new opportunities for investment. One of the major financial institutions, though it has been around since the late 1940s, is the hedge fund, a limited partnership vehicle that typically holds shorter-term positions in the debt and equities of public companies. Some hedge funds invest in other financial instruments as well. We nonetheless treat the hedge fund as "new" primarily because of the rapid growth in this particular form of investment vehicle. In chapter 4, Frank Partnoy and Randall Thomas examine the rise of hedge fund "activism," which they view as a logical extension of activism by institutional investors in general.
Economists typically distinguish between two ways that shareholders can be active, that is, ways to influence corporate behavior, especially of underperforming companies: "exit" (selling shares) or "voice" (voting their shares in favor of certain directors or corporate governance rules, or more directly by negotiating with managers about ways to improve company performance). Historically, institutional investors have preferred the strategy of exit to voice; it is much easier, after all, simply to sell the stock of a company not doing well than to take the time and energy to persuade its management to change course. The authors note, however, that this began to change in the 1990s, as some institutional investors-public pension funds and labor unions, in particular-decided to exercise their relatively large voting positions to make their views known to corporate managers. In principle, this should be a welcome development, since precisely because of their relatively large share holdings, institutional investors have a stronger financial incentive than smaller investors to monitor the activities of the corporation and thus to reduce the "agency costs" arising out of the separation of ownership from control of public companies.
Excerpted from New Financial Instruments and Institutions Copyright © 2007 by Brookings Institution Press and the Nomura Institute of Capital Markets Research. Excerpted by permission.
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