Experienced Japan watchers are getting ever gloomier about the country's prospects. They cannot see any way out of the present gridlock. The banks, all their time and resources focused on non-performing assets, have reduced new lending so dramatically that the real economy is grinding to a halt. The rate of corporate bankruptcy is increasing and each new Tankan survey is more despairing than the last. Lack of liquidity is forcing good as well as bad out of business, creating more problems for the banks and forcing them to cut lending further.
The banks will not reform themselves. Without the discipline imposed by angry shareholders, they have never chosen to face today's problem today. Every year, western investment banks wait eagerly for March 31. Every year, they make more and more, as the window-dressing gets more difficult and complex.
This year credit derivatives have been the trade of choice. The version chosen shows just how little interest the banks have in reform. The favourite trade is a short-dated step-up premium callable default option. The initial premium is low, so this year's accounts are spared, and the trade is unwound after the year end when the cost can be taken.