A recent decision by the Supreme Court in Japan relating to gray-zone interest rates concerned some investors in consumer loan ABS.
Analysts said they don't think the ruling will impact any transactions, but at least one urged investors to be vigilant.
The Supreme Court overturned the decisions of two lower courts when it ruled on an appeal demanding the return of excessive interest paid by borrowers on loans extended by SFGC Co., Ltd. (the former Shohkoh Fund Co., Ltd.). The Supreme Court sent the case back to the lower courts, saying the requirements of "minashi bensai" (deemed payment) under the Money Lending Law should be strictly interpreted.
"In effect, the decision is a reversal victory for the borrowers," Merrill Lynch analyst Chinatsu Hani said in a commentary titled "Gray-Zone Interest Rates and Consumer Loan ABS."
This particular case related to "shoko loans," a type of small-business loan. However, Hani said, the decision is likely to affect other lawsuits regarding borrower claims on gray-zone interest. The term "gray zone" refers to the zone between the interest rate cap under the Interest Rate Restriction Law, which ranges from 15% to 20% depending on the size of the loan, and the 29.2% cap under the Capital Subscription Law.
Hani noted the Supreme Court directive to more strictly interpret the law is likely to become a factor in the rising demand for reimbursement of excess interest payments. But even so, ABS structures typically mitigate gray-zone risk, which is considered inherent in all transactions that include Japanese consumer loans.
Hani said she received some calls from concerned investors. Although she doesn't think any transactions are in immediate danger, she urged caution.
"Of course, we are not implying that the demand for the return of gray-zone interest will have no effect on ABS investors," Hani said.
She suggested investors examine the rise in the possibility of early amortization, should gray-zone interest claims increase rapidly or should a legal framework be provided to allow for class-action lawsuits. She also suggested examining the direct impact on the underlying asset pool should originators begin to struggle financially.
"Early amortization triggers exist for investor protection," Hani said. "But the uncertainty in the redemption patterns may pose concerns for certain investors."
She said a separate reserve account is provided in some transactions to cover gray-zone claims in case of originator bankruptcy. But, she said, it is most important for investors to monitor excess spreads and other reserve levels that determine the speed of principal redemption under early amortization, as well as the originator's credit quality.
It is difficult to assess the scope of gray-zone claims, Hani added. The only figure available is an estimate of the interest returned by the five major consumer finance companies, compiled by The Money Lender's Association of Tokyo. In the fiscal year ending March 2001, the companies reimbursed 0.7 billion; in fiscal year 2002, 2.3 billion; and in fiscal year 2003, 4.5 billion. However, Hani said, the impact of the claims seems negligible when compared with the 7.5 trillion total outstanding loans at those five companies.
"There is no doubt that the gray-zone interest claims are on the rise," Hani said. "However, we are unable to get a clear picture of the situation of the industry overall."
Toshihiro Matsuo, an analyst at Standard & Poor's, agreed with Hani that the recent Supreme Court decision will not have any immediate impact on existing or future ABS transactions with gray-zone risk.
Matsuo said if Japan introduces a new regulation regarding class-action lawsuits, which could adversely affect the transactions, the accelerated amortization mechanism would be triggered in most cases.
The Money Lending Law stipulates that the gray-zone interest received by money-lending companies is allowable if certain conditions are met. Since most consumer loan companies don't meet those conditions, there is a risk of obligors demanding the appropriation of gray-zone interest to repay their debt, Matsuo said. But unless they're in default, there is little incentive for them to do that because of the small size of the loans and the legal costs of making such claims. An additional disincentive is that such claims might affect the obligor's ability to borrow in the future.
Still, potential gray-zone risk exists in any transaction that charges interest exceeding the Interest Rate Restriction Law. Matsuo said the law limits the annual interest rates a company can charge to 15% for loans over 1 million, 18% for loans between 1 million and 0.1 million, and 20% for loans under 0.1 million.