Gamble on US Commercial Property Blows Up for Japan’s Aozora

(Bloomberg) -- Aozora Bank Ltd. was in a bind in its home market.

The Tokyo-based firm was tiny compared with the megabanks that dominate the nation’s financial industry and lacked the well-defined customer base of regional lenders. So about 10 years ago, it decided to expand aggressively overseas, to the point where nearly a third of its lending was outside Japan.

That strategy blew up in spectacular fashion this week, with pain inflicted from bad loans in the US commercial real estate market, where valuations have been hammered by rising borrowing costs and lower demand as more people work from home.

While the downturn was well-known, Aozora President Kei Tanikawa assured investors as recently as November that the bank was adequately prepared and likely wouldn’t need large additional reserves. That all changed Thursday, when the bank stunned the market by setting aside 32.4 billion yen ($221 million) to deal with bad loans. It forecast an annual loss of 28 billion yen, compared with a previous estimate of a 24 billion yen profit.

“We thought office properties were the most stable,” said Tanikawa, who plans to step down April 1. “It turned out they had the biggest impact.”

Investors panicked on the news. Aozora shares fell 19% on Friday, building on its biggest decline in 15 years the previous day. At least five brokerages released reports trying to make sense of what happened.

“It’s almost a failure in risk management that they had this much exposure to a non-core market,” said Pri de Silva, a senior analyst at Bloomberg Intelligence. If you’re a diversified bank like Mitsubishi UFJ Financial Group Inc., he said, “you’re making plenty of revenue outside of core lending that enables you to absorb those losses.”

Aozora was especially hard-hit in Chicago and Los Angeles, where non-performing loans totaled $171 million and $127 million respectively. In all, the bank had $719 million of non-performing loans tied to the US office market.

Aozora isn’t alone in being caught up in the commercial property slump, and is a cautionary tale of what may lie ahead. New York Community Bancorp. set aside $522 million for loan losses, more than 10 times what analysts had estimated. The bank also slashed its dividend, sending its stock down a record 38% Wednesday and dragging the KBW Regional Banking Index to its worst day since the collapse of Silicon Valley Bank last March. The shares extended losses early Thursday, while its credit rating may be cut to junk by Moody’s Investors Service.

“The concern is across the board” and may extend from commercial to residential real estate, Chris Marinac, a bank analyst at Janney Montgomery Scott said in an interview on Bloomberg Television. “A lot of borrowers are stressed by higher interest rates.”

Strains are showing at other firms too. In South Korea, banks and fund managers followed a similar strategy as Aozora, leaving them exposed to a wave of bad loans tied to commercial real estate in the US and Europe. Deutsche Bank AG reported Thursday that it quadrupled provisions for losses in the sector during the fourth quarter from a year earlier. While the bank’s US office exposure is only 1.5% of total loans, it represents 23% of its stress-tested book.

Billionaire investor Barry Sternlicht warned this week that the office market is headed for more than $1 trillion in losses. In all, banks are facing roughly $560 billion in commercial real estate maturities by the end of 2025, representing more than half of the total property debt coming due over that period. Regional lenders in particular are more exposed to the industry, and stand to be hit harder than their larger peers because they lack the large credit card portfolios or investment-banking businesses that can insulate them.

Aozora’s vulnerability is tied to its relatively small size. The bank has assets of just 7.2 trillion yen on its balance sheet, a fraction of market leader MUFG’s more than 380 trillion yen.

The bank was one of the highest-profile casualties when Japan’s property-fueled economic bubble imploded in the early 1990s. The firm, known as Nippon Credit Bank at the time, was put under government ownership as it dealt with bad loans. Aozora was later controlled by New-York buyout firm Cerberus Capital Management LP, which sold its majority stake about 10 years ago.

In a briefing to reporters in Tokyo Thursday, Tanikawa apologized for failing to meet shareholders’ expectations, and said he’ll give up part of his compensation as he prepares to step down in two months.

His successor, deputy President Hideto Oomi, hinted that the company’s strategy may change.

“Before Covid, working at the office was a matter of course. We never thought the remote work conditions would come. I think this is where we made a mistake,” said Oomi. “We will pursue overseas business in a more balanced fashion.”

--With assistance from Emily Yamamoto, Taro Fuse, Hideki Suzuki, Winnie Hsu and Reina Sasaki.