SHANNON MCCONAGHY: You have to really look at the weakest elements of the banking system. And I believe they are melting down now at accelerating rates. The whole sector has seen its earnings since 2015 declined by 50%. Bank of Japan executive recently left and said in the public forum that loss making will become the norm for Japanese banks in the near future.

RAOUL PAL: In the next interview from London I asked Roger to interview Shannon McConaghy also Horseman Capital. Now Shannon's really interesting because he's looking at Japan and Japan's part of this global equation that's really important. Now he's got some unique views there particularly in the Japanese banking sector. So I wanted Roger on my behalf to go and dig into that to find out how that might affect some of our global recession framework.

ROGER HIRST: Shannon, welcome to Real Vision. Good to see you.

SHANNON MCCONAGHY: Thank you very much for having me. Pleasure to be here.

ROGER HIRST: And we've been talking on and off the last few months about Japan and Japan coming to an important juncture. There's been this sort of financial situation which we'll go into and which may be a blueprint for financial situations in the rest of the world particularly Europe. But then also there's this other element which is that the consequences of this could have an exogenous shock on the global system.

And I think what's really interesting here is when we've been talking about this- and Raoul's been looking at it- he talked about this big framework. And most people think of things like trade wars as being the exogeneous shock but the danger is there may be one or two other exogenous shocks out there which obviously we come to. But to put this all in context, can you outline this sort of financial scenario that eventually could lead to an economic scenario in Japan and how that's been building and brewing?

SHANNON MCCONAGHY: Sure. It's a complex beast. There's many moving parts. But one way I've recently been articulating this to others, try to simplify it, is drawing an analogy. A financial system is like a reactor, a structure that contains interaction between elements. So in the financial system, the dominant elements are borrowers and lenders. Lenders transfer funds to borrowers, and then borrowers transfer that back with interest, hopefully. Sometimes that goes wrong.

What we've seen is within that reactor, central banks have been trying to use extraordinary policies to stimulate interaction. And the way they do that is to reduce the flow of interest from the borrowers back to the lenders. And indeed now with negative rates, they've reversed the flow completely. They're trying to stimulate outputs such as inflation. It's very hard to see and measure how successful that has been.

But what we can clearly see is that their interference with the system is creating instability. And what I mean in particular is the lenders, most importantly, banks, which have had a in Japan, 0% deposit cost now for a number of years, essentially had just squeezed by the reduced flow back of interest payment. And they have their own outflows. They need to pay operating costs, staff, computer systems, regulatory. And that's about 1%.

So the central banks have been reducing that flow and reversing it back out from banks when they put overnight deposits on. And this, in my opinion, is coming to a real head this year. You have to really look at the weakest elements of the banking system. And I believe they are melting down now at accelerating rates.

Those are the regional banks. What we're seeing is the most important income source for them to remain viable and cover their own outflows is loan income in Japan. The average new loan interest rate they achieved in May fell from 82 basis points to 64 basis points. They have about a 1% breakeven they need to cover to cover those outflows to keep the bank going. And indeed, that 1%, I think, is artificially low, and indeed, it's a lot higher.

But if we just take that conservative 1%, they've gone from receiving 82 basis points to 64, and they've doubled the shortfall. A doubling in a meltdown is a very concerning acceleration. The real issues at large are tying in with global macro events. We can see the pressures in the system building in other areas- in Europe, for example, where we also have deeply negative rates.

And a way to measure this to see that the pressure gauge in the system is the amount of negative yielding bonds globally. And that has recently hit a new all-time-high of $13 trillion. What adds further pressure for the Japanese banks is they can no longer go overseas to secure yields in higher yielding markets to offset the problems at home. And that's due to some dislocation in the FX forward markets and FX hedging costs.

To look at this in terms of numbers, the Japanese banking system, which is the largest net creditor system in the world, now receives negative 70 basis points, when currency hedged, in 10-year US treasury yields. So the largest debt market globally for them is unviable. And this is why we are seeing in Japan with limited options overseas.

And we'll talk about later how they have been taking higher risk overseas, but it's not offsetting the domestic issues in Japan. And they are in meltdown. And this is something that I don't think the vast majority of observers are aware of the scale of.

ROGER HIRST: And so when we look at the performance of the Japanese banks versus the broad market, it's been in this sort of a record all-time-lows. It's been effectively sort of 40 years of slow death. But it sounds like that slow death, that they're now running out of runway. And you mentioned that there are now new loans or returns on new loans. Interest on new loans is below effectively the cost of capital. But sure that's been sort of building over a while. Are there elements within this that are creating an acute stress to the Japanese banks so that the death by 1,000 cuts now becomes death?

SHANNON MCCONAGHY: Yes. There's three things really coming to a head. One is so negative interest rates brought the new loan interest rate from around 1.2% to about 1% in 2016, but then flatlined just below that '17, '18. And then we've seen a big step down now. So that's really come to a head this year.

I noticed your colleague, Raoul, was recently suggesting that negative rates were thought to implode a banking system. We haven't seen it in Japan yet. The reason it hasn't happened yet is the banks have been using accounting tricks in abundance, not just the regional banks, but mega banks in Japan, to obfuscate the effects. And those are running out.

In addition to that, they've been hiding non-performing loans and substantial amounts under a government debt moratorium. Just to talk about the accounting tricks to start- so in 2012 when Kuroda and Abe basically said we are going to crush JGB yields until we get inflation, and those who knew what was going on in Japan knew that they wouldn't create sustainable inflation, so yields would decline precipitously.

The banks obviously had substantial JGB holdings. What they've done since 2012 is reduced their JCB holdings as the Bank of Japan has bought them and shifted a lot of their security holdings into domestic ETFs and foreign fixed income. The largest area is domestic ETFs that are in private investment trust structures that are in arrangement with brokers that are not marked to market. And whenever they generate capital gains, the banks cancel the investment trust arrangement and reflect the capital gains as interest income under the net interest income line within securities.

This is highly irregular under international accounting standards. I was calling it window dressing, but some of the guys involved just straight up call it an accounting trick. The issue with this is that played out well for them in 2012, '13, '14, '15 as the equity markets rallied and they generated capital gains. '16, so equity markets fall, and they got really worried, but then markets recovered late '16 and through '17.

Since the early part of 2018 when the TOPIX index peaked, the market is down between 15% and 20% now. They are not able to generate these capital gains to report as interest income to hide the fact that their loan books are dramatically below breakeven. They have a stock of unrealized gains that they are running down, but some banks now have completely run out.

And a big part of my job is digging through the layers of the onion to get to an estimate of the amount and also the relationship between the unrealized gains and various asset classes- some banks are more exposed to equity, some foreign credit- and modeling how their earnings will surprise and collapse. And indeed, many have seen earnings surprised that collapse.

The whole sector has seen its earnings since 2015 decline by 50%. I believe that they have deeply negative margins on their loans. And as the old loans roll over and accounting tricks run out, they will be perpetually loss making banks because it is not like they're seeing a growth in population. They are seeing accelerated decline in population. So conditions are just getting worse on that front. And many of these banks will see their shareholder 0. So there's significant downside to come.

ROGER HIRST: I think one of the other things you mentioned on this, was the, there's that loan issue, there's the accounting trick issue. But there's also sort of a collateralization issue. So the old people in the region, which are sort of declining demographically, they are effectively being given a moratorium on some of their own debt. Well, how is that adding to this picture?

SHANNON MCCONAGHY: So in 2009, the finance minister of Japan, Kemai-san he introduced a debt moratorium. And he officially said, we are going to get banks to lend more to struggling businesses, and they won't have to reflect the loans as non-performing. Indeed, many lines were reclassified to performing. So what's happened since 2009 is borrowers haven't been allowed to go bankrupt, in essence, because the banks have been forced, and if they don't do this, they receive a business improvement order.

They've been forced to do whatever they can to keep those businesses running from a cash flow perspective. That includes capitalizing interest payments. So the borrower can't make his payment, you essentially lend him money to make the payment, and the loan balance grows. Reducing principal payments, whatever they can do. And that's happened 95% of requests for rescheduling of loans have occurred.

And I've met many small businesses that have been negative assets for years and losing more and more money each year, and are on rescheduled loans, and sit within performing loan status, which is irregular under BIS in many, many different ways. So it's interesting to me, because I spend a lot of time traveling around regional Japan. And we're talking about regional banks, where the population decline is accelerated. And that doesn't just impact the banks from a reducing customer base, but also the customers they lend to are seeing falling customer base and collapsing real estate prices.

What's interesting about Japan, is when a lot of these loans were made to baby boomers in particular in the '80s, Japan had the most expensive land in the world. So there's a huge gap between the collateral value and the explanations of earnings and what's actually been going on. The issue is, many of these borrowers 10 years ago, when the debt moratorium came in, baby boomers were hitting late 50s, early 60s. They just wanted to extend and pretend, so that's what the government did to buy votes basically, extend and pretend.

Now these baby boomers are in their 70s. And many of them are keen to exit their businesses, but they can't, because they'll lose their own personal guaranteed assets. Their house, their car, their savings. It's interesting. The government has recently, in order to appease those voters, changed the rules. It's basically changed the rules such that those borrowers can now walk away from loans that have insufficient assets to cover the closure of that loan. So there'll be a write-down.

And indeed, they can keep and remove their personal house, car, savings from the recovery process under new policies. And this is seeing a very interesting increase in credit costs in Japan, which amazingly, have been at around zero for five years, because the banks have been reducing their provisions, because companies haven't been going bankrupt because of the debt moratorium, which reduces the look back provisioning requirement. And they've reduced their provisions in the Japanese system from about 2.3% percent to 70 basis points, while the global average of larger banks has risen to about 2.3%.

So Japan's gone completely the other way, reduced provisions, which is a positive P&L impact for the banks, and keeps credit costs at zero. And now you have a huge number of borrowers that could just walk away from their loans. If you just raised the credit costs for Japanese regional banks from around zero, they've risen already to about eight or nine basis points. But if you raise that to 40 basis points, which is still below US credit costs, I can tell you that the Japanese regional system is far worse than any major developed economy I've seen in terms of the scale of the decline of collateral prices, the decline in earning conditions for borrowers.

If you did raise the credit cost 40 basis points, which is conservative, no Japanese regional bank would be generating a profit. And so the fact that they've understated credit costs substantially has obfuscated the fact in their core business, they're deeply, deeply troubled, and as I suggested before, seeing an accelerated meltdown in recent months.

And indeed, the FSA in Japan says that over 60% of Japanese regional banks are loss-making on a core basis. They don't then walk into the finer details of accounting tricks and hidden non-performing loans, because that would be very un-Japanese. But it's very easy, if you know how to look for it, to identify those obfuscation-level tools.

ROGER HIRST: And this being Japan- they love their QE, et cetera. And you know what? People always argue that, or the lovers of QE always say, it's not that QE isn't working, we just haven't done enough of it. Won't the government kind of step in and just print loads more money and say, there's now a massive hole. You're now all underwater? I mean, are they going to let the banking or the regional banking system go? Or are they going to bail it out with just printing more money? Is anything changed in the way that the government is looking at bank equity and banks themselves?

SHANNON MCCONAGHY: So the mechanisms that Japan has used for printing money to stimulate inflation in the system are inherently negative for the banks. Because they suppress the transfer of interest income back to them by suppressing rates. And I don't think Japan can really reduce rates significantly from here, because that will create more accountability on the Bank of Japan for blowing up the banks. I think they just prefer to keep rates where they are at the moment.

They have already tried to transfer the blame to the banks by saying, look, it's you guys. The population decline is the real sort of driver for this, and also, you're being too competitive. It's not our fault. So it's very clear to me that the government and regulator in Japan is unable to resolve the problems at the regional banks.

And what I mean by that is, in the past, in the '90s and early 2000s, when they did let dozens of banks fail and shareholders were zeroed in some of those instances, what essentially happened is, you had banks that had over-lent to take Tokyo property bubble, having write-downs and then being patched up and sent on their merry way as their main market, Tokyo, recovered and the population grew.

The differences with regional banks is, you have an accelerating population decline. So it will get worse, conditions will get worse. It's very unlikely that Bank of Japan is going to raise interest rates by 100 odd basis points to save the banks and bail them out, because the consequences would be too large. These banks are sitting on assets or toxic assets that are going to get worse, because they're to baby boomer borrowers who are losing more money each year.

And so there's also very unlikely to be any white knight other bank coming in to bail them out. They all have a fairly clear idea that the toxic assets are dispersed and particularly concentrated within the weaker banks relative to their asset base. There's also a really strong aversion in Japan to bailing out banks from a political perspective. I've done a lot of work on this, a lot of surveys, and it is clear to me that actually the appetite for bailouts is even less than you would find in Western economies.

It seems the FSA is trying to warn the market by saying that 60% or more banks have negative core earnings. And that banks have been understating credit costs. They officially said recently, or the Bank of Japan did in its financial stability review, system review. They're trying to warn the market. They don't want to be accountable for buying assets that will cost taxpayers.

And there is an established precedent in Japan, an established legal procedure for dealing with banks that melt down, which is you essentially split it into a good bank, bad bank. Good bank owned by the deposit protection assurance corporation. Maybe those assets sold off to Japan Post. But the shareholders of the old bank get transferred into a non-viable court holding proceeding. And the precedent is, those shareholders were zeroed. I think there are going to be a number of banks zeroed in Japan. And the ramifications will be substantial, as they usually are.

ROGER HIRST: So what is that transmission mechanism between what is a financial crisis potentially in the regional banks to the potential recession in Japan? What's GDP, like a GDP in Japan? Is it fragile? What's been driving that? So how does it go from something which they're flagging, they're saying this is going to happen, everyone's watching this, to actually becoming recessionary or worse? How does that happen?

SHANNON MCCONAGHY: When you look at through the cycle GDP trends in Japan, so this century, nominal GDP has grown by less than 6%. More than half of that came from the consumption tax hike in 2014, which adds to nominal GDP just optically. And also government consumption. And we know that Japanese government consumption, if you've traveled around regional, Japan isn't always the most productive investment infrastructure, et cetera.

So there isn't really strong structural growth. And indeed, the reason there isn't, is because the population declined. And that's accelerating. So the structural stagnancy that they've seen, is only going to get worse. So what are we facing from in my opinion ramifications of some regional banks melting down? So firstly, I think it'll spread to other banks quite rapidly.

In Japan, you have added factors, such as banks, have large amount of cross shareholdings in each other. So when one bank starts to sell off aggressively, that impacts the asset value of other banks and the capital. Also interesting to see in past, I've spoken to financial institutions during financial crises in Japan that will start to short other banks to hedge exposure and risks.

What also is interesting to me, is the banks tend to crowd into similar assets. I'll talk about the