How to Profit from the Downgrade of Japan and Its Banks

After a strong opening, Japanese stock prices fell for most of the Wednesday trading session after Moody's Investor Service downgraded Japan's credit rating from Aa2 down to Aa3.

Moody's Investor Service said that Japan's disappointing growth rate, large budget deficits and political uncertainty were to blame for the downgrade.

The downgrade was expected by many, so it didn't have a great affect on the bond or currency markets and the Japanese stock market fell much less than it did in reaction to the recent downgrade of America's credit rating.

Another reason why the bond markets took the Japanese downgrade in stride is that a large portion of Japanese debt is owned by domestic investors, so Japan is better able to deal with a credit rating downgrade than other countries that find themselves in the same situation.

Although the decline in stock prices was fairly steep, it was less than half of the 2.18% fall suffered by Japanese stocks on the first day of trading after Standard & Poor's announced a historic downgrade of the United States' credit rating.

The Nikkei 225 index of Japanese stocks fell 93.40 points, or 1.07%, to end Wednesday trading at 8,639.61.

Like most recent downgrades of sovereign debt, slow economic growth was a major contributor to the Moody's Investor Service downgrade of Japanese debt.

Japan's economic growth is unable to keep up with increased borrowing, so the country's budget deficit is ballooning.

Political uncertainty was also a factor in the downgrade because Japan has burned though several Prime Ministers over the last few years, none of whom seem to have any answers for the problems facing the country.

Japanese Prime Minister Naoto Kan is widely expected to resign soon and there's no sign that any of the politicians hoping to replace him will have a solution to the economic woes that have plagued Japan for much of the last two decades.

Several major Japanese banks also had their credit ratings downgraded by Moody's Investor Service because the Japanese government's growing deficit will make it more difficult to support the banks in times of trouble.

Japanese banks also have a growth problem of their own due to nearly two years of declining loans.

There are a few different ways to play Wednesday's downgrade of Japan and its banks.

Optimist investors may want to take a look at the iShares MSCI Japan Index Fund (NYSE: EWJ) if they feel that with a new Prime Minister on the way Japan may finally find a solution to years of poor economic performance.

Investors who have more faith in the Japanese banking sector than Moody's Investor Service does may want to consider Mitsubishi UFJ Financial Group (NYSE: MTU) or Mizuho Financial Group (NYSE: MFG).

If the market reaction to the banks' downgrade proves to be an overreaction, these two stocks could move higher.

Investors who see today's downgrades as just another sign that Japan is nowhere near to solving its economic problems should consider the ProShares UltraShort MSCI Japan (NYSE: EWV) ETF.

There hasn't been much good news out of Japan for quite some time and the country's lack of leadership makes a turnaround unlikely any time in the near future.