As the US government has sponsored various plans to forestall the recognition of real estate related losses, ranging from the failed SIV bailout program to New Hope Alliance subprime rate freeze program to proposals to raise Freddie Mac and Fannie Mae’s mortgage ceilings, it has begged comparison to Japan in the post-bubble years. Even though economists attribute Japan’s so-called lost decade to its failure to write down bad loans quickly and shutter insolvent banks, we seem to be going down a similar path of socializing losses rather than letting investors and borrowers take their lumps.
A difference of degree is often a difference in kind. Japan’s stock market and real estate runup was far greater than ours of the late 1980s; taking that many losses in a compressed period could have produced large scale unemployment, something unknown in modern Japan and politically unacceptable. Our level of asset inflation does not appear to be as bad as what Japan suffered 20 years ago, but it is still large enough for policymakers to consider which course of action will be the least damaging in the long run.
Gillian Tett provides a useful analysis of how the current credit market distress compares to the one Japan experienced and concludes, as others have, that the issue for US institutions is how to restore trust in each other. Tett identifies three hurdles that need to be surmounted – convincing investors that financial players have revealed their losses, raising new capital, and providing evidence that the flood tide of credit losses has passed. Tett gives her take on all three measures.
Tett is cautiously optimistic on the progress so far versus the earlier Japanese trajectory. However, I wish she had considered teh role of Japan’s high savings rate. Japan entered its crisis with a high current account surplus and ample domestic savings, assets the US lacks that can complicate the resolution of our credit mess.
From the Financial Times:
A decade ago, Tadashi Nakamae, a prominent Japanese economist, was fretting about a credit crunch: a property bubble had burst in Japan, leaving local banks engulfed in bad loans and prompting a financial crisis.
Ten years later, Mr Nakamae feels an unexpected sense of déjà vu. For as 2008 gets under way, bad loans are yet again undermining major banks, partly due to falling property prices. But this time, the epicentre of the shock is on the other side of the Pacific, in America. “Japan’s banking crisis in the 1990s might prove an important lesson for America’s subprime woes,” Mr Nakamae concludes.
The parallel might have seemed almost unthinkable just a few months ago. After all, Japan’s 1990s banking crisis has gone down as one of the worst in history, generating a staggering $700bn of credit losses. And since then, Wall Street financiers have generally assumed that their own financial system was greatly superior to that in Japan (or almost anywhere else in the world). Indeed, confidence in American finance was so high that in recent years Washington officials have regularly travelled to Tokyo to “tell the Japanese what to do with their banks,” admits one former US Treasury official.
However, with America’s subprime saga now entering its seventh month, this latest crunch has turned far uglier than initially thought. Consequently, while Japan is not the only historical parallel for the current woes – banking crises have actually been fairly common in the past century – the events in Tokyo offer a useful prism for analysing events. In particular, they raise a crucial question: will Washington and Wall Street prove better at dealing with their banking shock than Tokyo? Or is the west now destined to face years of financial pain – as Japan did a decade ago?
By any standards, the challenges dogging western policymakers are huge. In some respects – as US officials are keen to point out – America’s situation looks much better than that which prevailed in Japan in the 1990s. Most notably, the US is not haunted by deflation, as Japan was a decade ago. What unites both sagas, however, is that both have been triggered by a tangible credit shock – rather than, for instance, a loss of market confidence of the type that triggered the 1987 stock market crash. At the root of both tales, in other words, are bad loans.
Moreover, the potential scale of US bad loans offers a further similarity with Japan. When so-called subprime borrowers (the term for households with bad credit history) started to default on mortgages almost a year ago, the US Federal Reserve initially suggested this could create credit losses of $50bn. However, default rates continue to rise – and property prices are now falling at a rate not seen since the second world war, according to Robert Shiller, an economics professor at Yale University.
As a result investment banks such as Goldman Sachs now expect subprime losses to reach $200bn to $400bn, as around 2m households default. But the rub is that subprime is no longer the only issue: there are signs that defaults are rising on other forms of consumer debt, such as credit cards and commercial property loans. Many bankers now anticipate the final tally of bad loans could be $400bn to $800bn, excluding corporate debt.
The good news – at least for US policymakers – is that American banks are not shouldering the burden alone. A decade of frenetic financial innovation has enabled bankers to turn loans into bonds and derivatives and sell them to institutions all over the world, including non-bank bodies such as asset managers. The bad news is that precisely because of the scattering of these bad subprime loans, the shock has spread around the world. In recent weeks, for example, it has emerged that governments in places as diverse as Norway, Australia and Florida face investment losses.
Moreover, even though the losses have been sliced and diced, they are so vast in scale that the “hit” to individual banks is still proving very painful, particularly on Wall Street. If credit losses did eventually rise to $600bn, for example, this might represent as much as one-third of the core (tier one) banking capital for US and European banks – and much more for some banks, since the losses are not evenly spread. Thus, just as the cost of writing off bad loans left some Japanese banks running short of capital a decade ago, a similar pattern is threatening to emerge in parts of the western banking world.
But there is a second, potentially more pernicious analogy with Japan: a loss of investor faith. In normal circumstances, loss of confidence gets little attention from modern investment bankers since sentiment is not something that can be factored into a computer model. However, since banks abandoned the ancient practice of holding an ounce of gold (or another tangible asset) to back each bank note, finance has relied on faith. Because modern banks never have enough cash to repay depositors if these all demand their funds back, they rely on the fact that depositors will not ask for their money back – as long as they believe it is there.
However, when faith crumbles, the consequences are brutal. The last time the world witnessed this on a significant scale was in Japan, when three local institutions suddenly collapsed in the autumn of 1997. Until then it had been assumed that Japanese banks would never collapse, due to the use of the so-called convoy system, a practice where strong banks supported the weak, under government pressure. But in the 1997 this faith in the convoy system collapsed, causing the money markets to freeze up as investors and depositors fled.
A decade later, something similar has occurred in parts of the western financial world. This time, however, confidence has been shattered in a field of banking known as structured finance – an arena where bankers have repackaged credit risk in recent years at a frenetic pace, creating new products such as collateralised debt obligations (CDOs) and shadowy investment entities such as structured investment vehicles (SIVs).
As this field rapidly expanded, many observers quietly wondered whether it was becoming dangerously opaque. But just as investors in Japanese banks before 1997 used to pin their faith on the convoy system – and closed their eyes to the fact that Japanese banks were not transparent – so 21st-century investors continued to buy complex structured products despite quiet misgivings. A key reason was that investors placed huge faith on judgments from credit rating agencies. If a product was labelled AAA, for example, it was considered extremely safe.
Further, the message from many regulators and policy officials in recent years was that structured finance had made the system more resilient to shocks because credit risk was less concentrated at individual banks. “It has been like an article of faith that innovation and risk dispersal was a good thing,” says one senior European central banker. “Almost everyone believed it.”
This faith in 21st century financial innovation has since evaporated. The events of last year showed with brutal clarity that risk dispersal does not always prevent financial shocks, but may fuel contagion instead. Innovation has not shielded the banks from losses, as regulators had hoped: instead, as entities such as SIVs have collapsed, banks have been forced to take more than $60bn of assets back onto their balance sheets, undermining their capital resources.
Meanwhile, confidence in the rating agencies has also crumbled. Having failed to foresee subprime losses, the agencies have been forced to downgrade thousands of securities – including triple-A rated instruments. “Not since the high-quality batch of railroad and utility bonds of the late 1920s faltered during the Great Depression have so many high-quality ratings been unable to stand the test of time,” says Jack Malvey, senior analyst at Lehman Brothers.
That has delivered a huge psychological shock to investors, particularly to risk-averse bodies such as local authorities, money market funds and pension groups, which typically buy “safe” AAA products. Many such investors have fled the market, halting purchases of numerous structured finance products or asset-backed commercial paper.
In turn that has made it increasingly difficult for banks to raise funding and contributed to a wider money market freeze. “The key problem is a loss of trust,” explains the treasurer of one of the world’s largest investment banks. “I have never seen this before . . . except in Japan.”
Fortunately, the Tokyo tale shows that such psychological shocks never last forever. A decade after investors’ faith in Japanese banks was so rudely shattered, these institutions are once again trusted: they can raise funding relatively cheaply and investors are willing to hold their shares.
Yet this recovery took many years, largely because the Japanese government spent years denying the scale of the problem. “The biggest lesson from Japan’s past is that bankers’ stubborn refusal to recognise bad debts and authorities’ secretive attitude amplifies the problem in the long run,” says Mr Nakamae.
So the question that haunts credit markets now is whether they will be able to regain this all-important investor faith any faster than their Japanese counterparts did. Western policymakers insist that the answer is “Yes”. They have already taken some dramatic measures: last month, for example, the European Central Bank and four other central banks injected more than $400bn-worth of short-term liquidity into the markets to persuade banks to continue lending money. “In some respects, what the ECB is doing now is similar to what the Bank of Japan did a decade ago,” says Hiroshi Nakaso, a senior official at the Bank of Japan. “Back then banks lost faith in each other as counterparties, but they still had faith in the central bank so the central bank became like a central counterparty.”
However, as Japanese officials such as Mr Nakaso also point out, such injections can only ever offer a breathing space – not a cure. “What is needed now is not cash but wiping out widespread mistrust,” explains Daisuke Kotegawa, a senior official at the Ministry of Finance.
In practical terms, the experience of Japan suggests that at least three steps need to occur to recreate trust: investors need to believe that financial institutions have revealed their losses; banks need fresh capital; and, crucially, investors need to know that the peak in credit losses is past.
On the first point considerable progress is already being made, and faster than in Japan. “The major banks this time round are being much quicker to reveal losses,” says Mr Nakaso. “I think that partly reflects accounting differences.” The current credit crisis is the first that has ever occurred in a system partly run according to “mark to market” accounting rules. As a result, Wall Street banks and other financial institutions have written off some $100bn of losses in a matter of months, not years.
“I do think this crisis will work its way through quicker,” says Timothy Ryan, vice-chairman of financial institutions and governments at JPMorgan, and formerly a senior US regulator. “Banks are bringing the problem assets back on the balance sheet … and writing down positions and adding reserves.”
However, progress is not uniform. In Washington, some politicians still seem tempted to delay the day of reckoning: the US government recently unveiled measures, for example, to help subprime borrowers. And while Wall Street banks may now be writing off losses, institutions in other jurisdictions are taking longer to reveal theirs. Worse, many structured finance instruments are so complex that it is hard even for the experts to measure the losses.
“This time it is a lot more complex than earlier [banking crises],” admits Mr Ryan. “Former US bank regulators like me feel a bit responsible because we used risk-adjusted capital rules to push riskier assets off balance sheet – but we never expected that it would lead to the creations of things such as the SIVs and complex leveraged CDOs … This was financial engineering that went too far.”
On the second necessary step to rebuild trust – capital injections – evidence is also mixed. Japan only managed to rebuild its banking system when the government agreed to pour in billions of dollars in funds. And observers such as Mr Nakamae think it is inevitable that taxpayer money will be used in the current crisis. Governments, however, seem very wary of this. “I don’t think there is any appetite in Europe or America among the regulators or government to do what the Japanese did in terms of using public funds to support the banks,” says Mr Ryan.
Nevertheless, as Mr Nakaso says, “another difference this time round [compared to Japan] is that there are new sources of capital.”
Some of this comes from private equity. Last month Warburg Pincus, a buyout fund, provided $1bn of finance to MBIA, a troubled monoline insurance group. But the most controversial new source of capital is sovereign wealth funds. Citigroup, Morgan Stanley, Merrill Lynch and UBS, for example, have received around $25bn of capital injections from Asian and Gulf funds – and more Wall Street groups are expected to follow suit this year. “The banks are getting public funds – but just not from our government,” quips one senior US banker.
But it is the third issue – namely evidence that credit losses have peaked – which could prove most difficult to resolve. Some bankers hope that the worst of the credit crunch could be over by the middle of this year. After all, they point out, the markets are already braced for a huge chunk of subprime losses. And in some important respects, the macroeconomic fundamentals look far better than in Japan. America is not beset by economic decline; on the contrary, the US has just enjoyed several years of strong growth and its policymakers are fretting about inflation.
What is vexing investors – and could derail any early end to the credit crunch – is the prospect of a recession. One of the most remarkable details about the western credit crisis so far is that it has hitherto only really affected consumer debt, such as mortgages. In the corporate world, by contrast, default rates have been extraordinarily low.
However, if a recession occurs, corporate defaults could rise sharply. Citigroup forecasts a sharp rise in the rate of defaults among sub-investment grade companies this year, projecting that if there is no recession the default rate will rise from 1.3 per cent to 5.5 per cent, meaning that five out of every hundred high leveraged companies will fail to repay their debts. If a recession were to occur it expects a far higher default rate.
“If Round One of the credit crunch was about the impact on money markets and bank finance, Round Two looks set to be about the impact on the economy and [corporate] defaults,” it said.
While mainstream US and European companies have not borrowed heavily in recent years, private equity groups have loaded huge debt burdens onto entities they have acquired. This does not give them much margin for error – meaning that if growth slows, they could struggle to repay their debts.
That in turn could create several hundreds of billions worth of corporate bad loans, which would hit the weakened banks just as they are overcoming their subprime woes. “America would be hit by a financial crisis should an increasing number of bought-out firms drop into the red and creditors refuse to roll over the loans,” says Mr Nakamae.
Indeed, the “nightmare” scenario outlined by some economists is a vicious cycle where a credit crunch tips the economy into recession later this year, creating more losses. This would worsen the credit problem and prolong the pain for years.
For the moment, most policymakers think such a gloomy forecast remains relatively unlikely. After all, the US economy has remained fairly resilient. And though corporate earnings are slowing, they are falling from a high base – a factor keeping equity prices relatively high. “There’s almost a strange divergence between the acute nervosa experienced in the credit markets, and the minor state of anxiety evidenced in other capital market sectors,” observes Lehman’s Mr Malvey.
From the Japanese experience, though, one can draw two key lessons: it is much easier to destroy trust in a financial system than to rebuild it, and crises have a nasty habit of being more painful than financiers or governments initially admit.
The longer the US credit squeeze lasts, the greater the danger that it will hurt the “real” economy – and thus harder it will be to restore investor confidence. Governments and bankers will need to be very wise – and lucky – if they are to bring a complete end to the credit crunch in 2008; or, at least, much wiser and luckier than they were a decade ago in Japan.