Japan’s Nikkei stock index peaked near 40,000 in 1989, but a year later, it had dropped 43%(see the chart, left). And as Japan entered the 1990's, a crisis began to emerge in its financial system, a crisis that lasted for years and resulted in the failure of several major banks. Many people believe this was one of the worst banking crises in history, generating an incredible $700 billion of losses, a number eerily similar to the bailout amount proposed by Paulson and the US Congress, but less than the $819 billion stimulus package. So what, exactly, happened during Japan's crisis and how did the experience compare with the crisis underway in America today?
In researching for this event, the first thing I checked was interest rates set by the Central Bank of Japan. In the late 1980's, these were lowered successively until they reached 2.5%, at that time a very low rate for Japan. During 1988 and 1989, inflation was running 2.5 to 3.0%, so real interest rates at the end of the 80's were near zero, or slightly negative. Was this the ultimate cause of the crisis? Looking back, most experts agree that it was instead excessive risk taking on the part of banks, that filtered throughout the economy. A combination of declining profit margins, deregulation, and weak regulation of banks led to:
Sounds familiar, doesn't it? At that time, reserve requirements in Japan were 4% for domestic banks, and 8% for banks with foreign operations. So, in short, Japan's crisis was caused by deregulation and declining profit margins, which led to increased competition between banks and increased risk-taking. This was true in both consumer credit and in the real estate industry. It all sounds incredibly similar to the scenario that is playing out across the US today.
Japan's financial crisis took an entire decade to play out as follows:
- 1989-90:The stock market peaked in 1989, then collapsed in 1990, dropping an incredible 43% (the Dow is currently down 43% from its peak). Japan's banks were allowed to hold equities as part of their capital base. Over the next three years the market experienced high volatility, with a general downward trend.
- 1992: Land prices begin a steep decline and defaults begin rising on consumer loans.
- 1993: Problem real estate loans are making life difficult for banks and they establish the CCPC, Cooperative Credit Purchasing Program. It is funded by banks to take bad loans off their balance sheets. The loan balance less appraised value is deductible from taxes on bad loans transferred to this "bad bank."
- 1994: Some banks still tried restructuring "problem loans" by lowering interest rates and extending maturities in an attempt to delay the inevitable.
- 1995: Residential and commercial property values continue to decline and take down a major residential mortgage lender. I found one study which reported that real estate prices for commercial land dropped 80% from 1991 to 1998, although other data seems to indicate a lower number.
- 1997: Many banks are experiencing negative return on equity, and some keep paying dividends even though they need capital. Making matters worse, the government had yet to intervene in a meaningful way, expecting the problem to self-correct. In April, Nissan Life goes bankrupt; later Sanyo Securities defaults and two major banks suspend operations.
- 1998: The crisis peaks. The government finally steps in and authorizes "almost unlimited" public funds to shore up capital. An initial $17 billion bank bailout is made, but a credit crunch ensues anyway as banks try to preserve capital. Later that year, Long Term Credit Bank of Japan is nationalized.
Resolving the Crisis: Part One- In 1997 the government creates a stress test for banks. They must revalue their assets realistically and the valuations can be audited. Capital ratio thresholds are specified at which the government can reduce dividends or scale back operations. Part Two: By 1999, banks need significant significant capital injections. Japan's Deposit Insurance Corporation will grant these through the purchase of preferred shares or subordinated debt, and each bank must submit a restructuring plan. If unsatisfied with the progress made by a bank, the government could convert these obligations to common voting stock, to have control over management. During audits the government found that many banks were still valuing assets at unrealistic levels. The Resolution and Collection Corporation is formed to buy bad loans from banks.
The resolution process results in a wave of bank mergers (think WaMu-JPM and Wachovia-WFC), and eventually the bailout funds reach $399 billion of which nearly $200 billion has been recovered.
Post Crisis: Consumers must reduce consumption significantly, as there is less credit available. Unemployment increases and GDP growth slows. From "start to finish" the problems in the financial sector took over 13 years to play out.
The situation seems to have many similarities to what is underway in the US. To date, the domestic financial crisis is not as bad as Japan's and not yet as bad as the S&L Crisis of the late 80's. Between 1989 and 1991, it has been reported that 1,187 banks and S&L’s failed, consisting of more than $454 billion in assets. This was according to the Federal Deposit Insurance Corporation. So far in 2008, there have been 11 bank failures, while in 2009 there have been three more. These represent total assets of around $42 billion. but it is my opinion that the crisis is still in its early stages and the US government has acted more swiftly, taking a cue from Japan's crisis. But I think it will be years, perhaps well beyond 2010, until the US problems play out to their conclusion. And they will mean less consumption by consumers and a resetting of asset values, as the US learns to live within its means. Meanwhile the Nikkei has yet to return to its 1989 peak - it is currently 7,994.
