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Is the U.S. Following in Japan’s Footsteps?by Tetsuo Mizunuma
English edited by Sam Alter
IS HISTORY REPEATING ITSELF?
When U.S. land prices started falling in summer 2006, most Americans remained optimistic and thought this would only impact the housing industry. However, as buzz words like subprime lending and securities fraud appeared in the media, Americans began realizing how grave the condition of the economy really was. As the recession deepened, researchers recalled Japan’s bitter “lost decade” of the 1990s and discovered striking similarities. Takafumi Sato, commissioner of the Financial Services Agency of Japan, summarized the similarities at a global symposium held in Tokyo last October, saying that irresponsible lending was widespread previous to both crises. He noted that everyone assumed that real estate prices would continue rising, but, in both cases, the financial market turmoil was triggered by declining real estate prices, and this market turmoil spilled over to the real economy. In both countries, Sato said, this resulted in a system-wide financial crisis, which necessitated public intervention by governments and central banks.
Breaking down the timeline of Japan’s crisis may help the U.S. understand its own crisis — what has happened thus far and what may be expected for the future.
PHASE 1 (1991-1994): INCUBATION
With the exception of 1974, post-war Japan historically saw continually increasing land prices. It was this phenomenon which led many to believe in the myth of an ever-higher land price. Indeed, in the late 1980s, land prices increased sharply due to loose monetary policy, deregulation and speculative investment. But the myth was not true; land prices peaked in fall 1990. As the euphoria ended and reality set in, banks found many questionable loans on their balance sheets. However, although the property bubble did burst, the economy still showed decent GDP growth. Most thought the recession was merely cyclical, that land prices would jump back up in a few years and that the problem would simply go away.
Change the years in the above paragraph, and the story has eerie similarities to that of the U.S. After World War II, U.S. land prices steadily rose, excepting some temporary recession periods. Around 2002, prices increased rapidly, then peaked in summer 2006. The U.S. recession, which had a much shorter incubation period than Japan’s, officially started in December 2007.
Source: Economic Survey of Japan
PHASE 2 (LATE 1994-1996): SYMPTOMS BEGIN TO APPEAR
Even in the mid-1990s, there were signs of rough times ahead for Japan. Several local banks and mortgage financing companies began going bankrupt. In April 1992, the Toho Mutual Bank failed, and by the end of 1996, three local banks and 12 credit unions bankrupted as well. In July 1996, Japan's government dedicated 685 billion ($6.3 billion) of taxpayer money to liquidate six major mortgage underwriters. After parliamentary hearings revealed the irresponsible lending practices at these banks, the government's decision created strong dissent among Japanese citizens. Out of the total 12.9 trillion ($118.6 billion) in mortgage loans, a full 6.4 trillion ($58.8 billion), or 49.6 percent, was unrecoverable. The Japanese people recognized the magnitude of negligent lending and feared a crisis.
In the U.S., this phase corresponds to 2007 and early 2008. Following a steep increase in subprime defaults, mortgage lenders started failing. Most prominently, the second biggest subprime lender, New Century Financial Corporation, filed for Chapter 11 in April 2007. More than 100 subprime lenders failed, and the Federal Deposit Insurance Corporation reported three community bank failures in 2007. However, the effect on the economy was peripheral, and the financial system still appeared buoyant.
PHASE 3 (1997-1999): CRISIS AND GOVERNMENT BACKLASH
When Japan’s fated financial downfall arrived, it was sudden. On November 3, 1997, Japan’s seventh-largest securities company, Sanyo Securities, declared bankruptcy and defaulted. As the first default in the Japanese inter-bank loan market in post-war Japan, it created domestic and international chaos. Just two weeks later, Hokkaido Takushoku Bank, a major nationwide bank, could no longer borrow money and also was forced to declare bankruptcy. This bank failure set yet another precedent in post-war Japan.
Another week passed, and the fourth-largest securities company, Yamaichi Securities, filed for bankruptcy due to its huge amount of illegal off-balance sheet liabilities. The Japanese financial system was left paralyzed and lost investors’ trust. This period was also famous for overseas investment fund managers called “hagetaka,” meaning vultures, eying Japan in their voracious hunt for the next cheap buyout. In Japan, this month in 1997 later became known as “Black November.”
In late 1997, Japan’s government decided to step in and used taxpayer money to prop up its seriously damaged financial system. It passed the Financial Function Stabilization Act in February 1998, allocating a total of 30 trillion ($231.7 billion) toward the purchase of subordinated loans or preferred stock of troubled banks. However, only 1.8 trillion ($13.9 billion), or 6 percent, was successfully injected into 21 major banks. The banks hesitated to receive the rest because they resisted depending on the government and feared the negative publicity that would inevitably follow.
In October 1998, the Japanese government got bolder and enacted two laws: the Financial Revitalization Act and the Prompt Recapitalization Act. Under this new scheme, the government quickly declared the Long-Term Credit Bank of Japan insolvent and nationalized it the same month. In December, Nippon Credit Bank was nationalized as well. Each bank had a long and glorious history, and consequently their combined downfall sent more shockwaves through Japan.
Finally, in May 1999, the tide of failures started to change. The government made a second injection of 7.5 trillion ($65.5 billion) into 15 major banks, ending the crisis situation. The Japanese government had successfully removed the largely insolvent “zombie” banks from the market, while giving capital support to healthier banks with some hope of recovery.
The U.S. had its first real challenge in March 2008, when the nation’s seventh-largest investment bank, Bear Stearns, found itself nearing bankruptcy. The Federal Reserve Bank (FRB) of New York provided an emergency loan to Bear Stearns to avert its sudden collapse, and J.P. Morgan ended up buying the firm at a fire-sale price. Had the U.S. economy staved off the crash at the last instant, or had it just seen the tip of an iceberg of underwater debt?
By the end of September, the gravity of the problem was clear. On September 8, the Treasury Department announced that it would take over the government-sponsored mortgage behemoths Fannie Mae and Freddie Mac. One week later, the fourth-largest investment bank, Lehman Brothers, filed for Chapter 11 protection. The following day, AIG accepted the FRB’s rescue package of $85 billion to secure credit for default swap trading. Finally on September 22, Goldman Sachs and Morgan Stanley announced they would transform into bank holding companies, meaning that the once-mighty U.S. investment banks had all but vanished for the first time since the Glass-Steagall Act of 1933.
The U.S. government sought an emergency plan as a quick fix. The bailout plan under the name of the Emergency Economic Stabilization Act was approved on October 3. $250 billion of public money was injected into nine major banks under the act’s Troubled Asset Relief Program (TARP) on October 14. Subsequently, the government provided large sums of money to banks, insurance companies, auto financing companies and auto companies.
Although the U.S. government reacted more quickly than Japan’s in their respective crises, the U.S. response was viewed as selective and disorganized. Initially, TARP’s $700 billion budget was aimed at buying toxic assets from banks, but instead, capital was injected into troubled and undercapitalized banks. Soon after, TARP’s target was expanded to cover non-banking industries.
PHASE 4 (LATE 2001-2003): LONG-TERM REMEDY AND GRADUAL RECOVERY
After successfully solving its crisis, Japan finally looked like it had recovered. In October 2002, the Financial Revitalization Program called the Takenaka Plan instituted a toughened audit system for banks, forcing them to write off bad loans and raise sufficient capital to realize the loss on these non-performing loans. It also created the government-supported Industrial Revitalization Corporation of Japan (IRCJ) fund. Over time, IRCJ purchased and financed 41 projects for a total of 4 trillion ($45.8 billion) in book-value loans, resulting in a 43 billion ($492.2 million) profit. The policy was very successful at reducing bad loans and restoring confidence in Japan’s financial system.
WHAT DOES THIS MEAN FOR THE U.S.?
In conclusion, the U.S. seems to be experiencing Phase 3, “Crisis and Backlash,” because the financial system remains unstable and investors still lack confidence. In February 2009, the U.S. government nationalized a substantial portion of Citigroup, owning a 36 percent share as of this writing. This is merely the first step to restoring investor confidence. When the U.S. does move into Phase 4, it will still face a tough reality. According to the latest estimations by the International Monetary Fund, potential deterioration of U.S.-originated credit assets is $2.2 trillion, or 20.5 percent of its GDP.
The U.S. economy and political system have shown their cleverness and resilience before. We in Japan hope the U.S. will learn from our troubles and demonstrate its strength in this challenge as well.
Tetsuo Mizunuma (’09) is a Rady School MBA student on a full scholarship from the Japanese government. He is an official at Japan’s Ministry of Finance working in trade policy and tax inspection. Mizunuma served as a guest lecturer at Gakushuin University from 2003-2005 and in 2008 won the Excellent Research Award from the Global Business Research Institute, a leading think tank in Japan.