apans salutary tale in banking crises

By Gillian Tett

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 dj 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. Japans banking crisis in the 1990s might prove an important lesson for Americas subprime woes, Mr Nakamae concludes.
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The parallel might have seemed almost unthinkable just a few months ago. After all, Japans 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 Americas 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 Americas 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 socalled 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 thatsubprime 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 worlds 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 Japans 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 allimportant 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 $400bnworth 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 dont 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. Theres 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 Lehmans 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.