Thursday, August 27, 2009

Turning Japanese

Once upon a time there was a country that was the envy of all others. Its currency was strong, its stock market was buoyant, its real estate was unstoppable, its banks were the largest in the World, its companies were imitated and their management techniques studied in business schools throughout the globe.

Then, one day, without any warning, everything began to go wrong. Markets went down, people couldn’t pay the outrageous mortgages they had used to buy expensive real estate. The economy got progressively weaker while analysts and policymakers forecasted a near term bottom and recovery while making one policy mistake after another.

That was Japan in the late ‘80s and early ‘90s. Nobody seemed to worry about 100 year mortgages and other oddities and nobody seemed to question the model because the market kept going up. Once the correction began, policy makers exacerbated the problem by trying to help every last financial institution. Banks were not forced by regulators to recognize their losses and so the final day of reckoning was indefinitely postponed until markets recover. Except markets never recovered (the Nikkei is still almost 75% below its peak of 1989).
Analysts said the problem was eminently cultural. The Japanese value the community ahead of the individual and they prefer to endure a long deflationary period rather than embarrass their bankers and ultimately their country. Sadly, by avoiding the problem, they managed to do both. Eventually somebody had to recognize the consequences of the bad decisions that are inevitably made during long, prosperous booms.

Fortunately, this could never happen in The United States. Americans understand risk-taking. Nothing ventured, nothing gained. If you fail, get up, wash your face and try again. Markets are allowed to clear. If someone has to go bankrupt, so be it. It is not the end of the World and, eventually, under these dynamic conditions, everyone who looks for it gets a second chance. We take our losses and move on because that is good for the economy. We understand the system.

Or do we?

Most analysts and market historians think that prolonged bear markets only come from policy mistakes. Japan in the ‘90s and the World in the ‘30s are classic examples. Naturally, we try to avoid policy mistakes. Except the allure of waiting for the market to bail us out is just to hard to resist. According to several stories published since yesterday (here is one), the US Treasury and the Federal Reserve have decided that the best policy for our banks is to follow a Japanese strategy. In other words, let the banks mark their loans and toxic securities at whatever price they (the banks not the regulators) deem reasonable until the market recovers or until they earn their way out of the problem by borrowing from the government at zero percent whichever comes first.

Call me old-fashioned, but I think it is at least illogical to ask any society to subsidize the industry where the average compensation is the highest while neglecting other basic needs. In any case, since I have yet to hear of a town-hall heckler complaining about bank subsidies I suppose this topic is not a high priority for the American people. The problem with the strategy, however, is that it has very little chance of success.

Unless you think real estate prices will come back in a hurry, most of the losses Ms. Bair worries about have already occurred. In fact, much money has already been lost no matter what happens next. Thus, the choices are when and/or how fast are the losses going to be recognized. Mr. Geithner, like the Japanese, hopes that the banks will write them off as they earn money from current activities either by increasing reserves or selling assets at a loss. Except nobody forces them to do so. As you may know, the dirty secret of the financial system is that one gets away with whatever the regulator and the market allow. Since both are currently looking the other way the banks have chosen not to do anything for the time being. That way, their earnings looks good and, you guessed it, they can compensate their talent.

I suppose this state of affairs could last for a very long time (ref. Japanese model), or maybe this will all blow up soon (the Nikkei was spooked several times by this issue), or (less likely) the politicians will force the regulators to act, or (least likely) the regulators will blow-up their chances of landing a job in Wall Street and act on their own. In the meantime, the banks will continue to surprise everyone by posting good earnings while they sit on their toxic assets and postpone the day of reckoning. If that day ever comes (I was tempted to write "when" but I hate predictions) all mentioned above will excuse themselves by stating that "things were worse than expected." Bonuses securely in the their bank accounts, toxic waste the responsibility of the American taxpayer, and fairness avoided by virtue of the ignorance of the average voter.

Fortunately, both Geithner and Bernanke have studied the Japanese crisis so they have all the information they need.

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