Turning Japanese and understanding the consequence of policy half-measures

This is another post I originally ran on Naked Capitalism last month. As you know, I have turned more positive about the potential for a cyclical economic recovery. However, I am unchanged regarding much of the sentiment expressed in this post – that any upturn must be considered with suspicion because the underlying fundamentals of the U.S. and global economies remain poor (See my post on macro disequilibria to see why).

My personal view at this time is that we will get a rebound of uneven quality, the prospect of which will be supportive of financial markets. However, it is far from clear how robust this upturn could be or how long it could last. I see an L- or W-shaped outcome as likely (i.e. prolonged weakness or a double dip recession).

I am not convinced we are in a new secular bull market either. More likely, we have seen a strong bear market rally (but, like the ones experienced in Japan and the U.S. post-2002, it can go on for much longer than anyone could predict). Remember, secular bull markets arise from a confluence of P/E ratios going from low to high, high secular earnings growth potential, and high secular GDP growth potential. We have not reached a low that is comparable to previous lows in 1942 or 1982 in this regard.

Now, here is the original post with some edits.

As I see it, the Geithner Plan is inadequate because it assumes illiquidity where insolvency is the problem. The long and short of it, from my perspective, is that this plan will not get at the heart of the issue, leverage, debt and unsustainable levels of credit growth. (Dan Roberts of the Guardian has an interesting take on this, suggesting the US is following the UK lead here).

Nevertheless, I want to suggest that the liquidity thrown at the U.S. economy by this and other stimulus plans is so great that it may induce a cyclical upturn. Heresy? Hardly, as I mentioned in my previous post, this is what essentially transpired in Japan in the 1990s. So, let’s look at Japan for a second.

Last July, I wrote a post, "Japan circa 1996 – forgotten already?" to remind readers of what took place in Japan in the 1990s. The Yamaichi Securities episode of 1996, as told by the International Herald Tribune, was the event I highlighted:

In a reminder of the scale of the bad debts still weighing on Japan’s financial system, Yamaichi Securities Co. on Wednesday became the second of the “Big Four” Japanese brokerage houses this week to unveil a billion-dollar bailout for a subsidiary struggling with irrecoverable real-estate loans.

Ryuji Shirai, vice president of Yamaichi, said the brokerage would spend 150 billion yen ($1.31 billion) to help its nonbank subsidiary, Yamaichi Finance. The bailout forced Yamaichi to revise its earnings forecast for the year to March 1997 to a consolidated net loss of 108 billion yen from a previously predicted net profit of 18 billion yen.

Yamaichi’s move followed an announcement by rival Nikko Securities Co. on Tuesday that it would spend 147.5 billion yen to help three affiliated units write off their bad debts. Nikko also cut its earnings forecast for the year, from a net profit of 24 billion yen to a net loss of 95 billion yen.

Yamaichi and Nikko’s bailouts and forecasts for big losses followed similar moves earlier this year by Japan’s two other major brokerages and came as little surprise.

But they again illustrated the difficulties that even Japan’s biggest financial institutions are having dealing with an estimated $400 billion in mainly unrecoverable real estate loans and underlined that it would take years for Japan’s financial system to recover from its real-estate lending binge in the late 1980s.

Over the past couple of months, Nomura Securities Co. has announced a 371 billion-yen bailout for a troubled financial unit while Daiwa Securities Co. has spent 120 billion yen. Nomura now expects to post an annual loss of 332 billion yen, while Daiwa said its loss would depend on the sale of securities.

The bailout of Yamaichi Finance was designed to maintain Yamaichi’s reputation and to “reinforce its competitiveness through early write-offs of the affiliate’s bad property-related loans,” the company said.

The daily Nihon Keizai Shimbun said Yamaichi Finance, which mainly lends to real estate firms, plans to write off all its bad loans in three years. Yamaichi Finance, which has 140 billion yen of bad loans and assets of 360 billion yen, will receive 100 billion yen from Yamaichi Securities and borrow 50 billion yen at low interest rates, the newspaper said.

Following Yamaichi’s announcement, the ratings agency Moody’s Investors Service Inc. said it was upholding its Baa-3 rating on Yamaichi’s senior debt and its Prime-3 rating on short-term debt, affecting $2.2 billion in debt securities.

“Although the full amount of the cash support will be recognized as an extraordinary loss, the actual impact on Yamaichi Securities will be reduced by the anticipated gain on the sale of securities and other assets and by profits arising from normal operations throughout the year,” Moody’s said.

Moody’s said its ratings had already “incorporated the expectations of substantial losses related to its affiliate” and noted that the size of the bailout was “within the anticipated range.”

“The firm’s capital adequacy, though weakened by its real-estate exposures, remains adequate, given the company’s liquid balance sheet and extensive domestic franchise,” the agency said.

On Tuesday, Nikko said it would give 82.1 billion yen to its affiliate Kyodo Mortgage Acceptance, 47.7 billion yen to Nikko Credit Services and 17.7 billion yen to Nikko Real Estate. Although Nikko plans to provide the money to the three nonbank affiliates during the 1997 financial year, the company said it would report a one-time loss of 147.5 billion yen for its financial year in 1996.

If you recall, Yamaichi was not the only Japanese brokerage to lose its independence. Three of the big four Japanese brokerages, Yamaichi, Nikko, and Daiwa were merged out of independence as the lost decade continued. Only Nomura remains independent from the halcyon days of the 1980s Bubble Economy. Certainly, this might be a bad omen for Morgan Stanley and Goldman Sachs, but more importantly, it should remind us of a couple of things:

  1. Even if economic and monetary policy have poor longer-term consequences, it does not mean that policy won’t gain traction in the short-term. I see the potential for a cyclical upturn due to the massive stimulus campaign (See Paul Kasriel’s take at the linked pdf). Ask Alan Greenspan regarding his 2001-2003 easy money campaign. This is what happened in Japan before Yamaiichi’s demise in 1996 – and again before Daiwa and Nikko were merged out of independence.
  2. Even if economic and monetary policy have stimulative short-term consequences, it does not mean that the structural problems have disappeared. They are merely lurking underneath, waiting for the next downturn to re-assert themselves. Again, the Japanese scenario is a cautionary tale on this score.
  3. Asset prices will respond to an upturn, but that does not mean we are about to embark on a new bull market. Japan is the right precedent here again. After the upturn inthe mid-1990s, property prices continued to collapse in Japan, sucking many more individuals into the deflationary spiral.

I do hope we can avoid the worst-case scenario here. However, I am concerned that the Obama Administration and the Federal Reserve are literally papering over the problem with half-measures. America is turning Japanese.

Whether they recognize this fact or understand the consequences their actions is unknown.

Brief Footnotes

Daiwa never did go bust and Nikko actually was merged into Salomon Smith Barney to prevent its demise. Parts of it are now on the auction block again. Therefore, Yamaichi was really the only one of Japan’s Big 4 to die. Cassandra of "Cassandra Does Tokyo" informed me as follows:

"Neither Daiwa, or Nikko went bankrupt to the best of my recollection – and I traded continuously large diversified books of stocks from 1991 to 2008, and was deeply anal about data integrity, survivorship bias and the likes, and deeply concerned with tail risk so I reckon I would have known had one of these listings drilled a hole in a long portfolio or scored-me a ten-bagger on a short torpedo. I certainly remember Yamaichi’s flame-out since specs (and Tiger Mgmt) started massively shorting each and every Yamaichi security holding on the suspicion and the news – both real and imagined, and this DID hurt and was VERY painful (at least until the end of the fiscal year.

Yamaichi was Fuji’s big-4 brokerage affiliate – both members of the Fuyo keiretsu, (including Fuji Bank, Yasuda Trust, Yasuda F&M, Taisei, Sapporo Brew, Canon, Nissan, Tokyo Tatemono, Marubeni amongst others too numerous to mention). Fuyo was closest to Sumitomo of the competitive keiretsus, and these groups had overlap. Fuji was the JP Morgan of Japan, but was weakened the most of the major banks thanks to real estate.

Daiwa was the Sumitomo-group big-4 broker, so it was natural that Sumitomo would agglomerate it’s second-tier affiliated brokers and then affix them to its own securities sub and JV with Daiwa in a resignation that they just couldn’t compete. Nikko, as well, didn’t go bankrupt, eventually choosing a foreign partner in 1999 or so that merged Salomon/Citi ops giving the Americans a large stake, and an exit from marginal business, and giving the Japanese access (so they thought) to US distribution clients and expertise to compete with Nomura. Of course it never happened, but that is just culture plain and simple. Americans took advantage of market punishment to acquire all of it (I think in 2007), though they are probably regretting it.

Even Daiwa Bank (now Resona) was never bankrupt. Rising like a Phoenix from many recaps."

Nikko was essentially ‘rescued’ by Citi and merged into Salomon Smith Barney. As I recall, everyone outside of Japan (in New York and London) was fired on the deal as several friends lost their jobs. The news story is below:

Salomon Smith Barney, the securities arm of Citigroup Inc., and Japan’s No. 3 brokerage firm, Nikko Securities, said yesterday that their investment banking venture would open on Monday after a month’s delay because of procedural problems. The venture, Nikko Salomon Smith Barney Ltd., will be capitalized at 106 billion yen, or $883 million, and will have a staff of about 1,100. Separately, Standard & Poor’s lowered Nikko Securities’ counterparty rating yesterday to ”BBB-,” one notch above ”junk” status. A counterparty rating reflects a company’s ability to honor its senior obligations for swaps, forwards, options and other financial contracts.

Daiwa did merge investment banking with Sumitomo but the securities group was never merged out of trouble.

Japanese securities firms have struggled ever since the bubble economy burst nearly a decade ago. Now, deregulation has made things worse, opening the firms to intense competition from foreign concerns with expertise in products and services they know little about.

Outsiders have already made big gains in Tokyo Stock Exchange trading and pension-fund management. Merrill Lynch has taken over Yamaichi Securities, and Salomon Smith Barney is in a joint venture with Nikko Securities.

Only Nomura Securities, the brawny leader of Japan’s securities firms, has a chance to survive as an independent, many analysts suggest.

So in July, when Daiwa, Japan’s No. 2 brokerage firm, announced an alliance with Sumitomo Bank, it was greeted with something verging on disappointment.

Sumitomo, Japan’s No. 2 bank after the Bank of Tokyo-Mitsubishi, is the core of the keiretsu, or business group, that includes Daiwa, and the alliance was largely seen as just another case of circling the wagons.

Moody’s Investors Service, which had already put four Daiwa subsidiaries on notice for a possible downgrade, said the announcement did little to dispel its concerns.

NY Times, 1998


Brokerage Is Last of Japan’s ‘Big 4’ to Recast Debt : Yamaichi Bites the Bailout Bullet – IHT

US follows UK – on the wrong road – Guardian

Related article

Geithner plan ‘short-sighted’ – The Age

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