Around the world in bail-out parallels, and why the US should look to SWFs

As the $700bn US financial system bailout plan moves closer to becoming a reality, there’s more theorising than ever on comparisons between the US situation and various other examples around the world (for one of the neatest yet broadest global, at-a-glance comparisons, see FT.com’s interactive graphic on bailouts) – particularly concerning Japan’s experience with its banks’ bad debt mountain in the 1990s and early 2000s.

Some analysts also throw in pointers from the Swedish banking crisis. Like today’s US financial crisis, it had its roots in the credit markets, which were deregulated in 1985, and in a finance and property bubble that eventually burst.

“The way Sweden acted – and in particular its adoption of the good bank/bad bank model – is highly relevant to the financial system bail-out now being implemented in the US”, noted the FT’s markets editor Christopher Brown-Humes last week, adding that in fact, “Hank and Ben learning Swedish” was how Lombard Street Research headlined a research note last Friday.

Sweden’s financial chickens came home to roost in the early 1990s after a huge pile-up of non-performing loans across the Swedish banking system, notes Brown-Humes:

Five of the country’s seven biggest banks required state support or huge injections of capital from their own shareholders. Two banks – Nordbanken and Göta Bank – were taken over by the state and eventually merged.

Crucial to maintaining confidence was the blanket guarantee for creditors – not shareholders – that Sweden put under the whole banking market in late 1992 and kept in place for nearly four years.

After taking over Nordbanken, the state dumped SKr67bn of NPLs into a “bad” bank called Securum, which, eventually found itself with an extraordinary portfolio of assets that had backed the NPLs – from the British Embassy building in Burma to a US ski lodge – as well as European property and Swedish industrial operations:

Securum was given a SKr24bn equity injection and 15 years to dispose of its assets. In fact, helped by a recovery in property and stock markets in the mid-1990s, it ended up being wound down after just five years. By that time it had recouped nearly SKr13bn.

More important, however, Sweden’s response to the crisis meant it cost the taxpayer very little, if anything – another reason why US policymakers have been keen to talk to some of the decision-makers who were directly involved in clearing up the Swedish mess.

One secret to Securum’s success, according to Brown-Humes was that it “took an activist approach to its investments to maximise value rather than just seeing itself as a liquidating company”.

But size does matter, in this respect, and when viewing the vast scale of the US problem, the Japanese experience yields more useful lessons for the US financial crises.

While parallels can also be misleading, as we’ve previously noted, here are some of the latest insights, historical and otherwise:

In a briefing note issued Monday, Goldman Sachs’ Tokyo-based economic research team notes that Japan disposed of nonperforming loans (NPLs) through three main strategies: (1) a plentiful supply of liquidity, (2) NPL purchases with public funds, and (3) public fund injections into banks.

A framework was adopted for using public funds to purchase NPLs that involved the creation of a Japanese version of the RTC. But this failed to restore confidence in the financial system, owing to deep-seated concerns in the market about bank capital shortages, notes Goldman.

Familiar?

Thus, Japanese monetary policy fell into a classic liquidity trap as corporate balance sheet restructuring pressures grew more severe due to declining asset prices. Fiscal stimulus meanwhile provided only temporary impetus to the economy:

There are many differences between what Japan experienced and current conditions in the US, where balance sheet restructuring pressures are concentrated in the household sector while nonfinancials’ balance sheets remain sound. NPL disposal may necessarily have to take a different form in the US, where direct or market-based indirect financing is predominant, than it did in Japan, where indirect financing via banks was predominant.

That said, Japan’s experience suggests that a unified approach to NPL disposal combining expansionary economic policies and public fund injections into banks is required, and that the more quickly NPLs are disposed of, the smaller the ultimate fiscal cost of NPL disposal may be. Even in Japan, which was not quick to dispose of NPLs, the taxpayer burden was less than 15% of available public fund outlays.

Meanwhile, Tokyo-based hedgie Peter Tasker reminds us in a recent discussion paper that in 1990, Japanese banks had the highest credit ratings of any in the world, Japanese policy-makers were lauded for their brilliance, and perceptive observers were claiming that the Japanese model of economic organisation was the wave of the future.

As it turned out, the imminent “Japanese century” was abruptly cancelled, and even now Japan has yet to make a full recovery from its post-bubble trauma. Japan’s Topix index is no higher than it was 22 years ago, and real GDP per head has fallen from No. 2 in 1989 to No. 20 in world rankings.

Total write-offs by Japanese banks amounted to 20 per cent of national GDP. The banks themselves were thinned out by several failures and succcessive waves of consolidation, in which stronger banks were encouraged to take over weaker banks.

Ultimately, not a single major bank remained sound, and all had to accept capital injections of public money. In addition half a dozen life insurance companies went out of business; of the big four securities houses, one went bust, two lost their independence and swathes of smaller fry disappeared forever.

As big as the problems in the US financial system are right now, “few expect a financial gottedammerung of this scale and duration,” notes Tasker. But then again, few in early 1990s Japan did, either. So…

Precaution 1: Complacency, popularism, and adherence to rigid principles are very dangerous. In 1992 then prime minister Kiichi Miyazawa first mooted the possibility of injecting public money into the banks. At the time bankers were highly unpopular, and his colleagues slammed the idea as a vote-loser. Bailing out the banks remained off the menu until a full-scale panic broke four years later. In the meantime, politicians, managements, regulators, and auditors conspired to hid the ugly truth until their credibility was entirely shot.

Precaution 2: It is vital to break the negative feedback loop of asset deflation- bad debts – deleveraging – economic debility – asset deflation – bad debts – and so on. Since wealth destruction is always deflationary, monetary policy has to stay super-easy for a very long time. Cash must not be allowed to become king. Inflation-fighting is not an issue until financial health is restored. Likewise, fiscal policy has to be expansionary to offset the increase in savings elsewere in the economy. Diving bond yields signal that public deficts are the last thing you need to worry about.

Precaution 3: Forget about moral hazard. In such an all-encompassing, once-in-generation crisis, the public sector must take credit risk off the shoulders of the private sector, or else the entire financial system fails. Attempts to protect the interests of taxpayers are potentially dangerous since a “good price” for the tax-payer means less of a capital boost to the system. Likewise, penalising bank managements is counter-productive. The interests of the decision-makers and the financial system itself must be aligned. In the late 1990s, Japan came up with a series of bad debt purchasing vehicles, none of which proved effective because of mismatched incentives. The final downwave of the banking crsis, when the government signalled unambiguously that it would bail out any major bank, took place in 2003.

Precaution 4: Remember, bigger is not necessarily better. The Japanese experience suggest that shotgun weddings without any financial support from the public sector sets the stage for bigger trouble in the future.

Precaution 5: Failures should be avoided at all costs. Refusing to backstop an acquisition of Lehman Brothers as a going concern was a very big mistake, and took the whole system to the brink in a matter of days. A longer-term issue is the loss of predictability and transparency in the policy-making process, compounded by the banning of short-selling, exactly the kind of ill thought-out and paranoic response which Americans derided in the Asian crisis of 1997-98.

Precaution 6: Strong hands (investors capable of taking risk) are rare and should be treated with respect. In 1990s Japan, the strong hands were private equity firms, foreign insurers and banks. Japan, for the first time ever allowed outsiders into key areas of the financial system. The equivalent now is sovereign wealth funds. It is absurd to be producing codes of conduct for SWFs when their capital is so valuable. After the shenanigans of recent weeks, what sensible investor would be willing to take a meaningful stake in a Wall Street firm without a say in the company’s future direction?