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BAILOUTS PRESENTATION WEEK 8 THE SUCCESS AND FAILURE OF THE JAPANESE BANK BAILOUT Mark Bass, Reid Bolton, Robert Dunn & Hadi Nilforoshan February 26, 2009 Agenda The Asset Bubble The Crisis The Government Response Lessons Learned 1 Bailouts Seminar Week 8 JAPAN’S ECONOMY BOOMED IN THE 1980’s 2 Bailouts Seminar Week 8 HOWEVER THE UNITED STATES PRESSURED JAPAN INTO MODIFYING ITS EXCHANGE RATE Plaza Accord signed between US, Japan, Germany, France and UK 3 Bailouts Seminar Week 8 THE BANK OF JAPAN STARTED CUTTING INTEREST RATES IN PART TO SPUR DOMESTIC DEMAND AND IN PART TO BALANCE INTERNATIONAL EXCHANGE RATES “The Bank of Japan hopes that this action will contribute to achieving domestic demand growth promoted by lower interest rates, and help correct Japan’s external imbalance. The Bank will continue to carefully watch the development of foreign exchange markets in future monetary policy management.” BOJ Official Statement 1986 4 Bailouts Seminar Week 8 JAPAN’S MONEY SUPPLY MORE THAN DOUBLED FROM 1980 TO 1990. 5 Bailouts Seminar Week 8 BANKS SEEKING HIGHER RETURNS BEGAN LENDING MORE MONEY FOR REAL ESTATE PURCHASES AND IMPROVEMENTS Increases in real estate loans also mirrored the increasing desperation of banks close to insolvency 6 Bailouts Seminar Week 8 REAL ESTATE BUBBLE GROWS SLOWLY FROM 1980 TO 1986 AND THEN EXPLODES BETWEEN 1987 AND 1990 Land Prices in Japan (1974-2007) Percent (Indexed to 1974) 7 Bailouts Seminar Week 8 THE LOOSE MONETARY POLICY AND BOOMING REAL ESTATE VALUES FUELED A MASSIVE INCREASE IN JAPANESE EQUITIES. NIKKEI 225 1970-2009 Peak in 1989: Land constituted 50% of corporate tangible assets 8 Bailouts Seminar Week GOVERNMENT POLICIES AND AGGRESSIVE BANK BEHAVIOR COMBINED TO PRODUCE THE ASSET BUBBLE Deregulation led banks to pursue riskier strategies. The government deregulated interest on deposits, decreasing bank revenues. Banks began making riskier loans to small companies backed by property, as well as other speculative realestate based loans. Also, as the government allowed companies greater access to securities markets, banks sought to compete by making risky real estate loans. BOJ pursued loose monetary policy for too long and fueled the asset bubble Loose monetary policy made funding for speculative real estate projects more available. Even as late as 1987, when the asset bubble was starting to emerge, the Bank of Japan lowered interest rates to 2.5 percent. The BOJ was using monetary policy to try and reduce the current account surplus, spur domestic demand, and stabilize the foreign exchange rate. By pursuing so many goals, the BOJ failed to act decisively to the real estate and equity bubble at home. Tax Policies Suppressed the Supply of Land and thus Drove up Prices. Tax rates were low for those holding land, but relatively high for land transactions. When land prices are expected to rise, those holding land tend to take advantage of the low tax rates and hold onto land. The high tax rate on sales further squeezed the supply by incentivizing land holders to delay their sales. These two factors combined to keep supply low and thus boosted prices higher. Bailouts Seminar Week 8 THE EFFECTIVE MARGINAL TAX RATE ON CORPORATE LAND FURTHER ENCOURAGED INVESTMENTS IN REAL ESTATE. Effective Marginal Tax Rate on Land Holdings 10 Bailouts Seminar Week 8 THE GREATEST ASSET BUBBLE IN THE HISTORY OF THE PLANET. . . A commonly quoted claim in 1989 was that the land under the Imperial Palace in Tokyo was worth more than all of California. Value of prime property in Tokyo’s Ginza district in 1989 reached $139,000 per sq foot. Land Value as Proportion of GDP at Height of Asset Bubble ~1990 ~1999 11 Bailouts Seminar Week 8 . . . CREATED BULLISH EXPECTATIONS AND SOME HUBRIS Rockefeller Plaza—$1.9 Billion, Abandoned in 1995 Japan Pebble Beach—Purchased for $841 Million, Sold for $820 Million in 1999 Everyone Else 12 Bailouts Seminar Week 8 . . . AND THE SPECTRE OF JAPANESE ECONOMIC HEGEMONY! On the forty-fifth floor of the Nakamoto Tower in downtown L.A.—the new American headquarters of the immense Japanese conglomerate—a grand opening celebration is in full swing On the forty-sixth floor, in an empty conference room, the dead body of a beautiful woman is discovered. The investigation begins…and immediately becomes a headlong chase through a twisting maze of industrial intrigue…a no holds barred conflict in which control of a vital American technology is the fiercely coveted prize—and the Japanese saying “business is war” takes on a terrifying reality Rising Sun was written in 1992, at the very end of the Japanese boom 13 Agenda The Asset Bubble The Crisis The Government Response Lessons Learned 14 Bailouts Seminar Week 8 JAPAN’S CENTRAL BANK MIGHT HAVE TRIGGERED THE CRISIS Bank of Japan Overnight Call Rate “Popping” of Asset Bubble” Six years of slow descent instead of rapid easing 15 Bailouts Seminar Week 8 JAPAN’S ASSET BUBBLE BURSTS Asset Price Deflation 1989-2000 Percent 16 Bailouts Seminar Week 8 THE CRASH WAS QUICK YET LONG LASTING CHART OF NIKKEI (JAPANESE STOCK MARKET) 1989- 2001 80% Drop in Nikkei over ten years 1989 1990 1992 1994 1996 1998 2000 17 Bailouts Seminar Week 8 AND LED TO A DECADE OF LOWERED GDP GROWTH GDP per capita annual growth rate Percent 18 Bailouts Seminar Week 8 NUMEROUS ECONOMIC INDICATORS SIGNALLED A DECLINE IN THE JAPANESE ECONOMY . . . Percent Growth in Residential Land Prices Six Years of deflation in Japan’s real estate 19 Bailouts Seminar Week 8 . . . BUT THE BANKS WERE THE HARDEST HIT 20 Bailouts Seminar Week 8 . . . BUT THE BANKS WERE THE HARDEST HIT Drop in Real Estate Values Hammered Bank Balance Sheets Japanese Banks had large proportion of their portfolio of loans in real estate Real estate asset values declined significantly which led to a drastic decline in bank asset values and the downgrading of banks by international credit rating agencies. Banks had large number of Non-Performing Loans (NPLs) within their portfolios Unique Keiretsu System Decreased Bank Willingness to Foreclose on Loans • System of “Lead Banks” and cross-shareholding between companies and banks made foreclosure on any loan catastrophic to both the bank and multiple companies connected to the bank • Foreclosure also signaled that the bank had failed its responsibility of effective oversight which could potentially lead to a run by bank investors • Therefore banks were willing to “roll-over” the loans continually and unlikely to cut off the companies from credit. Poor Oversight by Regulators and Internal Auditors Also Made Japanese Banks Particularly Vulnerable to Downturn • Lax accounting rules led to under-reporting of NPLs by banks • Approximately 40% of bad loans were made to mafia due to infiltration by mafia in MoF and bank officials • Foreign banks were not hurt by downturn nearly as much as Japanese banks 21 Bailouts Seminar Week 8 THE RISE OF THE “ZOMBIES” Regulators Banks Firms • Regulators explicitly and implicitly pressured banks to extend loans to avoid bankruptcy • Want to avoid job losses and decreases in loans to businesses • Banks continue to extend credit to insolvent debtors despite low probability of being repaid • “with a few exceptions, most Japanese banks still continue to extend new loans to debt-burdened companies, often in exchange for only modest restructuring plans.” • Firms with negative profitability continue to operate as “zombie firms” • Promote deflation and hurt innovation across economy 22 Bailouts Seminar Week 8 COMMENTATORS RECOGNIZED THE NEED FOR A BANK BAILOUT IMMEDIATELY A consensus developed for saving the banks Exposing the bad loans and nationalizing some banks “was a turning point in the crisis. After that, markets finally trusted banks again. Mr. Gomi (Japanese Financial Services Agency) It is critical to promptly restore orderly functioning of the financial system as the lifeblood of the economy. Finance Minister Hikaru Matsunaga Quick and decisive actions are needed to restore confidence. - Treasury Secretary Rubin Although the Electorate was More Concerned About Budgetary Discipline Japan was slow to move on bank bailouts because of public outrage over the bailouts. Japanese voters punished politicians at the polls who supported bailouts, particularly when the early bailouts didn’t stop the bleeding. 23 Agenda The Asset Bubble The Crisis The Government Response Lessons Learned 24 Bailouts Seminar Week 8 GOVERNMENT RESPONSE CAN BE GROUPED INTO THREE PHASES Phase 1: Stabilizing the Economy 1989-1993 • Dramatic Easing of Monetary Policy • Recognition of Problem without Taking Significant Actions Phase 2: Attempts at Recovery 1993-1999 • Large Public Works Campaign • Focus on Increase in Consumption • $514 Billion Bailout for Banks • Lack of Fundamental Change Led to the “Lost Decade” Phase 3: Jumpstarting the economy 2000 and onwards • Massive bailout of banks •New disclosure requirements for banks •“No bank too big to fail” 25 Bailouts Seminar Week 8 MAJOR STEPS IN NATIONAL RECOVERY PLAN Major Steps 1990-1992 1993 • BOJ decreased discount rates • Discount Rate is kept low, • Banks write off 4.3 Trillion Yen in nonperforming • Bank of Japan creates a bridge bank with • 1995 1996 • Nikkei continues to fall-- loses 60% of its value, house prices fall 50%. 14,569 firms with debt equal to +10 Million Yen go bankrupt. assets. Government doesn’t take much action. 1994 Resulting Health of Economy government support which supervises the takeover of two failing credit cooperatives. Income Tax Cut • BOJ provides liquidity and loans to several failing banks through Hougachou system, whereby private institutions support banks. • Economy continues to struggle, as GDP growth rate is nears zero. Reserves for loan losses of commercial banks grew by 35%. • Tokyo Kyowa and Anzen Credit Cooperative fail, and must be bailed out to prevent runs on other Japanese Depository Institutions • A series of bank failures sweep the country, as private institutions start second guess participation in funding pricey bank bailouts. • Deposit Insurance Law amended to remove the • Gov’t bailouts unable to stop additional bank payoff cost limit, which capped amount gov’t could use to support failing banks. failures, as appreciating Yen further hurts economy. Bailouts Seminar Week 8 MAJOR STEPS IN NATIONAL RECOVERY PLAN Major Steps 1997 • BOJ props up NCB and other banks but does not • 1998 • Legislation introduces $30 Trillion Yen in public • 1999-2000 funds to fix crisis. 13 Tril. for capital injections and 17 Tril. to cover losses of financial institutions 40 Trillion Yen Fiscal Stimulus Package passed • New legislation (FFESL and FRL) greatly • • 2001+ bailout Securities Houses. BOJ later forced provide liquidity for interbank market, replacing SH’s Consumption tax raised to 5% increases government ability to supervise struggling financial institutions, and allows nationalization of banks. Capital injection funding doubled, signaling government commitment to resolving crisis. 29 Trillion Fiscal Stimulus Package • Safety net of full-scale protection of depositors and creditors altered. • Alteration are a system risk exception, • Decrease in the BOJ’s role • Takenaka Plan Adopted Resulting Health of Economy • Collapse of Securities Houses furthers crisis. Security house collapse dry up interbank liquidity, as that was the function of SH’s. • Markets initially stabilize from cap. injection, but drop again as amount is too small. LTCB, Japan’s largest bank fails, and is nationalized • Increase in funding for capital injections, and much broader supervisory role slowly helped soothe economy. Nationalization of struggling banks removes need for private support, and allowed gov’t to restructure failing banks and transfer their bad loans. • Nikkei slowly rebounds from 2003 onwards. Japanese banks stabalize. 27 DBI-SDA006-20070110- Third EC council 1 PHASE 1: THE GOVERNMENT TOOK ONLY A FEW IMMEDIATE ACTIONS THAT DID NOT APPEAR TO IMPROVE THE SITUATION What they did The Impact •Increase in Discount Rate •Economic Boom Turn into Bust •Nikkei Begins its Descent •Reduction in Credit Available for Property Purchases •Housing Prices Fairly Steady •Inability to Stop Future Economic Troubles 28 Bailouts Seminar Week 8 DROP IN INTEREST RATE DID NOT SPUR CONSUMPTION Automobile Purchases 1980-2000 29 DBI-SDA006-20070110- Third EC council 2 PHASE 2: THE GOVERNMENT’S LACK OF AMBITIOUS REFORM LED TO A “LOST DECADE” FOR THE JAPANESE ECONOMY What They Did The Impact •100 trillion Yen in Fiscal •Early On: Drop in Interest Stimulus Programs oPublic Works oDirect Checks •Interest Rate + Devaluing •$514 Billion Bailout Fund Rate Doesn’t Change Consumption Yen Can’t Reverse Damage Created for Banks •Interest Rates Lowered to Zero •Direct Government Lending through FILP Program •FILP and Credit to Businesses Somewhat ` Effective oDebt = 200% of GDP oBanks Able to Lend oPork barrel Politics •Purchasing Commercial Paper •20 Trillion Yen Credit Guarantee for Businesses •“Zombie Banks” Cannot Undo Damage oStemming the Tide oTax cuts helped but then reversed 30 PHASE 3: TAKENAKA CRACKS SOME SKULLS "Big banks have their merits…They enjoy economies of scale. . . . But we do not hold the idea that they are too big to fail. October 8, 2002 Heizo Takenaka Minister of Finance 2001-2005 The maximum benefits of recapitalization can only be achieved under strict asset valuation standards. It is necessary to ensure that banks thoroughly and properly disclose their NPLs under the stringent supervision of the relevant regulatory authorities DBI-SDA006-20070110- Third EC council 3 PHASE 3: THE LONGER TERM CHANGES APPEAR TO HAVE HAD SOME POSITIVE IMPROVEMENTS What they Did •Capital Injections in 15 Banks oProfitability Plans oIntervention Option •Altering the Safety Net oP&A Method oSystemic Risk Exception oDecreasing BOJ’s Involvement • Stricter Disclosure Requirements for Banks oNew Accounting Mechanisms The Impact •Basic Measures of Early 1990’s + New Step of Post 1999 Take Effect •Better Operation of Banks Takenaka Plan Implemented 32 Agenda The Asset Bubble The Crisis The Government Response Lessons Learned Learned Lessons 33 Bailouts Seminar Week 8 THERE ARE LESSONS THAT WE CAN LEARN FROM THE JAPANESE BAILOUT Description 1A. Fiscal and Monetary Stimulus In Isolation Will Not Help 1B. Confront the Banking Problem Quickly 2. Ignore Deficits in the Short/Medium Term • Discount Rate was close to zero throughout the 1990s and 2000’s • Focus on “hard” infrastructure led to wasteful spending • Many projects built according to political needs, not where most useful • Half-measures and frequent changes diminish confidence in the restructuring • Japan’s Finance Ministry did not force banks to write down their debts for several years even after realizing many banks were insolvent • Government needs “bad cops” to discipline the banking system • Concerns about deficits and coming retirement of baby boomers led to diminished fiscal expansion • Government ended tax cuts after only a year of mild growth, sending GDP back to zero • Tax cuts are necessary to incent growth but only in the right places 34 34 LESSON #1A: FISCAL AND MONETARY STIMULUS WILL NOT FIX THE PROBLEM GDP Growth vs. Stimulus Measures Discount Rate Discount Rate GDP Growth % 10 Negative Growth Despite Zero Discount Rate Massive Stimulus Bills Passed by Congress only had temporary Effect 5 0 35 LESSON #1A: FISCAL AND MONETARY STIMULUS WILL NOT FIX THE PROBLEM Vast Majority of Japanese Public Works Spending was on Infrastructure Marine Bridge, Hamada Japan Built using stimulus money, it became known as the “bridge to nowhere” 36 LESSON #1B: CONFRONT THE BANKING PROBLEM QUICKLY Japanese Bank Officials Ignored Banking Troubles For Seven Years Money Supply vs Bank Credit 1994-1997 Indexed to 1994 dollars 130 120 Monetary base 110 M2 Bank Credit 100 90 1994 1992 1994-1995 Public recognition of problems in Jusen (S+L) corporations 1996 1997 Several major bank closures 1998 1997 FSA created to help offload toxic loans First round of gov’t capital injections Credit Cooperatives Shut Down Asset Bubble Pops 1990 1995 1999 Second round of gov’t capital injections (4x larger) 2000 Bank failures and nationalizations begin to improve industry health 2001 2003+ Takenaka becomes FSA head and institutes new accounting rules 37 LESSON #1B: CONFRONT THE BANKING PROBLEM QUICKLY (cont.) Bank Credit Ratings 1980-1999 (Top 7 Banks) A A/B B Government Delayed Major Actions While Watching Major Banks Deteriorate B/C C C/D D 38 Lesson #1B: CONFRONT THE BANKING PROBLEM QUICKLY We question whether the authorities in the U.S. and Europe have sufficiently examined the management and financial health of recipient banks in deciding how to allocate the public funds Shimizutani Satoshi Faculty Fellow Research Institute, Economy Shimbun Newspaper 11/28/2008 39 Bailouts Seminar Week 8 Lesson #2: IGNORE DEFICITS IN THE SHORT TERM 40 Bailouts Seminar Week 8 Lesson #2: IGNORE DEFICITS IN THE SHORT TERM Percent Initial Tax Cuts Taxes Increased 41 ITS BAAAACK (REDUX?) THE LIQUIDITY TRAP-that awkward condition in which monetary policy loses its grip because the nominal interest rate is essentially zero, in which the quantity of money becomes irrelevant The problem is one of credibility. The Bank of Japan must create a credible belief that inflation will be 4% over 15 years • During the 1990s, many economists stated that the Central Bank could fix the situation by creating high inflationary expectations. • However, Japanese officials did not follow through • Should the United States attempt these same solutions? 42 Bailouts Seminar Week 8 ARE WE GOING DOWN THE SAME PATH? Phase 1: Stabilizing the Economy 1989-1993 2007-2008 United States Policy? • Dramatic Easing of Monetary Policy • Recognition of Problem without Taking Significant Actions Phase 2: Attempts at Recovery 1993-1999 • Large Public Works Campaign • Focus on Increase in Consumption • $514 Billion Bailout for Banks • Lack of Fundamental Change Led to the “Lost Decade” Phase 3: Jumpstarting the economy 2000 and onwards Current US Policy? • Massive bailout of banks •New disclosure requirements for banks •“No bank too big to fail” US Policy 2010? 43 CONCLUSION: ARE WE MAKING THE SAME MISTAKES? FOR DISCUSSION Wait and See? ? ? Treasury Secretary Willing to Get Tough with Banks and Force Disclosure? Public Works Projects Targeted at High Multiplier Spending? Good Choices •We have made some of the same mistakes •And tried some of Early Stimulus Package the same solutions Disregarding Deficits in the Short Term •Are we acting Federal Reserve Acting as Lender of Last Resort quickly enough? •Are we acting decisively enough? Mistakes •Are there Not Requiring Banks to Disclose their NPLs (yet) Exhausting Monetary Policy Options Early in Crisis Incremental Injections of Capital Into Banking System instead of “Shock and Awe” characteristics of US that make comparisons inappropriate?