Is the U.S. Headed Down the Same Path as Japan?

by: Reggie Middleton

After dealing with European banks during my work with GGP, I have come to the conclusion that most regional, community and even global banks have no where near the capacity and/or expertise to properly evaluate and value the projects/assets that they have invested.

Well, if that is the case, this is their chance to rectify that problem - on the cheap, at least on a relative basis. Here is the broader macro argument for lenders pulling bad debt from under the REIT and CRE industry, thus supporting a bearish thesis for said players.

First: A picture is worth a thousand words:

fasb_mark_to_market_chart.pngClick to enlarge

Instance asset gains and market value stemming from just a small tweak of truth. Financial stocks fly, moving farther and farther from their fundamental values.

Second: We have the obvious manipulation that is occurring in the REIT space (see Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!). Zerohedge speculates "Is Goldman Preparing To Upgrade The REIT Sector?"

Third: We have government complicity in the purposeful opacity of the values of the mortgage assets (see the FDIC "Prudent Commercial Real Estate Loan Workouts" guidance issued Oct. 30th, as reported by the WSJ: Banks Hasten to Adopt New Loan Rules and the new FDIC guidance that states performing loans "made to creditworthy borrowers" will not require write downs "solely because the value of the underlying collateral declined").

Fouth: We have a false sense of security that nearly everybody believes should make us insecure, yet somehow we have those long in the markets feelng warm and fuzzy. See You've Been Bamboozled, Hoodwinked and Lied To! Here's the Proof. What Are You Going to Do About It?.

Now, for those who believe that the government's "pretend and extend" policy has any chance in hell of working, or better yet, that we are not following in the footsteps of Japan, let's take a pictorial trip through recent history. There are nearly no Japanese banks in the top 20 bank category on a global basis by 2003 - none (save potentially Nomura (NYSE:NMR), which arguably survived in name, alone). As you can see, they literally dominated 90% of the space in 1990. (Click to enlarge)

top_20_banks.jpg

Source: Cap Gemini Banking M&A

Well, are we following the Japanese "Lost Path"? Notwithstanding the damning evidence of hide the truth and hide amongst lies linked to above, ponder the following rather dated, but still quite poignant data:

housing_price_futures.jpg

Source: Nomura on Balance Sheet Recessions

Futures have corrected even farther since this graph was made. As excerpted from a previous guest post on "Animal Spirits."

First consider this chart of Japanese home prices:

Japan asset bubble us asset bubble

US and Japan housing bubbles

Their prices peaked in the middle of 1991 and have declined ever since. We have now seen 18 years of decline. One may then counter that Japan is a one off case due to their poor monetary policy. Well, then what about Los Angeles?

Consider the following chart:

Note, our bubble was bigger, stronger and longer than theirs. Ours has also has considerably more stimulation than theirs. Yet periodically throughout that bubble we saw seasonal upticks, and they were also during the March-June/August time frame.

Our housing prices peaked in December 2005. Through June 2009, that's 3.5 years. Even relative to this smaller bust, we are still in the crash phase, which is then followed by a long tail of lower prices at a diminished rate of decline. Given that our bubble was much bigger and longer in the making, I contend this will be longer if anything, not shorter.

Notice, in some ways, as of 2008 US and Japanese bank losses have been similar. I posit the US losses will end up being much worse. Notice how the chart below references the subprime crisis. I have always alleged, and apparently have been proven correct, in that this is an Asset Securitization Crisis. and by definition is much broader, deeper and more intense than any subprime crisis could ever be. jp-us_banks_losses_are_similar.jpg

Source: IMF, Global Financial Stability Report (October 2008), p.16

Japanese asset prices literally collapsed after 1990, but several banks remained in the Global top 20 for some years (reference the second chart from the top of this blog post). Don't be fooled, though. If the value of your assets plunged significantly, your equity and enterprise value are soon to follow.

japanese_asset_prices.jpg

japanese_cumulative_losses.jpg

Here are a few quotes from others who have studied the situation:

  • Japan financial minister Watanabe: "Unlike Japan's 1990s crisis, financial risk in the U.S. spread beyond the bank sector to the rest of the financial system, i.e. hedge funds."
  • In the May/April 2009 issue of Foreign Affairs, Robert Madsen, a senior fellow at MIT, pointed out that, "Japan’s illness occurred in a relatively benign international environment," with overseas markets hungry for Japanese exports, the yen holding strong, and the government posting a modest surplus. The U.S. is in a very different place, Madsen writes. The U.S. deficit is skyrocketing, and appetite for its exports is weak.
  • Economist David Rosenberg at Merrill Lynch: "Japanese consumers had a higher saving rate (13%) going into the 1990s crisis than Americans had going into the present crisis. In the USA, there is no high savings rate to wind down in support of consumption. It's been more than 25 years since the U.S. savings rate was anywhere close to where it was in Japan at the onset of its multi-year real estate deflation and credit contraction."
  • Analyst Koyo Ozeki of PIMCO: "One factor that probably helped stem the default rate on home mortgages in 1990s Japan despite the sluggishness in the economy was the relative employment stability, thanks to the system of lifetime employment." [as opposed to 10%+ employment here in the states]
  • Analyst Masamichi Adachi of JPMorgan: "Reliable valuation is key to solving financial instability. A key underlying issue through Japan's lost decade was a distrust of valuations of land prices and NPLs. This issue applies to the current global credit situation too, i.e. valuations of structured finance products and of likely losses at financial institutions." [reference the first graph at the top of this post, and then wonder why no one trusts the banks, even the banks themselves!]
  • Analyst Takehiro Sato of Morgan Stanley: "During a liquidity crunch, market players retain cash regardless of the level of interest rates and do not supply funds to external parties during a sharp rise in credit risk. Monetary easing alone won't expand credit or stop collateral values from falling...However, unconventional measures (such as nationalizing corporate debt) are still an option." [reference the chart below]
  • Central Bank of Cyprus Governor Athanasios Orphanides: "Low or zero interest rates alone do not indicate a liquidity trap as long as there are assets in the economy that the central bank can purchase with money." [Bernanke read these notes!]
  • Analyst David Rosenberg of Merrill Lynch: "Fiscal stimulus in 1990s Japan was a band-aid, not a solution. All the stimulus did was prevent an even greater decline in real GDP. As for monetary policy, aggressive moves to boost the money supply are offset by the contraction of private sector credit as money disappears into debt elimination. Reflationary monetary policies are merely going to minimize destabilizing deflation pressures."

japanese_business_debt_paydown.jpg

So, how's it looking across the Pacific over here in the good 'ole US of A? As excerpted from, and sourced with the assistance of RGE Monitor:

  • The National Federation of Independent Business (NFIB) Index of Small Business Optimism posted a modest gain of 0.3 points to reach 89.1 October 2009 after remaining largely flat in September. Small business owners reported weak sales as the biggest cause of concern and a net 40% of firms reported a negative profit trend. Plans to increase employment remained negative in October, but improved over September. Firms continued to liquidate inventories in October. Plans for capital expenditure over the coming months fell, and as of October, stood 1 point above the 35 year record low reached in August. (National Federation of Independent Business, 11/11/09)
  • Demand for loans remains weak as a result of a delay in restocking and capital expansion plans. The net percentage of borrowers reporting tighter access to credit remained high at 14% in October, and firms reported high rejection rates. (National Federation of Independent Business, 11/11/09)
  • Melinda Pitts, Research Economist, Federal Reserve Bank of Atlanta: When national employment levels were expanding since 1992, small firms operating with under 50 employees accounted for one-third of the employment growth. While in the 2001 recession, these firms accounted for only 9% of job losses, in the current recession, they have accounted for 45% of job losses. If the financial constraints are a major contributor to the disproportionately large employment contractions for very small firms, then the post recession employment boost these firms typically provide may be less robust than in previous recoveries. (Macroblog, 10/06/09) [which portends significantly longer lasting unemployment than I think many are even coming close to pricing in]
  • According to a New York Times report on October 12, 2009, many small businesses are struggling to get bank loans, which is constraining expansion plans. While the credit squeeze from banks reflects risk aversion as lenders confront economic uncertainties, the banks say that the tight credit conditions stem from weak borrower performance rather than a reluctance of banks to make loans. (NYT, 10/12/09) [exactly as experienced in Japan, seen via the chart above. This is exacerbated by major sources of small business loans going bankrupt - reference Retailers Fear Impact of a CIT Bankruptcy - washingtonpost.com and CIT Bankruptcy Filed: US Will Likely Lose $2.3 Billion, Goldman ...]
  • Dennis Lockhart, President, Federal Reserve Bank of Atlanta: Banks with the highest exposure to commercial real estate loans also happen to account for 40% of all loans going to small businesses. The potential impact of the commercial real estate problem on the broader economy remains a concern. Commercial real estate could be a factor that suppresses the economic recovery by impairing the ability of small banks to support the small business sector, which is critical for job creation.
  • William C. Dunkelberg and Holly Wade: Financing is cited as the most important problem by only four percent of NFIB’s member firms. Enhancing SBA lending programs will not help as too many owners have no reason to borrow. "Record low percentages cite the current period as a good time to expand, more owners plan to reduce inventories than to add to them, and record low percentages plan any capital expenditures. In short, the demand for credit is in short supply and failing to understand the more major problems facing small business leads to bad policy." (National Federation of Independent Business, 11/11/09)
  • According to the October 2009 Federal Reserve Senior Loan Officer Survey, lending standards for commercial and industrial loans for smaller firms (with annual sales less than US$50 million) continued to tighten, though at a slower pace as compared to July 2009. About 16% of the surveyed banks reporting tighter lending standards for loans to smaller businesses. 55% of respondent banks reported lower demand for commercial and industrial loans from small businesses. 44% of the surveyed banks reported weaker demand for commercial and industrial loans in Q3 2009, with 40% of the surveyed banks attributing the weakness to lower investment in plants or equipment. (11/09/09)
  • Jan Hatzius, Economist, GS: Indicators that reflect the performance of small businesses look significantly weaker, like the National Federation of Independent Business (NFIB) small business index. The household survey of employment, which does not contain a small business bias unlike the establishment survey, shows an average loss of 140,000 jobs per month over the establishment survey. Standard economic indicators such as nonfarm payrolls, factory orders, shipments and the ISM extrapolate from the behavior of larger firms to the behavior of the aggregate economy and may be overstating economic activity at present. "Although both the economy and the financial markets are in much better shape than they were earlier this year, we are far away from a V-shaped recovery." (via the October 13, 2009 Report: "The Small Business Slump, and Why It Matters")
  • Jan Hatzius, Economist, GS: The economy might have grown between 0.5 to 2 percentage points more slowly than indicated by the advance Q3 2009 estimate of 3.5% annualized real GDP growth, because of the inability of official estimates to capture the unusually poor performance of small firms. Even if this is correct and shows up in the revision data, it could take several years.(via the November 11, 2009 Report: "Small Firms and GDP Measurement")
  • William C. Dudley, President, Federal Reserve Bank of New York: “For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector.” (10/05/09)
  • Apart from the traditional interest rate channel of monetary policy transmission, the effects of monetary policy are argued to work through a separate “bank lending channel” – the effect of policy changes on the supply of credit by banks. Mark Thoma, Economist’s View Blog: While large firms can raise credit from non-bank sources such as the issuance bonds and commercial paper, small businesses are dependent on bank lending for credit. The effect of a credit or policy shock on borrowing by large and small firms is thus asymmetric, and can cause small firms to contract activity more sharply. Tight credit conditions for small businesses are suggestive that the bank lending channel has been important in this recession. (10/13/09)

japanese_land_vs_gdp.jpg

This really calls into question the usefulness of broad GDP reports in anticipating asset value recovery after a land bubble bust. See, "Who are ya gonna believe, the pundits or your lying eyes?" (for pictures), "Who are you going to believe, the pundits or your lying eyes, part 2" (for numbers and a very shaky video) and Boo!!! Will Halloween Scare the Market into Respecting the Fundamentals? for an idea of what needs to be cleared up in this space before we move forward.

And read this -- Treasury Sales Smash Record - WSJ.com: Oct 30, 2009 -- For all the concern over Washington's deficits and its $12 trillion debt load, the US demonstrated this week that it retains the capacity to.

Now check out the chart below and tell me if this calls anything to mind...

japanese_spent_private_sector_savings_through_borrowing.jpg

If we do follow the path of the Japanese (and thus far I see nothing but similarities except for where Japan was in better shape than the US, save sume structural rigidity) one can be rest assured that their will not be a big future in lending and fixed income products...

japanese_companies_deleverage.png

If our situation is indeed more intense than the Japanese, then it can easily be surmised that to exist stimulus before Midterm Elections next year will push us back into recession. Who wants to take that bet?
japanese_fiscal_stimulus.png

According to Nomura, although the US and Japan may be (have been) successful in bolstering the money supply through government action, that money acts very, very differently during a balance sheet recession.

The logic behind the debasement of the dollar? According to the most popular school of thought amongst the academics, it is unavoidable.

nomura_on_why_a_weak_dollar_in_balance_sheet_recessions.png

I will suggest congress force the three main ratings agencies to post this disclaimer everywhere their name or logo appears.

accountability.png

The graphic comes from the Nomura report linked above.

Bankers, if you are not yet convinced it is time to take the first mover advantage on some of those rotting CRE assets, then I don't think you will be convinced at all.

Disclaimer: Assume I am short anything I am bearish on.