• Hopes for a turnaround in property prices: From the collapse of the bubble economy until the mid-1990s, most people assumed that real estate prices would eventually turn upward again. Policy makers were also focused on encouraging an economic and market recovery through fiscal stimulus measures such as public works projects.

• Existence of colossal latent stock profits: At the start of the 1990s, Japanese banks had stock portfolios with unrealized profits amounting to nearly twice their net worth. This acted as a buffer for loss write-offs, encouraging a complacent stance that they could hold out until the real estate market made its comeback. The plunge in the stock prices in 2000 severely eroded these latent profits, and appraisal losses began to have a negative impact on profits. Banks and financial authorities gradually came to recognize the risks regarding the shares in their portfolios, and proceeded to trim their holdings.

• Massive scale of the problem: Japan’s cumulative bad debt totaled an estimated 25–30% of GDP, while the value actually written off by financial institutions amounted to nearly 100 trillion yen (US$910 billion) or 20% of GDP. The large banks alone accounted for 75 trillion yen (US$680 billion) of this total (Chart 10). This exceeds the combined value of their net worth of 20 trillion yen (US$180 billion) and 14 years worth of net operating profits at 50 trillion yen (US$450 billion). They realized profits from their share holdings to supplement the portion that could not be covered by net operating profits. Though this conclusion is made in hindsight, it is clear that banks simply did not have the financial strength to dispose of these vast losses in a short period, and they had no choice but to take their time to write off debt using their annual earnings and unrealized profits.

 

 

Q: Why did the capital injections in 1998–99 fail to solve the problem?

A: At the time of the taxpayer money injections in 1998–99, authorities maintained the position that most of the major banks were fundamentally healthy, despite the fact that they were aware of the damage being done to bank capital by bad debt. At the same time, a credit crunch was becoming a serious issue as the banks turned increasingly reluctant to lend, and authorities provided public funds to ease the credit situation. They set their policy goals with this in mind, such as requiring banks to boost their lending to small businesses. These cash injections might be characterized as preventive actions, but because the policy had multiple objectives, it did not act as a genuine incentive to comprehensive bad debt disposal.

 

Q: Is rapid disposal really the key to early resolution of problem?

A: In responding to a crisis, authorities must 1) rapidly analyze the nature of the problem, 2) evaluate its scale, and 3) devise necessary measures. It is difficult to identify the precise causal relationship between financial system measures and a bottoming out in asset prices, but one lesson that can be learned from Japan’s financial crisis is that the delay in recognizing the problem during Phases 1 and 2 (1991–96) made the subsequent fallout even worse, and an underestimation of the situation’s severity and the authorities’ trial-and-error approach in Phase 3 (1997–99) caused the delay in settling the problem.

 

Q: How effective were the BoJ’s zero interest rate and quantitative easing policies?

A: Phase 4 of the crisis (2000–04) was a problem of surplus debt at private corporations. Under the surface, however, corporate fundamentals were improving rapidly (Chart 11). The ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) in the corporate sector as a whole took a swift turn for the better, improving from 5.3 times in 1999 to 3.0 times by 2005. Reduction of capital spending mainly made debt repayment possible (Chart 12).

 

During this period, interest payments also dropped considerably, bringing the ratio of interest payments to operating profits down from 42% to 15% (Chart 13). This is due to both a reduction in interest-bearing debt and a decline in interest rates, but we estimate that the latter had around twice the impact. That is, monetary policy not only helped maintain liquidity in financial markets, but also played a large role in improving corporate balance sheets.

 

 

Part 4: Implications for the Subprime Loan Crisis

Differences between U.S. Subprime Crisis and Japan’s Crisis
Both the subprime loan turmoil in the U.S. and the financial crisis in Japan resulted from a bubble created by the presence of surplus liquidity. However, there are several differences.

• Complex structure of U.S. bubble: Whereas Japan’s bad debt problem stemmed from commercial real estate and excess corporate debt, the U.S. subprime problem involves a more complicated mixture of bubbles related to the housing market, financial institution business models and financial products for investors.  
   
• Speed of valuations: Japan’s bad debt was mostly bank lending, and valuations took some time as regulators conducted asset inspections. In contrast, the subprime loan problem involved securitized products, so market valuations were completed relatively quickly. The valuation of housing loans by commercial banks in the U.S. could take longer than securitized products, though, so we should keep a close eye on future developments.   
   
• Creditor nation vs. debtor nation: Japan is a creditor nation and does not rely on overseas financing, so its bad debt situation was an internal problem. The U.S. is a debtor nation, which complicates the matter. Also, U.S. housing loans and other securitized products are widely held by overseas investors, so the risk can easily spread to global markets. This will naturally impact how the government responds to the problem. 
    
• Scale of the problem: Japan’s bad debt problem on a cumulative basis amounted to a whopping 25–30% of the nation’s GDP (Chart 14), whereas the subprime problem is an estimated 5–10% of U.S. GDP. The difference in scale will likely affect the cost and speed of resolving the situation.

 

 

Part 5: Summary

Framework Necessary for Cleanup of Individual Bank Failures

It is important for a government’s financial crisis–response package to include a framework that will help avoid systemic risks arising from the bankruptcy of financial institutions that are crucial to overall stability. Japan finally introduced such a framework in 2001 after much trial and error, which helped bring the crisis to a close. We believe that the Federal Reserve opening its discount window to investment banks and facilitating the rescue of Bear Stearns in March 2008 were important steps in the right direction. However, lending by a central bank is essentially a liquidity policy. There are limits to the extent to which the central bank can accept bad debt risk in dealing with solvency problems at financial institutions. In the case of Bear Stearns, the Fed will provided loans at official discount rates for ten years to the bad bank, which was established to take over Bear Stearns’ high-risk assets. If the loans go bad, however, it could compromise the credibility of the central bank and therefore the currency. Thus, a Bear Stearns–type rescue model should be seen only as a temporary measure until a solid framework for government support can be established. A financial institution rescue package using public funds will require the approval of Congress, and the appropriate legislation needs to be laid out quickly in order to better prepare for possible future developments. Japan’s financial crisis–response framework designed in 2001 could serve as a useful reference.

 

Preventive Capital Injections: Impact Questionable, but Methods May Be Useful as a Reference

Because bank rescues are a very delicate matter politically, it is not easy to move proactively to keep the situation from getting out of hand in the first place. In Japan’s case, capital injections in 1998–99 had no clear policy goal and thus no substantial result. However, major banks were able to repay the money in the subsequent economic upturn, and the nation earned a profit from the rebound in share prices, consequently reducing the fiscal burden. In going-concern bank support, indicating a clear exit strategy can help in winning taxpayers’ understanding. The Japanese examples may be helpful in this sense.

 

Framework Needed for Debtor Balance Sheet Adjustments

Loss write-offs and capital restructuring at financial institutions are, in fact, balance sheet adjustments on the creditor side. It is important that their balance sheet adjustments also lead to adjustments on the debtor side in order to halt the decline in asset prices caused by a downturn in the overall economy. For example, the Brady Plan played an important role in resolving the Latin American debt crisis of the 1980s, and the Resolution Trust Corporation helped resolve the savings and loan crisis from the late 1980s and early 1990s. Likewise, Japan’s bad debt disposal process was helped considerably by various measures in the framework that addressed debtor balance sheet corrections. Such measures included the passage of the Civil Rehabilitation Law in 2000, the reinforcement of the Resolution and Collection Corporation (RCC) in 2001, and the establishment of the Industrial Revitalization Corporation in 2003. A cleanup of the high volume of housing loan debt will require a different method than for corporate debt, and we will be closely watching the future course of debate and policy initiatives.