Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?
The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.
The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.
The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.
The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?
The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.
The Japanese Banking Crisis of the 1990's: Sources and Lessons
In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.
The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?
The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…
Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.
The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".
The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.
Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.
By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.
Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.
Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.
Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.
Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.
The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.
Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".
Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?
Conclusions for the current crisis
I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.
Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.
As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.
The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.
Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.
The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.
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- The Big Mac Index – Applying Simple Economic Common Sense
- Is the Stock Market a Big Ponzi (Madoff) Scheme?
- Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
- How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
- How to Protect Your Money From Inflation
- On the Psychological Effects of Ownership and Overpricing
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