Wall Street Confidential

The Japanese Zombie Crisis:

Can It Happen Here?

October 19,2008

by Edward Jay Epstein


Does this sad tale sound familiar?

Fueled by low-interest mortgages, real estate prices in Japan had risen so high that by the end of the 1980s just the land under the Imperial Palace in Tokyo was nominally worth more than all the real estate in California. Then, in late 1989, the bubble burst and real estate prices plummeted, leaving Japan’s financial institutions saddled with toxic mortgages and facing bankruptcy.
Despite the common misconception that the Japanese government neglected the crisis, it intervened from the outset. In 1990, the Japanese Central Bank cut interest rates until they reached absolute zero. So money was free for banks to borrow. Nevertheless the Japanese stock market continued its fall, with the Nikkei index going from a high of 40,000 in 1989 to a low of 12,000 in 2001. So did real estate, which lost 80 percent of its value during this period.

The government next tried the classic Keynesian tactics, spending and tax cuts. Between 1991 and 1998, it pumped 100 trillion yen into the economy through public works programs and, to further stimulate spending. cut taxes by 2 trillion yen. All these measures succeeded in accomplishing was raising Japan’s public debt to 100 percent of its GDP.

To deal with the ever more ominous threat of bank insolvency, the Japanese government injected public funds directly into Japanese banks, investing first in 1996 $100 billion and then in 1998, under the Obuchi Plan, another $500 billion to pay for bank loan losses, bank recapitalizations and depositor protection. The bail-out, which amounted to over 12 percent of GDP, resuscitated the individual banks but not the financial system . The banks, although on government life support, resisted lending out their new found capital. Paralyzed by the fear of losing their new found capital, many such banks became, in Japanese terminology, “zombies,” since they were neither dead nor alive (at least in fulfilling their function of extending credit.) As a result, the money Japan pumped into its banks did not thaw the frozen system. Indeed, it was not until 2002 that the Japanese economy, buoyed by the boom in China and other of its export markets, showed positive growth. The moral of this financial Kabuki play is that government intervention does not always work immediately, or, in this case, for a decade.
America of course is not Japan. The differences, when it comes to restoring financial confidence, cut both way. On the bright side, American financial institutions, unlike their Japanese counterparts, quickly moved to recognize their losses from their toxic debts and find ways to recapitalize themselves. The US government also intervened much earlier in the process than did Japan. In the first year of the crisis, it committed about $800 billion (about 7% of GDP) of tax payers’s funds to re-capitalizing the banks and guaranteed depositors against loss. That is the good news. On darker side of the equation, unlike in Japan, there is a multi-trillion dollar casino dealing in credit default contracts overhanging, like a Sword of Damocles, the financial system . Through buying or selling these contracts, American banks, hedge funds, insurers, and other players have wagered at least $47 trillion on the fate of a wide range debt instruments. Like any other punter, the buyer or seller of one of these contract need not own the debt that is being wagered on, so pay-offs made in the event of a default of a bond can be vastly higher than its face value. Indeed, a default can result in such huge losses from these contracts that it triggers a chain reaction of other defaults. Witness, for example, the near-bankruptcy of AIG from the credit default contracts it held. Worse. there is no central registry that lists obligations undertaken in this casino activity. This lack of transparency makes it exceedingly difficult to figure out the exposure of financial institutions to catastrophic loss. In this environment, banks, even if they don’t become zombiefied, may not rush to lend their money out. So the Japanese experience may yet prove instructive.