By Kuen Chan
The Complete Investor
Volatile as the overall market has been in the last eight months, financial stocks have been on an even wilder ride. From Lehman's mid-September collapse through early March, financials in the S&P 50 plunged 70 percent. Then during the subsequent rally extending through early May, they nearly doubled. Nor is it surprising they dramatically led on both the downside and upside: after all, the financial sector has been central to the economic crisis.
The remarkable rally was sparked by optimism about bank rescue efforts and further fueled by encouraging first-quarter earnings announcements from the big national banks. But investors shouldn't take all the seeming good news at face value. Despite some signs of a thaw in credit markets - for instance, the TED spread, an indicator of perceived credit risk, has come down from last fall's dramatic highs - bank lending isn't rising. The latest numbers show that lending volume in February for the 21 banks receiving TARP funds was 4.7 percent lower than in January. That, not the supposed improvements in earnings, shows how banks really assess their own health. And it's increased bank lending that's crucial to economic recovery.
Here we want to do some historical analysis - to see what we can learn by comparing the current crisis with Japan's agonizing "lost decade" of the 1990s.
In the late 1980s, easy credit and loose regulation in Japan led to lucrative lending and an enormous real estate bubble. By 1990, residential land in Japan's largest cities was 2.5 times as expensive as five years earlier, while commercial real estate had nearly quadrupled. (One story has it that an empty 30-square-foot parcel - too small to build on - in Tokyo's Ginza shopping district sold for around $600,000).
The housing bubble burst when Japan's government raised interest rates to quell inflation. Banks were left with a huge number of bad loans on their books; this crippled lending, straining the credit markets and dragging down the economy.
Similarities to the current crisis in the U.S. are obvious, but there are some striking differences. Japan's government, unlike the U.S. government, reacted indecisively to the crisis. It took more than a decade for interest rates to reach zero, and not until 1998 was anything resembling a comprehensive policy response, including bank rescue funds and spending, put into place. Even then, implementation of the spending initiative was half-hearted because of public dissent. Meanwhile, deflationary pressures further discouraged borrowing.
The Japanese government also erred by guaranteeing blanket insurance of all bank debts, keeping alive some banks that should have gone bankrupt. These "zombie" banks didn't have the wherewithal to lend, but they absorbed funds that otherwise could have been allocated to stronger banks.
Japan's tradition of saving and frugality helped cushion the economic pain - unemployment remained below 6 percent - but also helped prolong the crisis. That's the Keynesian "paradox of thrift": when people save during recessions, aggregate demand falls and growth stagnates. (Americans' propensity to save, while on the rise, is far less than that of the Japanese). As a result, Japan was mired in a decade of stagnation and lackluster stock and credit markets. By the time it hit its bottom in 2003, the Nikkei 225 Index was down some 75 percent from its 1989 peak, while real estate prices fell for 15 straight years, until 2005. Economic recovery didn't begin until 2003 when the Japanese government finally took drastic action, subjecting banks to rigorous audits and weeding out the weak from the strong - nationalizing one major bank in the process.
The U.S. government seems to have learned from Japan's mistakes. It responded swiftly to the financial crisis despite partisan bickering, and it seems to be focusing on saving select banks rather than trying to rescue all.
One clear lesson from Japan is that banks overwhelmed by toxic assets won't lend. Banks are legally required to maintain a certain level of capital relative to assets. When the assets drop in value, as happened both in Japan and here, banks need to raise more capital. And if banks aren't confident that loans will be repaid or if they fear their assets will lose even more value, they will hold onto capital ever more tightly to keep their balance sheets looking better.
The "stress tests" performed on 19 select U.S. banks have been completed. Ten banks were found to need to raise a combined $75 billion to ensure they remain well capitalized should economic conditions worsen. The amount is less than some experts had feared, but some criticize the tests as too lenient. Fed Chairman Bernanke described the results as encouraging, but he urged the banks to continually self-test. This suggests that even he thinks more capital may be needed.
Still the results are good news for the economy, since it appears the financial system will continue to function. No one knows how much more capital will really be needed to get credit flowing at healthy levels again, however, and it may be wise to avoid bank stocks for now.
Editor's Note: Kuen Chan is a contributor to The Complete Investor, P.O. Box 248, Williamsport, PA 17703, 1 year, 12 issues, $72. www.completeinvestor.com.
