The Sub-Prime Crisis: American Origins, Global Effects, Japanese Lessons?*

* This post is an updated English excerpt of Henrik Schmiegelows article Seikai Keizai Kiki no Dasshutsu no Kagi wa Ajia to Oushu , Chuokoron (Tokyo), Vol 124 N° 8, p. 152-161 (July 15, 2009)

There is global agreement on both the origin and the effects of today’s world economic crisis, the worst since the Great Depression of the 1930’s. There is, however, global disagreement about the proper solutions. The divergence between unanimity in problem analysis and dissension on policy response is alarming. It suggests inability or unwillingness to learn the lessons of economic history. While the monetary lesson of the Great Depression is well rehearsed (Fisher, 1933; Friedman and Schwartz, 1963; Bernanke. 2002), reluctance to learn the fiscal lesson of that case may be forgivable, since only a war, the Second World War, brought the US a full recovery through fiscal expansion. But policies disregarding an example as recent and telling as Japan’s lost decade in the 1990’s are precarious policies indeed.

I. American origins

The crisis originated in the US. As traced by Felix Salmon in Wired. an application of a standard mathematical formula, the Gaussian copula function, to mortgage default correlations was published in 2000 by a “quant ” at JP Morgan Chas. It was severely flawed by an implicit assumption of a continued rise of real estate prices far beyond historical trends (available in Robert Shiller 2005). The assumption was derived from a flimsy record of less than a decade of available price statistics of credit default swaps (CDS), conveniently the period of the last real estate boom.  But it was transformed into a mathematical constant reducing, as if by alchemy, the probability of mortgage defaults. American banks used this magic formula enthusiastically to justify extravagant mortgage lending to low-income (“sub-prime”) homebuyers in the US. Sub-prime mortgages were “packaged” in small slices beyond recognition with prime mortgages in “asset-backed” securities (ABS). ABS were, in turn, repackaged in structured credit instruments called “collateralized debt obligations” (CDO), CDO further reused as building blocks in a higher structured credit architecture called “CDO squared”, and CDO squared in CDO cubed. These securities were rated AAA by the three American rating agencies, insured at low cost by CDS and sold globally to banks blindly trusting “financial innovation” from Wall Street. The result was a financial bubble in the US with pervasive global effects. CDS reached a volume of 60,000 bn US $. Whereas the Japanese bubble was induced from abroad, i.e. intense US pressure on Japan to simultaneously appreciate its currency and expand domestic demand according to the Plaza Agreement of 1985 (see H. and M SchmiegelowObei Ijoni Obeitekina Nihon Keizai(More Western than the West: the Japanese Economy), Chuokoron Vol. 108, No.1 (January 1993), pp. 72-83, p.77), the US bubble was “home-made”.

The crisis erupted in 2007, when the first American sub-prime lenders defaulted, as sub-prime borrowers could not afford the rise from the initial “teasing” rate of 2 percent to the eventual contractual rate of 8 percent of the mortgage. A wave of foreclosures brought real estate prices down. ABS and related CDS became “toxic assets”.  The global financial bubble burst a year later, when the US Treasury and the Fed allowed Lehman Brothers to default, apparently as a warning to the banking sector against reckless risk taking. The action was reminiscent of President Hoover’s stand in triggering the Great Depression and Governor Mieno’s stern monetary move in bursting the Japanese bubble.

II.  Global effects

While the effects of the bursting of the Japanese bubble, though severe and prolonged for Japan, remained contained within the Japanese economy, the US sub-prime crisis caused a crisis of confidence in the global banking sector and hence a global economic meltdown. Uncertainty about the exposure of individual banks to toxic assets put credit markets in a state of freeze. European banks had massively participated in the frenzy of securitization of US mortgages. With the notable exception of Deutsche Bank, which like Goldman and Sachs had doubts about the assumed rise of real estate prices and hedged its bets while selling ABS to other institutional investors, scores of European banks including Germany’s leading real estate lender Hypo Real Estate and several public “Landesbanken” “followed the herd” in blind trust of “financial innovation”. When they noticed that the trust was unwarranted, they realized their exposure was out of proportion with their capital. Unable to put a value on toxic assets and, just like their Japanese colleagues in the 1990’s, not daring to proceed to write-downs for fear of being nationalized, they stopped lending and no longer assumed their function of financing the national economy. Hence even loans unrelated to toxic assets became non-performing and the hidden need of further write-downs grew as in a vicious circle. In a first attempt at quantifying necessary global write-downs in April, the IMF estimated 4.1 trillion $, with 2.7 trillion $ of bad loans and securities originating in the US and 1.12 trillion $ in Europe. Japan, whose banks, sobered by their own bubble experience, had hardly touched ABS, faced “only” 149 billion $.

Early hopes that the still thriving industrial sectors of exporting countries like China, Germany and Japan might remain unaffected by the collapse of the US financial sector quickly evaporated. On the contrary, they became the countries worst affected with declines in exports in the first months of 2009 in the ranges of 21,1% (Germany), 25,7 % (China) and 46 % (Japan). On July 8, 2009, the IMF predicted a deeper recession in Europe and Japan than in the US, with declines of GDP in 2009 of 2,6% in the US, 6,2% in Germany and 6,0% in Japan. For Keynesians, the reason was obvious: the hitherto most important sources of global demand, i.e. the Anglo-Saxon countries combining low savings and high consumption propensities with structural fiscal and external trade deficits, have suddenly disappeared from the international trade equation.

While the October 2009 Global Financial Stability Report of the IMF acknowledges a reduction of global losses by 600 billion to $3.4.trillion largely due to rising securities values in mid 2009 -, it warns of further credit deterioration, as over half of potential write-down needs through end-2010, estimated at $1.5 trillion, has yet to be recognized. It emphasizes that banks need to crystallize losses through realistic assessment of asset values and that capital levels may need to rise further to rebuild lending capacity to finance recovery. The IMF urges banks to use the chance of extremely low interest rates, wide spreads and, hence high profitability, still prevailing in late 2009 for this purpose. It warns that such favorable conditions may not last, as public credit demand resulting from the massive programs of fiscal stimulus in all major economies might soon exert upward pressure on interest rates.

These figures underscore the urgency of adopting the right strategies to solve the crisis faster than in Japan’s lost decade, but with the strategic pragmatism that helped Japan to recover within 12 months in 2002/2003 ( Michèle Schmiegelow, “Senryakuteki puragumatisumu ni tachi kaere: Nihon keizai e no shohosen” (Recover Strategic Pragmatism: the Prescription for the Japanese Economy) Tokyo: Japan Center for Economic Research Bulletin. 1/10/2002, N°895, pp.4-10). Unfortunately, so far, dogmatic dissension and, hence, cognitive confusion prevail. Sometimes, the disagreement appears to be between nations, such as between France and Germany or France and the UK, or groups of nations, such as the transatlantic divisions or those between the “Anglo-sphere” and the “rest of the world”, or the G7 and the G20. In fact, the most acrimonious debates are domestic ones, between monetarist and Keynesian economists everywhere, US Republicans and Democrats, Wall Street and “Main Street”, defenders of the Common Law or of Civil Law, advocates of laissez-faire and proponents of social protection.

In early 2009, the US had the initial advantage of a new administration with huge popular support, while Germany’s coalition government was compelled to focus on elections in September 2009. To the global media, Japan, France and the UK appeared much more eager for action than Germany.  But as attested by the IMF’s study The Size of Fiscal expansion: An Analysis of the Largest Countries, in February 2009  with one of the most generous social security systems of the world functioning as an “automatic stabilizer”, Germany was devoting 3.4 percent of GDP to fiscal stimulus, the third largest proportion of major economies after the US (4.8 percent) and China (4.4 percent), but before Japan (2.2 percent), the UK (1.5 percent) and France (1.3 percent).  In May 2009, Japan surged to the top with a supplementary budget adding 3 percent, bringing the sum of all fiscal stimulus programs combined to 5.2 percent.  And yet, just as in Japan’s lost decade, the debate about whether Keynesian stimuli provided so far were sufficient or not, goes back and forth. “Exit strategies” are intensely discussed, while most participants in these discussions, foremost among them Ben Bernanke, are convinced that it is far too early to apply them.

However, even though more fiscal stimulus may be needed to preempt a “double-dip” or even “triple dip” recession with intermittent short-lived recoveries, it will not address the roots of the sub-prime crisis. The crisis has rightly come to be called a “balance sheet recession” because of its origins in the balance sheets of the financial and household sectors, just like Japan’s debt deflation after the bursting of the Japanese bubble in 1991.  The term “balance sheet recession” was first coined for the Japanese recession of the 1990’s by the Head of Nomura Research Institute,  Richard Koo, (see his Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (2003)). Michael Spence. the former Dean of Stanford Business School whose work on information asymmetries was awarded the 2001 Nobel Price, has emphasized the tremendous depth and destructive power of the balance-sheet destruction characterizing the sub-prime crisis. “In the future”, he writes, “central banks and regulators will not be able to afford a narrow focus on (goods and services) inflation, growth, and employment (the real economy) while letting the balance-sheet side fend for itself. Somewhere in the system, accountability for stability and sustainability in terms of asset valuation, leverage, and balance sheets will need to be assigned and taken seriously”. Japan’s lost decade should serve as a warning of what happens as long as balance sheets are not taken seriously.

President Obama has not only great charisma, but also a vision of structural change in the US economy. As explained in his speech at Georgetown University on April 14,2009  that vision no longer relies on “voracious consumption”, “excessive debt”, and “reckless speculation”, but on savings, education, health care and investments in scientific, technological and ecological innovation. His combination of strategic vision and American philosophical pragmatism is unmistakably reminiscent of the strategic pragmatism that enabled Japan to emerge post-war as the second largest economy of the world .

Unfortunately, US Treasury Secretary Geithner’s efforts to stabilize the American banking system by public-private partnerships are perceived even in the political spectrum favorably inclined to the administration,such as Paul Krugman. as relying to a worrying extent on the very same financial sector whose collective cognitive failures are at the origin of the crisis. Neil Barofsky, the Special Inspector General of the Troubled Asset Relief Program (TARP) has warned that not enough has been done to guard against fraud in a program offering public money to private investors who buy toxic assets. Geithner’s programs cling to the assumption that financial markets know best how to find a price for toxic assets. They require banks holding such assets to sell them, which for fear of having to write down the realized losses after such sales, they are reluctant to do, the more so as Barofsky calls for supervised screening of each security. As neither prospective sellers nor prospective buyers have a clear idea about the value of the toxic assets, the process will be protracted. The “market” cannot clear, as its “sell side” (banks and brokers) and its “buy side” (pension funds, hedge funds, insurers) are fighting each other about who will “control” the regulators. Law suits between mortgage lenders and borrowers as well as sellers, buyers and insurers of mortgage-backed securities have just begun in the US and may take many years at huge legal cost. The world economy seems “hostage” of the outcome of these American lobbying campaigns and legal battles.

While some green shoots began sprouting in the real economy in May/June 2009 as depleted inventories were replenished, and commodities hoarded for a future recovery, banks in the US and Europe continue to fail in their essential economic function of financial intermediation. Instead of being liquidity providers, they have become liquidity users. The German legislation, adopted in May 2009, to allow each German bank to isolate toxic assets in a separate “bad bank” is a strategy of buying time until market dysfunction ends in the US.

The “stress tests” conducted by US regulators at the 19 top US banks were designed to offer a perspective of survival of those banks rather than to encourage the building of sound new banks ready to channel credit to a struggling economy. The projection of combined losses of  599 bn US $ over 2009 and 2010 announced on May 7,2009 did not lift the cognitive fog covering ABS. For “just in time” for the stress tests, on April 2,2009, the Financial Accounting Standards Board (FASB) had responded to pressure from the US Congress to change the accounting rules for banks. Rather than applying the “mark-to-market” rule that force them to report the losses on ABS, they were allowed to use “internal models” in view of “conditions indicating that markets were dysfunctional”. While American banks pressured Japan to impose mark-to-market accounting on Japanese banks burdened by nonperforming loans in 2002, they asked key members of the US Congress to pressure the FABS to exempt them from this very same rule in April 2009 (Wall Street Journal “US Congress helped banks defang key accounting rule”, June 4,2009).

This presages a replay of Japan’s decade of fruitless attempts at different fiscal and monetary crisis solutions without prior cleaning-up of the financial sector. Only in 2002, when the Koizumi government finally imposed complete rigorous write-downs of bad loans, Japan’s banks recovered the ability of financial intermediation in the economy. They began responding functionally to the Bank of Japan’s path-breaking policy of quantitative easing under Governor Fukui. In the third quarter of 2003, the success of these policies was demonstrated:  the Japanese economy bounced backed with an annualized growth rate of 6 percent. Of course, the upswing of the global economy at the time, and more particularly Chinese demand for Japanese exports did help. The Japanese case is a historical example to be remembered today.

III.  Japanese Lessons ?

The case suggests that two cognitive efforts must be undertaken, before new policies can be designed to put the global economy on the path to recovery:

Finding a method of re-pricing the toxic assets for rapid write-downs

Identifying new sources of global growth

1. Re-pricing toxic assets

At first sight, the Japanese case seems to indicate an effective solution to solve the balance sheet crisis. Only in October 2002, when Prime Minister Koizumi appointed the determined reformer Heizo Takenaka as Head of Japan’s Financial Services Agency, were the balance sheet problems of the financial sector seriously addressed. Takenaka enforced a fair value re-pricing of bank assets and rigorous write-downs of non-performing loans combined with recapitalization and restructuring of the banking sector. As mentioned above, only then did Japan’s banks recover the ability of financial intermediation in the economy.

During the preceding decade, Japanese banks had been protected, just as US banks today, against revealing the extent of their capital shortfall. Similarly, they became liquidity users rather than liquidity providers. And similarly they failed to recover the confidence essential for the functioning of financial markets.  When Takenaka finally imposed fair value re-pricing of bank assets and corresponding write-downs of bad loans in 2002, he did so in response to intense prodding by the US government and American banks. The immediate success of that strategic policy reversal perfectly vindicated the validity of the American arguments at that time.

And yet, as evidenced by the successful efforts of the American Bankers Association to secure exemptions from fair value accounting as long as “dysfunctional market conditions”, US banks are not ready to adopt the strategy recommended to the Japanese colleagues at the time. Arguably, the differences between the Japanese bubble of the late 1980’s and the sub-prime bubble of the mid 2000’s may explain some of the reluctance of US banks to heed their own advice of that time. Although both Japan’s debt deflation and the US sub-prime crisis are balance sheet crises, the differences are significant on at least two levels, the degree of securitization of the non-performing assets on the balance sheets and the doctrines on a government role in recapitalization and restructuring of the banking sector.

Although securitization of debt had made advances in Japan just as elsewhere, nothing comparable to the hypertrophied financial engineering of the US sub-prime bubble described above was present in the Japanese bubble of the 1980’s. Although massive and debilitating, Japan’s decade long debt deflation was still essentially a classic crisis of banks burdened by non-performing loans, more comparable in the nature of its balance sheet problems to the Swedish banking crisis of the early 1990’s than to the “toxic assets” crisis of financial engineering in the sub-prime case. Arguably, what distinguishes the sub-prime crisis is that it is also a cognitive crisis. It was a failure of “many bright people”, as certified to the Queen of England by the British Academy. Hence bankers may feel justified to plead that it is difficult to re-price the toxic assets on their books.

In a working paper of the Joint CRIDES/IRES/CECRI Working Paper Series on Institutional Competition between Common Law and Civil Law on contract modification as a solution to the subprime crisis,  we show how cognitive crises can be dealt with in contract law and hence in the assessment of the value of mortgage loans. US banks do not yet seem to be aware of that solution, however, and the point remains that the cognitive failure of financial engineering in the sub-prime crisis continues to be invoked to justify their reluctance to re-price their toxic assets.

While in 2002 US banks have wholeheartedly welcomed Heizo Takenaka’s vigorous enforcement of the strategic triad of write-downs, recapitalization and restructuring of the banking sector in Japan, they would certainly balk at a similar treatment to themselves by the US government. Although even the strongest US banks have gladly accepted short-term bail-outs, and many not so strong ones continue to depend on what George Soros calls “artificial life support”, and although there was significant prodding even from the Bush Administration in the Bank of America/Merrill Lynch merger, an all-out government-led restructuring of the banking sector would be rejected as not in keeping with free market rules and share-holder rights. In view of the large literature on the uniqueness of the relationship between government and business in Japan, the Takenaka strategy can easily be discarded as not applicable to the West. Timothy Geithner has a much more restrained view of governments role in financial markets, and his view is shared by the centrist spectrum of the Democratic Party. Together with the Republican Party, this spectrum appears to command the inclination of a majority of the US Congress in this respect.

In the West, if everything else fails, the endgame will inevitably involve protracted legal battles. We believe that there is indeed a legal solution to the balance sheet crisis resulting from the sub-prime failure. In the working paper already cited, we argue that the earlier the legal dimension of failed sub-prime lending is recognized, the easier it will be to avoid the enormous cost of such an endgame.

2. Identifying new sources of global growth

If we take President Obama by his word, the American economy will no longer be consumer of last resort for the world economy.  Unlike Japan’s economy in 2003, the recovery of today’s world economy will not be assisted by some “external” source of demand. Private enterprises and public policy-makers everywhere in the world will have to look beyond demand-pull from abroad and organize Schumpeterian supply-push innovation that creates its own demand. This is the most promising form of strategic pragmatism in the economic field. Japan’s microelectronic revolution in the 1970’s and America’s software revolution in the 1980’s are the leading examples. Post-war Europe did not offer a technological revolution, but mustered strategic pragmatism for political innovation: the functional integration of Europe’s economy. Its success demonstrated that prosperity springs not only from Ricardian comparative advantage in international trade, but also from trade between industrial nations producing similar goods and services.

There is, however, one new source of demand to consider: the domestic demand of 3 bn people in Asia. Except for Japan and urban coastal China, it is not yet fully present in markets. But it just waits to be awakened by adequate policies of economic and social development as well as economic integration in Asia. Western China’s pent-up demand and the emerging Chinese legislation of a social security system on the Northern European pattern will unleash enormous domestic dynamics, offsetting some of the declining US demand for Chinese products. ASEAN+3 seems on course to organize proper flows from savings to investments in the Asian region (see our post is Asias integration less functional than Europes,). Thanks to such an “Asian solution” to the American sub-prime crisis, Europe’s functional experience may yet be tested on a global level.