Guest Post: Where We Are Is Where Japan Has Been
Submitted by JM
Where We Are Is Where Japan Has Been
Once upon a time, there were a bunch of banks that said “Hey, forget balance sheets. If they have collateral give them a loan.” For a while it was good money. As long as they got payments, it was OK. So there were more loans, which in turn bid up the value of the collateral.
Then the worm turned, because what goes up must come down. When collateral values collapsed, so did lending. It got real hard to keep up with the loan payments. Banks started looking like they came straight out of Goodfellas.
This isn’t an American story at all. All of these types of issues are about debt resolution. It has happened for centuries, probably further back in history. You know the story, but perhaps there are some details here that may open eyes. Like why you heard about Japanese CEOs committing suicide. Often it was because to keep their businesses running, they had to pledge all their personal possessions for a loan. The insurance benefit was all that was left for their families when their businesses went bankrupt.
This collateral value collapse implies banking crisis implies real problems for a lot of voters. Anywhere this happens, it is a political crisis, and governments have to step in. This is where the story goes from bad to worse.
The chapter we are in is technically called “central bank balance sheet expansion”. The subtitle is “Bank Bailouts”. It doesn’t make any sense for a politician to let a bunch of voters lose everything. Central bank balance sheet expansion keeps this from happening: it works only if it is done in enough size to repair bank balance sheets. Thus they will expand their balance sheets and offer loans. And hopefully collateral values will reinflate.
It doesn’t seem to work anywhere. All that money just sits on bank balance sheets as cash and reserves in the large. Some portion of it goes to risk-taking in financial assets. But these banks are the last entities that need to be taking excessive risk. Ultimately, they will need more liquidity to cover their bets. This means more balance sheet expansion. Ultimately it will end in some way, but I’m not sure how.
This chapter is nowhere near being written, but I can see how it is going to play out. This summer, the Fed started to unwind its balance sheet via unwinding the Maiden Lane assets, and this is a really small piece of the Fed balance sheet. They backed off when the results of their actions were clear. Risk in the credit space (ABS, RMBS, CMBS) has yet to recover, which is profound in a way. Markets are information processors, and they are learning how to price this stuff without a floor. And of course, the Fed is going to have to take a major hit on this crap if they sell back to banks. Taxpayers will pick up the tab.
Alright. It is good to get it off one’s chest. And now you have to figure out how to protect yourself.
Money Stock Doesn’t Mean Anything
Inflation is a Mixed Bag, Year-on-Year % Changes by Component
Education doesn’t deflate because parents sacrifice for their children.
The Big Picture Story on Rates and Inflation
Things will remain stuck because of the intrinsic interest rate risk. Rising interest rates cause significant capital losses for some insurance firms and individuals that hold bonds. Commercial banks that hold government bonds would experience a capital loss with an increase in their yields that is offset by an increase in loan demand—i.e., economic growth, so the effect is ambiguous for them. Banks can game this through repo and other tools efficiently, but the bottom line is that they can buy cheap and sell rich given their balance sheets. Anyone can do this.
This translates into liquidity risk. Financial markets are highly illiquid at times, thus subject to sudden spikes in volatility. Liquidity can dry up due to contagion (correlation) effects, there is a basic rule that serves one well: the more liquid assets you have, the better. This reduces exposure to liquidity shocks that go along with volatility.
There will be balance sheet repair. Some slow and steady, some sudden through default. Weak balance sheets are susceptible to financial strains caused by insufficient reserves of liquidity and thus try to hold more cash and cash equivalents. This will put surviving businesses in pretty good shape. You can tell this is happening by a:
- Rising liquid assets to assets ratio.
- Low Financial Book Value–the sum of total liabilities plus market capitalization divided by total assets. This measures the cost of purchasing the firm outright relative to the accounting cost valuation of assets.
- Rising Return on Equity–net income divided by book equity value in 1995.
Also, firms with more short-term debt are more exposed to the shocks, so they issue more long-term debt. This is the slow and steady.
The rougher part of the story is that there will be defaults in the process of debt resolution. A big part of debt resolution is about recovery value. Recovery value is pretty pro-cyclical, which isn’t good given the current situation. There are institutional factors of debt resolution that matter too.
The Central Problem is Debt Resolution: Japan Compared to the United States
How society works through cascading default is in part through basic laws of nature. Part of it is based on social tendencies. Another part is through political decisions. Within these parameters, we have yet to see how this will end.