Thursday, October 16, 2008

Cygnus Crises

That the current sub-prime crisis is a “black swan” event, a metaphor for induction logic not working after black swans were discovered in Australia, not if you choose to believe all swans are white (or indeed white or black?) Recession is easy to find precedents for going way back, but the sub-prime crisis - is that an improbably 'black swan'. Well yes, if you blame modern financial engineering, and no, if it is comparable to what happened before somewhere - such as in the late ‘80s and through the ‘90s in Japan, and again at the end of the ‘90s in SE Asia. Oh, yes, you know about those? They are topics our latest Nobel prize-winner in Economics, Paul Krugman, worthy successor to G.K.Galbraith, and others at Harvard wrote a lot about. But, just maybe they only got the picture half right? The consensus view in 'the West' was that Japanese banks were insolvent because of their own unique mistakes. They were accused of being under-regulated and even of having weak accounting and poor regulatory reporting standards (only partly and certainly not entirely true). And the Asian crisis was a currency misjudgement caused by de-pegging from the US dollar. That is therefore black swan stuff - couldn’t be repeated in the white swan world of US, UK, Europe etc. not when we knew about it. Did we learn about it?
The Japanese banks’ insolvency was discovered by noticing that Japan’s banks were borrowing at high rates on the international money markets – a sure sign of trouble. But the experts got it wrong by simply blaming the banks and not looking for deeper sectoral causes, not for some years anyway. Is there a lesson here too? Was it just irresponsible bank lending or also irresponsible property markets that the authorities failed to control? Insofar as if we should regulate the former maybe we need to do more thorough zone planning to regulate the latter? The facts of the matter became clear in the US media in the noughties. I recall reading an insightful warning in the New York Times in December 2005 that was news for many Americans at the time. I remember reading the NYT in the Palm Court at New York Plaza, but not a lot of the people I discussed the paper with took too much notice, or of any doom-mongering on Wall Street back then even though it was clear from official stats that property values were now turning south. That’s when I learned how important in world economic history the New York Plaza Hotel actually was! Anyway to return to the main story, property prices rose much faster and more steeply in Japan in the ‘80s than in the US (and UK, Spain, Greece, but similar to Ireland) in the noughties, because speculators used paper profits from a booming stock market to invest in property, leveraging the prices of both higher and higher. Folks made their own complex structured products. Japan’s growth had enjoyed a long one-way trend and deep-pocketed corporations plumped up commercial property market as home prices too were inflating. Export-led economies need construction and property growth to deepen and broaden their domestic economies when, like China this decade, everyone works such long hours and live in such small homes that consumer spending is low.
American readers may dislike being compared to Japan at any time, but it was then and remains still the world’s second biggest economy. That said, there are, of course, differences. Construction alone was for many years over 20% of Japanese GDP when elsewhere in OECD countries 5% or less was the norm. Land values in central Tokyo had increased in every year except two since 1946, with double digit increases since 1983. They tripled in 1986/7 and were forecast to more than triple in the coming decade. The value of all new construction in Japan in 1989 was 150% that of the whole of the USA. In a country only the size of California all of Japan’s building land values in 1991 could be estimated as $18 trillions or almost four times the value of all building land in the United States at that time! This was a bubble bursting to burst, which it did spectacularly in 1991 and continued deflating for years. Even 15 years later properties were worth only half of their values in 1991 even though construction remained at about 12-14% of GDP! The biggest loans that local retail banks make are for construction and property. These banks were in turn guaranteed by the big City banks who traded in international markets and invested the surpluses of major corporations. When construction suddenly halted as property crashed all retail banks became insolvent and this in turn bust the big banks. Because of all the corporate speculation, the collapse wiped also out many company balance sheets. In the US in recent years, although construction was much smaller in the total economy, the leverage applied via property, via mortgage backed assets especially, fed through the financial system to greatly enhance the sector’s economic scale. Property (not construction) is always a huge dependency anyway as a major collateral for household and property development borrowing. US households, like some European countries too, built up consumer spending by annual borrowings on average equal to 60% of annual earned incomes, and from 2003 on much of US growth was supported in this via equity release, and continued even after property values began falling in 2005. Property rises and falls had hotspots however, like CA and FLA and major cities generally. This is also a familiar problem in Asian economies. The countries like Thailand, Malaysia, Philippines with one dominating megalopolis funnel central city property speculation to dizzying levels. Remember when some wag estimated that the Imperial Palace in Tokyo was worth more than Manhatten or all of California? Well soon after that the property market burst and so did the Japanese stock market, after which it never recovered its previous highs (a problem that caused index arbitrageur Nick Leeson to lose $1.5bn fatally for Barings Bank, double it capital, and a situation many western banks are in today). This was a result of 20 years of export success (like the Asian Tigers later before the Asian Crisis of the late ‘90s) growing in a decade as much as the US or Western Europe was growing in 50 years! All this was until the Plaza Accord meeting of 22 September 1985 at the New York Plaza Hotel, when G5 nations agreed to increase the Yen against the US Dollar to rebalance US-Japanese trade. By late 1987 the Dollar ceased falling, at around half its value relative to the Yen. That appreciation of the Yen, allowed Japanese consumers and corporations to buy more overseas. Imports soared in 1986/7 and the Finance Ministry and Bank of Japan, reduced interest rates down to 2.5%. The conjunction of sustained low real interest rates, the hollowing out of industry (particularly SMEs squeezed by major manufacturers) and a multiplied real estate prices - increasingly on a speculative basis, with a shift via zaiteku ('financial engineering') into property and away from manufacturing – sound familiarto you? When mortgages defaulted and property companies crashed, banks had enormous loan loss provisions and write-downs that bankrupted them. The Bank of Japan stepped in with $trillions and it was a decade before banks recovered entirely and have even now not yet regained the credit ratings they once enjoyed when half of the world’s top 10 banks were Japanese. Pumping money into the banks was arguably the wrong end of the food chain, because consumer confidence was not restored and domestic spending remained low and household savings high for 15 years and will probably continue now for another 10! The Japanese property crash by value was bigger than the US is so far today, but in the US the effects are amplified more through the financial system, internationally as well as nationally. When the Bank of Japan aggressively raised rates, investors sold stocks to cover property losses, and vice versa, plunging prices into a 15-year trough. Real estate in Japan is worth less than half its 1991 peak, while over the same period property in the US tripled in value, to about $60 trillions before falling 15% since 2005. In Japan's six largest cities, residential prices dropped 64% from 1991 to last year. By most estimates, millions of homebuyers took substantial losses on the largest purchase of their lives. The image above is not offices, but social housing in Tokyo. In the US peak to trough which is the long term trend of property prices is expected to be 30-35%, but this will vary from place to place. In the US, property values were driven by internal migration to CA, TX and FLA and some other states. The experience contains many warnings. One is to shun red-hot real estate markets, or when doing so to use risky or exotic loans to borrow beyond one's means. Another is to avoid property that’s hard to unload when a market cools. At the top of the list is to learn from the failure of Japan's central bank to slow the rise of the country's real estate and stock bubbles, and then its failure to soften their collapse and failure to deliver any domestic growth impulse to the economy; export-led growth alone doesn’t do it. These are lessons for the new incumbent of the White House from January. Desperate speculators who are late entrants into property bubbles take the biggest risks.
During the boom years Japanese homebuyers felt comfortable about taking on huge debt by using exotic loans that required little money upfront and that promised low monthly payments, at least for a time. A similar pattern formed in the US. Japan had three-generation loans i.e. 90- or even 100-year mortgages to spread payments out over the lifetimes of children and grandchildren! From 1994 to 2003, the number of personal bankruptcies rose six-fold to an annual record of 242,357. In the US, John McCain’s idea of a £300bn subsidy to help distressed homeowners survive their mortgages is not unrealistic. Lawrence Summers idea of infrastructure spending was tried in Japan for years to resuscitate the market and other parts of the economy with expensive public works projects, but they were so poorly planned that they succeeded only in inflating the national debt.
In the late 1990's did the government try a new tack: deregulation. To kick-start the economy, Tokyo started loosening restrictions on the financial industry just as the US abolished Glass-Steagal. While aimed at reviving the banks who responded by merging securities firms and traditional banks, it also allowed investors to create REITS, mutual funds to invest in commercial property. The government also eased building codes, such as height limits, and cut approval times for building permits. Such restrictions were blamed for the high property prices in CA when actually the problem was more one of a lack of new social housing, low-income homes. Japan showed this when despite deregulation, house prices barely moved despite new builds and more money; the problem remained that homeowners could not afford to move if this meant realizing the losses on their existing homes which would match or exceed the lower prices of new homes. Japan’s economy basically continued to flounder because while the banks were saved the debt burden on ordinary folks was not lifted. Prices recovered in cities by less than the population growth of those cities. Western economists believed Japan and Asia to be a black swan while white swan USA would be extremely unlikely to suffer such a decline as severe or long-lasting as Japan's, because the USA is more skilled hand at managing the financial tiller of the American economy e.g. Greenspan and Bernanke’s Federal Reserve. An unlikely or unprecedented event is called a black swan. We have to conclude that the subprime crisis is not a black swan event, though the resultant credit crunch may qualify, why, because all the events and factors leading up to the current crisis were known to those who chose to know them. I preached the lessons to many bankers, but bankers don’t like economics. The Asian Financial Crisis too.
From a macro perspective, the Asian financial crisis and the sub-prime debacle share similar causes and symptoms – namely a prolonged period of low interest rates leading to accelerated lending, after the fact regulatory oversight, concentration risk (low risk diversification) and asset bubbles that remained very dangerous bubbles even when the risk could be insured or sold on. Financial service firms could not differentiate their individual risks understood merely in balance sheet terms and systemic risk when all counterparties would default together (so called double default risk). And the advent of financial derivatives has made the sub-prime crisis more complicated still. The US current account deficit ballooned to above the crisis threshold of 5% of GDP before the sub-prime crisis broke, just like in Asia before the 1997/98 financial crisis. Notably, Thailand, where the Asian crisis started, had a current account deficit of over 8% of GDP prior to the crisis; the US had a current account deficit of 6% in the year before the sub-prime crisis. These are not the highest around. Greece has a trade deficit into double figures. These deficits had to be financed and that meant selling financial assets to the export surplus countries. When credit boom Governments’ bonds were insufficient, private mortgage-backed bonds filled in and grew and grew. The blow-out in US loan-to-deposit ratio resembles SE Asia prior to its regional crisis ten years ago. SE Asia financed its excessive spending by foreign borrowing, and so did the US, a problem issue Barack Obama is now very conscious of. Foreign debts in US and the three Asian countries that needed bailouts by the IMF (Korea, Thailand and Indonesia) all soared before their respective crises. The IMF role is now being reconsidered for similar emergency action again and this time the countries in need will include many emerging markets including some in Europe experiencing currency crises.
Asia’s role in the US/Europe financial crisis is not a black swan. Cheap goods from Asia, notably China, arguably helped to keep down US inflation though the effect was really to shift spending from goods were inflation is measured to services and property where inflation is not measured. Nevertheless, using a narrow household inflation measure the Fed was relaxed about spending levels and household debt so long as households had net property assets. $4.3 trillion of dollar reserves held by Asian central banks, combined with $trillions of petrodollars from the Middle East, recycled back into the US maintained the economy’s liquidity. This poured into US Treasuries and mortgage-backed securities, lowering US bond yields and narrowing government and non-government risk gradings and spreads, encouraging households to seek the higher returns of property price rises to maintain high consumer consumption. This of course was a benefit to emerging markets like China, whose total GDP is only twice the US trade deficit and a quarter of which depends on exports to the US. Export growth-led frugal Asians, notably the Chinese and Japanese who account for over 40% of the world’s central bank reserves, lived below their means with savings flowing westward to allow the spendthrift Anglo-Saxon economies plus a few continental European states to live (arguably) beyond their means. While it lasted, this cross-Atlantic saving-spending became a stable dis-equilibrium. Now that party is over, Japan and the BRIC economies will suffer too as the pattern of world trade goes into reverse gear. US growth in the last year was mainly explained by export growth and falling imports, while China and Japan’s growth rates were led entirely by domestic demand until their recessions kicked in following stock market and other asset price collapses. Japan has already announced it is in recession while China will follow some time in the near future. The crisis is getting more global and yet also closer to a full-scale governments-led bailout and a U, if not L-shaped recovery, but not a V-shaped rapid bounce. The global leadership in this will be USA first, Europe second, and in this respect the USA needs to recognise that its present crisis is neither white swan nor black swan, but both.
My thanks to Chi Lo, Dir. Research at Ping An (China Asset Management, HK) for some of the ideas in this essay. Note that white swans are Northern Hemisphere, black are Australian and SE Asian, while black-necked are South American. There are many sub-species. Some analysts have several times argued publicly about sub-prime crisis and recession, notably Nassim Taleb whose book The Black Swan: The Impact of the Highly Improbable is a US best-seller just now about randomness and uncertainty including in financial risk matters. Aristotle's Prior Analytics used example syllogisms involving "white", "black" and "swan." Aristotle used White Swan as accepted fact and Black Swan as improbable, demonstrating deductive or inductive reasoning, though neither is infallible since premises of an argument may support a conclusion but a false premise leads to false results, and inconclusive premises to inconclusive results. John Stuart Mill our first social scientist used the black swan narrative to discuss falsification.

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