Wednesday, December 17, 2008

With US Fed Rates At 0.25% (or Zero), Would US Turn Into A Japan Redux?

Houston, we are at ground zero: Fed Cuts Rates to Near 0%, Vows to Bolster Economy

  • The Federal Reserve slashed its target for overnight interest rates to a record low of zero to 0.25 percent, and said it would employ "all available tools" to battle a year-long recession.

    The surprise move to lower its target for the benchmark federal funds rate from one percent puts the Fed in uncharted territory. Financial markets had expected the Fed to lower rates by no more than three-quarters of a point, to 0.25 percent.

    In its statement, the Fed underscored its committment to use extraordinary measures, including using its balance sheet to support the credit markets.

    "The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said.

    The cut in the federal funds rate pushes it to its lowest level on records dating to July 1954, and the central bank said it would likely keep it at "exceptionally low levels for some time."

    "There is no more room to cut rates, as the target cannot go negative," said economist Chris Rupkey of Bank of Tokyo-Mitsubishi. "Quantitative easing will be the new way for the Fed to stimulate the economy going forward."

    In addition to the rate cut, the Fed said it was prepared to expand already announced large purchases of debt issued by government-sponsored mortgage agencies to support the battered US housing market.

Commentary from dearest Kathy, Fed Cuts Interest Rates to 0.25% and Formally Enters QE

  • It is no surprise to see the US dollar selling off aggressively as it is now the lowest yielding G10 currency. This was the right move for a central bank that wants to be proactive and no longer just reactive. There is no point for the Federal Reserve to play games anymore by denying what is already being priced into the markets. Cutting interest rates to 0.25 percent was inevitable and they rather deliver this stimulus now than later. Fed funds were trading as low as 0.15 percent going into the FOMC meeting. The Federal Reserve expects to keep interest rates at “exceptionally low levels for some time,” and to employ all available tools going forward including the purchase of long term Treasuries. In other words, the Federal Reserve is telling us that they are formally moving to Plan B, which is Quantitative Easing.

So are we going to see a Japan Redux?

Back in September, I made the following posting: Comparing Past Japan's Financial Crisis With Current US Financial Crisis

I think it's appropriate that I reproduce what was highlighted then.

Here's an absolute cracker. The following article, Responding to Financial Crises: Lessons to Learn from Japan’s Experience from PIMCO compares the past Japan's financial crisis with current US Financial Crisis and focuses on the similarities and the differences between the two crisis.

Here are some interesting issues pointed out by Mr. Koyo Ozeki

Summary: The Four Phases of Japan’s Financial Crunch
Japan’s financial crisis persisted for nearly 14 years, from the burst of the economic bubble in 1991 until around 2004, but throughout that timeline there were transitions in the state of the markets and the nature of the crisis. Broadly speaking, we can divide the progression into four phases (Chart 1).

Phase 1 (1991–94): The real estate bubble collapsed, triggering an economic shock. The government responded typically with economic stimulus packages, such as public works projects.
Phase 2 (1995–96): Signs of instability appeared in the financial system. Even as banks failed due to financial difficulties, the government failed to come up with a comprehensive policy package that would address financial system issues.
Phase 3 (1997–99): The bankruptcy of major banks triggered a financial emergency. Through establishment of new laws and budgetary measures, the government nationalized failed banks and injected taxpayer money into large financial institutions. Even so, it was unable to resolve the situation.
Phase 4 (2000–04): The system again reached a crisis point due to the massive volume of excess debt held by corporations. The Financial Revitalization Program (“Takenaka Plan”) promoted the disposal of non-performing loans, and the government supplied public funds to tottering Resona Bank. These measures finally helped bring the crisis to an end.

==> The Q&A section was interesting.

Part 3: Questions and Answers Regarding Government Response

Q: Why did it take so long to resolve the crisis?
A: It took nearly 14 years from the burst of the Japanese bubble economy in 1991 until the financial crisis finally came to an end. There are several reasons for this unusually long timeframe.

Hopes for a turnaround in property prices: From the collapse of the bubble economy until the mid-1990s, most people assumed that real estate prices would eventually turn upward again. Policy makers were also focused on encouraging an economic and market recovery through fiscal stimulus measures such as public works projects.

Existence of colossal latent stock profits: At the start of the 1990s, Japanese banks had stock portfolios with unrealized profits amounting to nearly twice their net worth. This acted as a buffer for loss write-offs, encouraging a complacent stance that they could hold out until the real estate market made its comeback. The plunge in the stock prices in 2000 severely eroded these latent profits, and appraisal losses began to have a negative impact on profits. Banks and financial authorities gradually came to recognize the risks regarding the shares in their portfolios, and proceeded to trim their holdings.

Massive scale of the problem: Japan’s cumulative bad debt totaled an estimated 25–30% of GDP, while the value actually written off by financial institutions amounted to nearly 100 trillion yen (US$910 billion) or 20% of GDP. The large banks alone accounted for 75 trillion yen (US$680 billion) of this total (Chart 10). This exceeds the combined value of their net worth of 20 trillion yen (US$180 billion) and 14 years worth of net operating profits at 50 trillion yen (US$450 billion). They realized profits from their share holdings to supplement the portion that could not be covered by net operating profits. Though this conclusion is made in hindsight, it is clear that banks simply did not have the financial strength to dispose of these vast losses in a short period, and they had no choice but to take their time to write off debt using their annual earnings and unrealized profits.

Q: Why did the capital injections in 1998–99 fail to solve the problem?
At the time of the taxpayer money injections in 1998–99, authorities maintained the position that most of the major banks were fundamentally healthy, despite the fact that they were aware of the damage being done to bank capital by bad debt. At the same time, a credit crunch was becoming a serious issue as the banks turned increasingly reluctant to lend, and authorities provided public funds to ease the credit situation. They set their policy goals with this in mind, such as requiring banks to boost their lending to small businesses. These cash injections might be characterized as preventive actions, but because the policy had multiple objectives, it did not act as a genuine incentive to comprehensive bad debt disposal.

Q: Is rapid disposal really the key to early resolution of problem?
: In responding to a crisis, authorities must 1) rapidly analyze the nature of the problem, 2) evaluate its scale, and 3) devise necessary measures. It is difficult to identify the precise causal relationship between financial system measures and a bottoming out in asset prices, but one lesson that can be learned from Japan’s financial crisis is that the delay in recognizing the problem during Phases 1 and 2 (1991–96) made the subsequent fallout even worse, and an underestimation of the situation’s severity and the authorities’ trial-and-error approach in Phase 3 (1997–99) caused the delay in settling the problem.

Q: How effective were the BoJ’s zero interest rate and quantitative easing policies?
Phase 4 of the crisis (2000–04) was a problem of surplus debt at private corporations. Under the surface, however, corporate fundamentals were improving rapidly (Chart 11). The ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) in the corporate sector as a whole took a swift turn for the better, improving from 5.3 times in 1999 to 3.0 times by 2005. Reduction of capital spending mainly made debt repayment possible.


Part 4: Implications for the Subprime Loan Crisis

Differences between U.S. Subprime Crisis and Japan’s CrisisBoth the subprime loan turmoil in the U.S. and the financial crisis in Japan resulted from a bubble created by the presence of surplus liquidity. However, there are several differences.

  • 1. Complex structure of U.S. bubble: Whereas Japan’s bad debt problem stemmed from commercial real estate and excess corporate debt, the U.S. subprime problem involves a more complicated mixture of bubbles related to the housing market, financial institution business models and financial products for investors.

  • 2. Speed of valuations: Japan’s bad debt was mostly bank lending, and valuations took some time as regulators conducted asset inspections. In contrast, the subprime loan problem involved securitized products, so market valuations were completed relatively quickly. The valuation of housing loans by commercial banks in the U.S. could take longer than securitized products, though, so we should keep a close eye on future developments.

  • 3. Creditor nation vs. debtor nation: Japan is a creditor nation and does not rely on overseas financing, so its bad debt situation was an internal problem. The U.S. is a debtor nation, which complicates the matter. Also, U.S. housing loans and other securitized products are widely held by overseas investors, so the risk can easily spread to global markets. This will naturally impact how the government responds to the problem.

  • 4. Scale of the problem: Japan’s bad debt problem on a cumulative basis amounted to a whopping 25–30% of the nation’s GDP (Chart 14), whereas the subprime problem is an estimated 5–10% of U.S. GDP. The difference in scale will likely affect the cost and speed of resolving the situation.

Do read the rest of the article here