10-01-2008

LESSON FROM JAPAN’S MELTDOWN: $700 BILLION IS NOT ENOUGH TO SOLVE U.S. CRISIS; RESCUE MUST COME IN THREE PHASES

Kenichi Ohmae, Japan's leading management guru, is author of "The Borderless World" and "The Next Global Stage."

By Kenichi Ohmae

Despite the heroic, if impulsive, efforts of America’s political and financial leaders, the U.S. crisis continues to worsen, going through the same three phases of events that unfolded elsewhere. We are now at the point at which it threatens a meltdown of the global banking system as well.

 There are three guidelines to follow in facing this financial crisis:

• Understand the sequence of events as they unfolded in Japan and the Nordic nations, so that the right problem can be solved at the right time;
• Treat the meltdown as a systemic failure and do not act on individual situations;
•  Put in place a new regulatory regime to avoid similar problems occurring again -- but later, after the immediate crisis has abated.

So far, the U.S. government is violating each one of these principles, hence aggravating an already dire situation.  

Understand the sequence of events that unfolded in Japan and the Nordic nations, so that the right problem can be solved at the right time.

If the experience of Japan is any guide, the U.S. financial crisis will go through three phases, each requiring a different set of policies. The first phase is a round of panic and bank failures due to the lack of liquidity. That is the top priority now, as I will discuss in detail.

The second phase involves the working out of bad assets. As the bank write-offs far exceed their equity and the banks cannot raise fresh capital from the market, their share price falls. The Long-Term Credit Bank, Nippon Credit Bank and Hokkaido Takushoku Bank all failed due to the write-offs coming from loans to failing or failed companies.

At this stage, it is important for the government to inject fresh capital to let the banks revive and return to their normal operation. In doing so, the government could end up owning a bank directly or through debt-equity swap. Paulson’s rescue plan is designed for this phase, as its main purpose is to buy bad assets.

The third phase is characterized by the massive failures of operating companies. This is because the financial institutions that survived are being so closely monitored by the regulatory authorities they cannot easily extend loans to traditional customers, or corporations. This creates a problem for companies, which have traditionally relied on the bank loans for their operations. All of a sudden, a banker comes to the company, and says, “ Sorry, we need to close the credit line and you need to return the money to us as your are no longer bankable (a new word they will invent to pull the money from a good company).” In Japan, we have lost hundreds of companies, such as Daiei, which was the largest retailer in Japan, in Phase 3. 

Japan failed to address the right issues at the right time. We know we could have come out of the mess much sooner had the government proactively, not reactively and unwillingly, faced the issues straight on.

It has taken Japan 15 years, and luckily, we are OK now. We do not have any further to fall.

Treat the meltdown as a systemic failure and do not act on individual situations.

The U.S. is faced with a systemic problem, not a collection of individually failing banks. The nature of the problem at hand is the lack of liquidity.

The lack of liquidity has led to what is known as the “wolf pack” syndrome in group theory. While the wolves are good at attacking their prey as a team of hunters, they have a tendency to attack the weakest of their own should extreme hunger prevail. 

If Lehman Brothers goes, the remaining members of the pack look for the “next” weakest victim. After Lehman, it is Washington Mutual, and the next is Wachovia. When Wachovia merges with Citigroup, the diminished pack looks for another victim -- perhaps National City Bank. This process continues until the last few of the pack survive.

In Japan, we now have only three national money center banks, down from over a dozen banks in the 1980s. They are all mega-banks that, according to the Japanese Financial Services Agency, are too big to fail. They are not necessarily good banks, as they do not pay more than .2 percent interest to their depositors. But they are strong enough to call the shots from their oligopolistic commanding heights.

At this rate, the U.S., too, is heading toward an oligopoly of three mega-banks, which is not healthy for any competitive economy.

Almost all banks would be saved, however, if a global credit line were to be set up so that they’d have access to unlimited liquidity. This is not the time for buying bad assets -- which is the core of the Paulson proposal with its $700 billion price tag. As I will discuss, that should come in the second stage once the banking system is flush again.

Banks are failing due to the lack of capital and the plummeting value of their stocks. Gone are the days when long queues of desperate depositers bang on the banks' armored doors. In the 21st century, panicked investors and depositors rush to the Internet to transfer funds in a nano-second, as we have seen with Washington Mutual.

What the U.S. needs to do under the circumstances is seek help from the rest of the world in setting up a credit line that fits the scale of the problem -- on the order of $5 to $10 trillion -- to provide the necessary liquidity so that troubled financial institutions can buy enough time to work out their assets and liabilities without the fear of the wolves at the door. Though necessarily of a far greater amount, this is similar to the “Emergency Room” the Swedes set up in the early ‘90s during their financial crisis. We’re talking about a lot of money, but this amount is suggested by the $3 trillion it cost Japan in public funds and foregone interest to get our banking system back in order over a decade.

It would be a mistake for the U.S. government just to print more money to try to cover this enormous cost. They have already printed too much. Indeed, one of the problems with the Paulson approach is that he is trying to solve all the problems with internal American resources. Even before the $700 billion bailout package was proposed, the U.S. had issued so many promissory notes that the value of the dollar is teetering toward collapse -- something the rest of the world fears greatly.

The International Monetary Fund is the natural facility to provide liquidity for the U.S. banking system. Alternatively, a temporary “global pumping station” like the Swedish Emergency Room could be established under U.S. initiative as a place where financial institutions can come to fill their tanks with the necessary liquidity transfusion.

To assemble a deep enough liquidity facility to inspire market confidence, the U.S. must look beyond its own taxpayers for help in the global financial system. Those outside the U.S. would suffer much more from the fall of the U.S. dollar because they have piled up huge amounts of dollar-denominated instruments. For this reason, they should be expected to chip in.

China has accumulated up to $1.5 trillion in foreign reserves coming from their trade surplus, mostly in U.S. dollars. Japan can contribute $1 trillion that we do not need in a hurry. Taiwan and Russia could come up with $.5 trillion each, and the Gulf countries certainly could come to support Uncle Sam easily with $2 trillion. The EU can collectively contribute $2 trillion, if the facility is made available also to their financial institutions.

That’s already $7.5 trillion, and if the U.S. adds $2 trillion to the pool, the total would nearly reach the requisite $10 trillion. This money will not be lost altogether, of course. Based on the experience of Sweden, we can expect 3 percent interest. After this facility is dissolved in three to five years -- when good banks can walk way -- we can even expect the full amount of the principal returned to the donating countries.  

Put in place a new regulatory regime to avoid similar problems occurring again -- but later, after the immediate crisis has abated.

Only when the dust has settled -- not during the Phase 2 workout -- should a new system be set up that will avoid the same mistakes in the future.

First, in Phase 3, there should be strict guidelines for the process of securitization. We have allowed too much freedom in mixing up the sub-prime loans with the good loans and calling it an edible hamburger.

Irresponsible insurance companies came in and guaranteed the content -- so it seemed. Rating institutions came in and called the minced meat U.S. Prime, which, with this golden label, was exported throughout the world. Freddies and Fannies were also labeled as if they were U.S. government securities. A much more rigorous process of rating the meat, and labeling the mix, must be established. We need to have more rigorous international standards in financial products, like we have with industrial products.

We might also think about making the liquidity pumping station mentioned above a permanent facility.

We need also to talk about short and long trading practices as we revive the system. If the liquidity facility I have proposed had been in place, we probably wouldn’t have had to worry too much about the short-sell pressure that was fatal to some institutions this September.

Then we need to establish compensation guidelines for publicly traded financial institutions. Most of the executives and traders are immediately rewarded for transactions, even if they turn sour later. In Japan, we do not have a marked skew of compensation between the financial institutions and manufacturing companies -- except for the branches of American banks.

In the end, we need to recognize the fact that the rest of the world is really dependent on the U.S. dollar for their reserves and savings. So, it is an act of self-interest to stem the falling reputation of the dollar and dollar-denominated U.S. government securities. There is only one chance to do this right. It will work once, but never twice. There should be no doubt that the rest of the world will quickly realign their reserve positions to neutralize the impact of an American financial meltdown.

The first order of the day, then, is for the world’s “have nations” to establish a liquidity facility to avoid unnecessary casualties coming from the case-by-case treatment of the troubled institutions.

Even following the successful execution of policies in Phase 1, there will be major challenges in Phase 2. Citigroup, for example, has to sell $400 billion Tier 3 assets over the next few years, as it has already announced. What will that mean to its already weakened balance sheet? Phase 2, therefore, will also be as turbulent as Phase 1.

Let’s do what has to be done now and not try to do all three phases in one step. It will take time and enormous sacrifice on the part of the American people to get through this. In its own self-interest, the rest of the world should share the burden.