Don't Repeat Japan's Mistake

The Japanese way or the American way?

That’s the choice now confronted by the Obama administration as it tries to stabilize our financial system. Unfortunately, it seems to be making the wrong choice, which could have disastrous consequences.

As is now well-known, by refusing to recognize the dire condition of Japan’s banks until the late 1990s, Japanese policy makers prolonged their country’s malaise and made economic recovery more difficult.

When the US government took over scores of S&Ls in the 1990s, the cost to the taxpayers turned out to be only about 20 percent of what was predicted.

In the same decade, things were done dramatically differently in the US, when many savings and loan associations failed, and in Sweden. In both cases, the government quickly took control of the banks, cleaned up bad assets, and returned the banks to private ownership, a strategy that resulted in shorter and far less severe economic declines. Sweden had to choose between hoping its banks could earn their way back to solvency or taking them over for a brief period. The Swedish government decided that the former path was too dangerous because it could be lengthy or things could get worse—something that with each passing day may now be dawning on the new Obama administration. In the US in the early 1990s, the government set up the Resolution Trust Corp. to deal with the toxic assets infecting the balance sheets of failing S&Ls.

This time around, however, the US Treasury Department appears to be veering toward the problematic Japanese approach. In the case of Citigroup, for example, the Treasury and other investors have converted part of their preferred stock to common equity at a price about three times the current market. So the government, which now owns 36 percent of the bank, now has no dividend and a more junior security. Citi has more tangible common equity, but not enough, especially after deducting deferred tax assets that may never be utilized. No toxic assets have been removed from Citi’s books, making more writedowns and government assistance highly likely.

Indeed, the two major ratings agencies, Moody’s and S&P, lowered Citi’s credit rating after the government’s new deal was announced. (Within a couple of days, Citi stock was selling for less than $1 a share, down 95 percent over the past year.) Private capital is unlikely to invest, given the continuing uncertainty about the real value of Citi’s assets. This strategy amounts to nothing more than the old “kick the can down the road and keep walking” approach so typical of government bureaucracies. Unless the Treasury changes course, the estimated $2 trillion of toxic assets on US banks’ balance sheets will be clogging our credit system indefinitely.

Another key aspect of the government’s plan, the Treasury’s bank stress tests, only adds to the worry. For starters, the tests are administered by the banks themselves, and stress testing is a highly imprecise art, as is evident from the bank’s own failure to predict their loan losses over the past 18 months. The economic assumptions behind the stress-test scenarios are also suspect. The Treasury Department says the banks should assume GDP growth of 0.5 percent to 2 percent in 2010, hardly a worst-case scenario. And finally, the implementation of the post-stress test rescue plan is also flawed. To receive government funds, a bank will be required to increase its lending by an agreed amount, another failed tenet of the Japanese bailout. Banks need to lend to creditworthy borrowers, not just to meet arbitrary government mandates. It is just those lending policies that contributed to the subprime mortgage crisis and the implosion of Fannie Mae and Freddie Mac.

Instead, the government needs to create a new Resolution Trust Corp. The new RTC would immediately take control of banks that would be insolvent if their assets were valued at the price that could be received today, just as the old RTC took over failed S&Ls. The new RTC could then sell the toxic assets or hold them. At the same time, the new RTC could extinguish all or part of the current equity and funded debt of the failed institution and replace boards and officers, if desired. It is just not credible that the same boards and managements that created this fiasco in the first place be given the job of repairing the damage. The banks would then be “clean,” and private capital would surely invest, as the franchises are valuable, particularly those with large bases of deposits. This will return us to a healthy banking system capable of increasing lending and fueling an expanding economy.

This bank-cleansing process could happen relatively quickly. IndyMac, seized in late 2008 by the FDIC, is already in the process of being returned to private ownership. Washington Mutual, another recent ward of the government, was restructured and quickly sold to JP Morgan Chase. Nor does the government have to get in the position of trying to manage these institutions over an extended time period, something critics have argued, probably correctly, that it is incapable of doing. The government can, and often has, financially restructured banks and changed boards and managements before privatizing them once again. And there is another hopeful precedent to proceeding in this fashion: When the US government took over scores of S&Ls in the 1990s, the cost to the taxpayers turned out to be only about 20 percent of what was predicted.

The US is now at a crucial tipping point, but it’s not too late for the Obama administration to change course. The “N” word—nationalization—upsets many Americans, who see it as a path to socialism, and some in the administration appear fearful of taking this kind of bold action. But nobody seriously believed that the US was taking a step toward socialism when the original RTC was created. And as we’ve seen before, government ownership only needs to be for a short time, until the government prepares the banks for a return to private ownership. Let us not jeopardize the trillions of dollars we are spending to end this malaise by leaving our banks frozen by their toxic assets.

Stephen Robert joined Oppenheimer & Co. in 1968 as a portfolio manager of the Oppenheimer Fund. He became a member of the Executive Committee and Director of Research in 1977. In 1979, Mr Robert became President of the firm and in 1983, assumed the role of Chairman and CEO. From 2005-2008 he served as Chairman and CEO of Renaissance Institutional Management LLC.