The New Post-Recession Paradigm

February 11, 2010

Susan Jansen
, Managing Director & Head of U.S. Credit Research, Nomura Securities International Inc.
Alicia Ogawa, Adjunct Associate Professor, School of International and Public Affairs; Senior Advisor, Center on Japanese Economy and Business, Columbia University
David Resler, Managing Director & Chief Economist, Nomura Securities International, Inc.

Leslie Norton
, Foreign Editor, Asia, Barron's

A distinguished panel of specialists in economics and financial markets met at Japan Society to reflect on the way forward after the global economic downturn.

Moderator Leslie Norton of Barron's asked the panel:

How would you grade President Obama's first year and Prime Minister Hatoyama's first half year?

In the case of Prime Minister Hatoyama, the grade would be "mostly absent," said Alicia Ogawa of Columbia. The prime minister has been largely silent on financial market issues. Though Japan's financial crisis has been stabilized, "there hasn't really been much real reform that has succeeded in changing those behaviors in Japanese banks which led to the 1990s crisis."

To President Obama, Susan Jansen of Nomura would give a grade of "mostly town hall," she said. On the positive side, the president "was very supportive of the Treasury and the Fed when we needed it most." His legislative agenda is another story. There's little that's helped business, and "seeking to put a bank tax on the financial markets, who have largely repaid all of their loans, is pure populism."

President Obama has earned "at best a C," said David Resler, also of Nomura. Upon taking office, the president "decided to turn his agenda over to two fairly unpopular leaders in the House and Senate, Pelosi and Reid," and left it to them "to formulate the fine details. I think that was a big mistake."

"In all fairness," Dr. Resler added, "rating any president after one year, the only thing you can give any president is an incomplete, because much has yet to be done, and certainly all is not lost." The election of Scott Brown to fill the late Senator Edward Kennedy's seat "may have been a wakeup call" for the administration to re-engage Republicans and win back broad support.

Globally, how does the rest of the year look to you? There's turbulence in Southern Europe and Ireland; will it be confined to the euro zone?

"Contagion is a reality of the world we live in," Dr. Resler said. "I do think the global economy is on more solid footing." The U.S. manufacturing sector has surprising vigor, likely because of much stronger economies in Asia ex-Japan.

"A handful of consumer sectors are actually getting a little bit stronger as well," one being cruise line bookings and the like, Ms. Jansen said. Overall, recovery among U.S. corporates is "extremely fragile, and it's extremely disparate. There are plenty of sectors out there, like the commercial real estate sector, that are in great difficulty."

The possibility of contagion from the euro zone "is clear. There is no part of the world that is not connected. And I think it is something that, should it grow and should it become more difficult, it could certainly set the U.S. economy back."

"We don't really see any signs of green shoots in Japan yet. And this is I think a bigger concern than people seem to be giving attention to," said Professor Ogawa.

"Someone who was born in 1980 who is now 30 years old... has never ever in his adult life seen interest rates go up or the stock market go up. I think sociologically it's really an important, interesting study to be done on how that affects someone's attitudes."

The market for Japanese government bonds is huge, but almost entirely domestic. Households, directly and through bank accounts and pension funds, own 51 percent of JGBs outstanding, she noted. With many new retirees who will be drawing down their savings, "it's really not clear where the demand for JGBs is going to come from." To pursue foreign investors, JGBs will have to pay much higher rates, "and it will be very, very interesting and difficult to see how the JGB market reacts to that."

What kind of recovery can there be in the United States given the debt crisis?

It will not be "quite as dire an outcome as Japan has seen over the last decade and a half," Dr. Resler said. In both the U.S. and Europe, quantitative easing has been employed to good effect, whereas Japan's use of that tool "has been marginal at best."

As Americans deleverage, he added, we won't see the early surge in consumer spending that typically happens after a deep recession. Thus the U.S. recovery will have to rely to an unusual extent on exports and capital spending. The good news here is the strength of demand in China and other non-Japan Asian countries, which will lift American exports.

Ms. Jansen noted, "The largest share of the U.S. corporate market is sitting on absolute mountains of cash." Companies' expectations for their own growth are restrained. Given these factors, even a slight rise in demand will trigger the deployment of some of this cash, for example on technology, where spending has been low relative to GDP.

In both Japan and the U.S., companies have cut jobs and salary expenses in order to show better net earnings despite drops in sales, she said. This has dragged on for a decade in Japan, where it's become a structural problem. "You have no growth in salaries, no growth in wages, and you have for Japan a record high unemployment rate, and yet companies refuse to go out and hire, or to pay higher bonuses and salaries." The hope is that the U.S. will avoid repeating the pattern.

Are the U.S. and Japanese governments going too far with proposals on a new global bank tax, or not far enough?

"We, looking at corporates, get nervous about huge amounts of additional reporting burdens being put on companies," Ms. Jansen said. "Comprehensive regulation of financial markets protecting the consumer is a hot button, and certainly is very debatable."

"I only hope that regulations, as they come out of the other end of the political sausage factory, end up with more transparency and help us all to understand where we are going, and where we are investing."

In Professor Ogawa's view, the bank tax proposals are "really a response to a much more structural problem," namely the "artificially low" cost of capital being paid by financial companies that are "still judged too big to fail, or too important to fail."

"I would like to see them pay the kind of cost of capital that their risk profile really would represent," which "would solve all kinds of problems" including compensation: "you can only pay in compensation what is left over after you pay for raising capital."

Business finance in Japan needs to become less bank-dominated and more flexible, she added. "One of the CEOs of one of the largest Japanese banks operating here told me that a year ago he was looking at very large losses on his credit portfolio, but that over the past year he had been managing to trade those up, and his P&L was looking pretty good, and he said, 'There is no way I could have done that in Japan.'"

Dr. Resler commented, "It's pretty easy to define the rough outlines of what ought to be done" to re-regulate the financial markets, but "it's another matter altogether to do so in a way that gets it right." Sarbanes-Oxley, which was supposed to fix the Enron and WorldCom problems, "has done no good that I can detect whatsoever." In 1982, the Garn-St. Germain bill raised the level of federal deposit insurance from $40,000 to $100,000, but "literally the fingerprints of guilt were all over that legislation for creating the thrift crisis."


The audience joined in the Q&A:

Maybe to pick up on this last point about regulation: It's difficult to understand the specifics of what the financial sector would actually propose to improve the regulatory situation.

"Your point is well taken, that the industry does not speak with a single voice, and quite often it's a voice of opposition to specific proposals without necessarily constructive alternatives," Dr. Resler replied. "Many people in the system I think quietly believe that as bad as things are, you're likely to make it worse with anything that's done, but recognizing the political reality and imperative of the day that at least you have to move in that direction, will support some kinds of reforms."

One that has some merit is a financial-institutions fee, provided it's used "to fund the creation of some kind of new resolution authority" for institutions not now covered by the FDIC, rather than simply added to general revenues.

"That could be a step in the right direction," he said. "The big failure of the system was that when Lehman needed to file for bankruptcy, there was no effective mechanism to resolve that crisis without the crisis spreading throughout the entire financial system."

"The Lehman example is the perfect one" in terms of positive regulation that "can be very helpful in terms of breaking up banks" and resolving global bankruptcies, Professor Ogawa said. "It always boils down, like most ugly things, to several very hard, horrible facts, which is to say financial institutions fail, will cause trouble, will do so again, will do so every number of years." There are really only three things to do: "inject new capital; ... set up some kind of asset management company, a bad bank to sell off the bad assets; or ... steepen the yield curve so that banks can earn stuff back."

Now, the question is who pays, and when do they pay, and through what form do they pay, and that's the discussion that really needs to happen.

It's just like resolving the issue of cost of capital for companies that are too big to fail. It's one of those big elephants in the room that nobody ever discusses, but that is the political issue. It's not a financial issue. It's who pays for those three bank rescues that always have to be trotted out.

"I don't think you're going to gain anything by making Citibank a hundred little Citibanks, or if Lehman Brothers were 1,000 different little Lehman Brothers," Dr. Resler objected. "The problem is not one of size; it's one of complexity. The system is simply too complex to let these very closely interconnected firms fail. Actually you probably could let them fail," but only if you "have a mechanism that allows the losses to be born by creditors. Make creditors more attentive to the balance sheet of their counterparties."

Would you make equity holders bear the losses too?

"And equity holders--they're out," Dr. Resler agreed. "The firm fails, they should be out."

"Part of the Lehman problem was that when Lehman failed, they had something like 900,000 unclosed derivative contracts," Ms. Jansen said. Despite some foot-dragging, there's firm industry support for beginning to clear derivatives on exchanges. This is "one of the regulations that I actually think will probably succeed, and it probably will bring more transparency to the derivatives market, which is a virtually opaque market."

The CCC bonds, the lowest part of the high-yield market, were the first part to come back. Recognizing that there's going to be a population of investors that are going to keep reaching for yield, is regulation the answer? Or is it better risk management on the part of financial institutions?

It doesn't make sense to have endowments going after investments with a 32 percent annual return, or top Fortune 500 companies "still basing their pension liabilities on the expected yield of 9 percent," commented Professor Ogawa. "One of the easiest things that Treasury could regulate would be to say for an endowment or a pension fund, x percent over Treasuries is deemed risky, or something like that. That's what I would do."

"Frankly I'd hate to see the Treasury telling the private endowments what they had to achieve or not achieve in terms of earnings," Ms. Jansen said. "We have seen risk appetite return in ways I don't think any of us ever suspected, and that is in the face of some very, very high default rates." However, "a fool and his money are soon parted, so let's see what exactly happens."

"Right now it seems as if the default rate is falling" and market prices are assuming much lower default rates than the rating agencies forecast, she concluded. "So, the market would suggest that it's gotten ahead of itself. But to let fools enter the market and to let them invest in triple-Cs--that's what a market is all about."

--Katherine Hyde
Topics:  Business, Policy

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