Is US entering Japan's nightmare?

Mitsubishi wasn't alone. The Ministry of Finance was putting pressure on all the country's big banks to make more loans to failing institutions, often at no interest, or to buy loans at face value. In 1994, official figures put the nonperforming loans at the country's 21 biggest banks at $136 billion. If you added in the bad debt from these affiliates, however, the total came to $400 billion.

A day of reckoning that lasted a decade

Eventually, all this asset shuffling and all these accounting gimmicks couldn't hold off a final reckoning. Even a $70 billion bailout in 1999 wasn't enough to turn the tide. By 2000, a wave of 25,000 bankruptcies finally rippled through the Japanese economy.

In the fiscal year that ended in March 2000, Tokyo's big banks sold $20 billion in stock from companies they had propped up, sending the Nikkei stock index down an additional 35% in the last nine months of 2000. That returned the stock market to the lows it had hit a decade ago.

It would take Japan's economy, stock market and real-estate prices five more years to recover. The final result was more than a decade of slow or no growth in the Japanese economy and in Japanese asset prices.

Will it happen here?

That's why I worry that the Federal Reserve is going to repeat the mistakes of the Japanese financial crisis of the 1990s. In the third and fourth quarters of 2007, we had the kind of quick write-downs and acquisitions under duress -- like Bank of America's (BAC, news, msgs) deal to buy troubled mortgage lender Countrywide Financial (CFC, news, msgs) -- that are required to put a financial disaster relatively quickly to bed. Citigroup (C, news, msgs), Merrill Lynch (MER, news, msgs), Morgan Stanley (MS, news, msgs), Bear Stearns (BSC, news, msgs) and other big banks wrote off billions in asset-backed securities and derivatives that had tumbled in price. The write-offs seemed big enough to account for about half the total of distressed securities at these banks.

But then came the Federal Reserve's surprise three-quarter-point interest-rate cut on Jan. 21 and a half-point cut Jan. 30. And banks seem to be hoping they can squeeze through again.

If interest rates drop enough, it might be sufficient to support the prices of distressed assets so that banks won't have to write them down. If interest rates drop enough, banks will be able to raise new capital and avoid having to sell distressed assets at distressed prices. If lower interest rates keep the economy from slowing too much, maybe banks won't see a big jump in defaults from overstressed corporate and consumer borrowers.

The trouble with wait-and-see

If I were a bank looking at the policies of the Bernanke Federal Reserve, I'd certainly take a wait-and-see attitude. Maybe the Fed will bail out my loan portfolio, I'd think, so I don't need to take the write-offs now. I'll wait.

What's so bad about that? Well, while a bank is waiting and hoping to scrape by, it's still sitting on billions in "challenged" securities. For example, in its annual 10K filing for 2007 with the Securities and Exchange Commission, Morgan Stanley reclassified $7 billion in assets to Level 3, the riskiest category under new accounting rules and one that says there is no market for these securities and thus no way to publicly value them. Morgan Stanley didn't take a charge on this accounting shift.

But Morgan Stanley and other banks can't be certain they won't have to write off these assets, so it's prudent, from the banks' point of view, to take less risk now and make fewer loans. They know the prices on these assets still can't be trusted, so they're not about to buy them from other banks or gear up to create more of them in the mortgage market.

How to lessen the pain

By giving banks the hope they can dodge rather than bite the bullet, the Federal Reserve has created the possibility that what would have been a very painful but short lesson for the banks could turn into a long-term drag on the financial markets and the economy.

If banks lend less because they're spending so much time watching their past mistakes that they shudder at the idea of adding loans to their balance sheets, if nobody trusts the prices for distressed assets, so big parts of the financial markets remain frozen in place, if consumers and corporations with decent credit can't get new loans to fix bad ones or to expand production or consumption, then the economy will run slower than its potential. And if the Japanese experience is any indication, it will run slower for a very long time.

Slower economic growth and the accompanying low returns to investors from bonds and stocks would be a big problem for a U.S. economy that faces the huge challenge of paying for the looming retirement of the baby-boom generation.

All of which puts me in the very odd position of hoping to see another round of painful write-offs from the big banks at the end of the March quarter. That would help me believe we're still on the road to putting this mess behind us in a matter of quarters, rather than years.

Continued: Updates to Jubak's Picks

< previous |  1 | 2 | 3 | next >