A Japanese Tale

In early 1991 I read in Newsweek that the land value of Greater Tokyo was worth 20% more than the whole of the USA.

If a hypothetical owner of Tokyo sold his property in early 1991, he could have bought outright all 50 states of the USA and still have 20% of his capital available to develop his new home - the US of A. UNREAL!

As an ex-physicist and ex-computer systems analyst turned technical analyst with an interest in markets and economics, this fact to me spelled Disaster with a capital D. From that time on I gathered as much information I could find about what was happening in Japan and why the situation had developed in the first place. This became more urgent when the property bubble burst later in 1991 - and it became evident to me why the whole world was being caught up in a vortex that would drag most economies into its depths.

We begin with a brief review of why this situation developed at all - and then see how the property meltdown was handled in Japan, what it probably meant to the Japanese economy and also how the rest of the world reacted to this. The next section is perhaps of greatest interest to Americans. It deals with certain changes in Japan's posture towards the US, and what these changes could mean.

All this hints that Japan could well be preparing an economic "Pearl Harbor" in the not too distant future. Either that, or the mother of all kamikaze attacks.

Finally, we take an exploratory look into the future in the light of what is presented here.

Historical background

After the Second World War, the devastated Japanese economy began its recovery by concentrating on the manufacture and export of low quality merchandize. Authorities soon realised this was not a long term solution for growth, and consequently formed the Ministry of Trade and Industry (MITI), which is still a major force today. New regulations required the MITI's seal of quality before any product could be exported. This was just what was needed to make a mark in the post war world hungry for consumer goods.

One other matter that was of concern for the authorities was to find a source of working capital so that the new companies could maintain the steep growth curve that was fast becoming a reality. They knew, probably from past experience in their small island state, that property was always a good investment in a strong economy. They therefore allowed companies to revalue any land they owned on an annual basis, knowing that the rising demand for land would keep prices in a steep trend. By this means the balance sheets of companies strengthened annually, enabling them to obtain ever increasing loan levels from the banks.

This worked like a charm. As the Japanese economy grew, making ever greater demands on the relatively small amount of land suitable for industrial use, land prices rose steadily and steeply. Companies were able to obtain additional working capital after each revaluation of their property. Understandably, banks were keen to lend to the full value of such good collateral.

The 1973 oil crisis.

Matters went along smoothly and the Japanese economy grew by leaps and bounds, becoming the envy of the rest of the world. Then the 1973 oil crisis erupted and energy poor Japan entered a period of high inflation. Interest rates soared and so did mortgage rates, which of course meant that companies were tempted to sell their property holdings to get their hands on the very extensive capital gains, after which they could earn interest on the cash so realised.

Authorities were again quick on their feet and, realising that a sell-off in property would lower prices and put financial institutions at risk, they instituted a measure to stop the rot. It was ruled that any company that sold its property and then failed to put the proceeds into a more expensive property within one year would have to pay an 80% capital gains tax, if I remember the figure correctly. As can be expected, this measure nipped the threatening sell-off in the bud and added additional incentives for companies to hold onto the land they owned. Further, this meant that financial institutions viewed fixed property as by far the best form of collateral for any loans they may make.

Of course, with this measure in place the after-burners were lit and property prices really took off.

For obvious reasons, mortgages was a favourite among financial institutions and it can be accepted that they had little hesitation in writing a mortgage very close to or for the full amount of the purchase price.

CNN reported at one point in time that by about 1989 Japanese authorities became very concerned about the degree of exposure of the banks in Japan to mortgages. They addressed the potential problem by placing a moratorium on the ability of banks to write new mortgages. The report went on to say that the banks circumvented this rule by lending large amounts of money to the building societies, which, of course, meant that the new regulation had no effect on the intended limitation of the banks' exposure to risk.

During the next two decades prices of property first went through the roof and then continued higher. When, according to Newsweek, the value of greater Tokyo in 1991 was 120% of the value of the US, it was clear to me that the situation had become completely irrational according to every possible interpretation of the basic principles of economic theory. Sooner or later something had to give; the slump started in second half 1991 and by late 1992 property prices were as much as 40-50% off their early 1991 highs. Prices continued to slump and are now more than 60% of their highs.

The reaction in Japan.

According to a report on CNN, once property prices fell by 40% and more, many property owners stopped paying installments on their mortgages – the reasoning being, why should one pay good money on a mortgage of ¥10 million if the property is only worth ¥5 million?. Surely it is wiser to put the installment money into a special account and later, when the property market has bottomed, use that money as deposit for the purchase of the same or another property.

Even if the bank should foreclose on your property, it sooner or later has to sell it by auction and then the you can buy it back at a much lower price – and end up with a much lower mortgage!

Of course, if your property was owned by your company and you had borrowed against the balance sheet, this option was not as readily available. Matters really had to become very tough before the company as a whole would be placed at risk of foreclosure by defaulting on servicing the loan.

The squeeze on institutions.

With their cash flow drying up, financial institutions were suddenly being squeezed. In addition, they also faced a more serious problem of a regulatory nature – information again courtesy of CNN. In Japan, if payments on a mortgage are six months or more behind, the lending institution must consider the full outstanding amount of the bond as bad debt.

Given the magnitude of the situation, this could not be allowed to happen. According to CNN, the banks and building societies came up with an ingenious solution. Once an account is five months behind, the bank approaches the lender with the following proposal: 'We are prepared to make you an interest free loan, repayable only after the mortgage itself has been paid in full, on one condition: you must use the loan to pay the installments in arrears that are now due.'

Since the borrower knows that the odds of the mortgage ever being paid in full are rather small, if not non-existent, there is of course no reason to refuse such a generous offer.

It was also about this time that CNN reported, quite tongue in cheek, that members of the newer golf clubs in Japan were taking out insurance to obtain cover for the very large amounts of money they had to pay just to join the golf club. The reason for this strange behaviour, it turned out, was that the market value of the land on which the golf clubs were situated had fallen so far below the amount of the mortgage that the banks were foreclosing. This they apparently could do, because the practically vacant land was much in demand from speculators who could turn a profit by turning the golf club into a housing estate.

Given the Japanese fascination with and passion for golf, this said a lot about the severity of the situation.

It is of interest to note that a front page article in the NY Times (30 July 1998?? – could you check on this, please) in which the situation in Japan was reviewed, stated that a similar practice was being applied to overdrafts and loans to companies that were no longer able to service their debt.

The magnitude of the problem

When property prices fell steeply, it was of course no secret that Japanese financial institutions were facing a spot of bother. Some minor - and even not so minor - building societies and banks were in real trouble and had to be baled out.

The problem of course was due to bad loans and non-performing mortgages on property, which, as noted above, was to quite a significant degree concealed from public view. The question therefore becomes, 'How large is the total amount of potential bad debt faced by the banks.'

Initially, the amounts bandied about in the media and by government spokesmen were of the order of $4-5 billion. This was gradually pushed up, at first to $7-8 billion and then to much larger amounts. Quite early on, time the government established a ¥9 trillion (about $90 billion at the time) fund to support banks with bad property loans. It would appear that this fund was oversubscribed within a day. Much later there was a large jump in the estimates, to $250 billion or thereabouts and more recently the government indicated that the problem could be in the vicinity of $500 billion.

It is interesting that all comments so far – even the 'outrageous' $500 billion estimate – as a rule only referred to non-performing loans, mostly mortgages, that had gone sour. Is this the true picture?

The loan books of Japanese banks.

Trying to analyse the state of the loan books of Japanese banks is of course a matter for speculation. The key to this speculation is the question of what the exposure to property as collateral of the total loan book is likely to be.

Given the above history, combined with the fact that between 1989 and 1991 – when the banks were constrained from writing mortgages - much money was lent to building societies, it is clear that the exposure to property must have been a significant percentage of the total loan book. Property prices, we know, were extremely inflated – if Greater Tokyo was worth 120% of the value of the USA, then the whole of Japan could easily have been worth double the value of the USA.

However, even though astronomical amounts have been supplied against mortgages, this is likely to be only the tip of the iceberg.

It can be stated with near certainty that property constituted the single biggest asset category - and in many cases nearly the full asset base – of most Japanese companies. It means that when these companies obtained overdrafts or other facilities from their banks on the strength of their balance sheets, the funds loaned to them were largely secured by the underlying value of the property owned by the company.

Under these circumstances, the percentage of the total loan book of Japanese banks with property as collateral could easily be in the range of 70%-80%.

It was reported in an article on Reuters in early 1997 that the total loan book of Japanese banks is of the order of ¥750 trillion – or just less than $7 trillion.

If the above reasoning is correct and if a 50% fall in property prices is assumed, the amount represented by the fraction of the loan book that is now unsecured be about 35-40%, or about $2,45 - $2,8 trillion dollars.

To place this in perspective, the unsecured portion of the loan book is estimated to be about one third of US GDP and probably about 60% of Japanese GDP.

This estimate of course does not represent officially recognised bad debts due to lapsed payments of mortgages and other non-performing loans – the sole topic of discussion in the media so far. The perhaps $2,8 trillion is the amount of 'missing' collateral, which represents the potential shortfall in depositor's accounts if the deterioration in the economic situation in Japan continues, as seems to be the case still.

Any attempt by the banks to foreclose on bad and non-performing loans and then to sell the newly acquired property would of course increase the magnitude of the problem they already face.

© January 1999 Daan Joubert
All rights reserved.

(Part II next week)