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The Risk of Avoided Pain: It's More Than Quarterly Earnings


Japan entered its protracted period of asset deflation with enormous surpluses and savings, while Americans face housing deflation while already burdened with debt and leveraged to the hilt.


MVHQ is proud to introduce the 'Ville's newest professor, Eugene Linden. Best known for his journalism and social criticism, Eugene Linden has in recent years entered the world of finance as Chief Investment Strategist for Bennett Management, a family of hedge funds specializing in distress investing.

OK, we're entitled to be confused, irritated, maybe even a bit homicidal. Just a couple of weeks after being told that the worst of the credit crunch is over, things are normalizing, markets are functioning, etc., a Treasury Department choreographed dance troupe of Citibank (C) J.P. Morgan (JPM) , and Bank of America (BAC) comes tripping onto the stage pushing a $200 bln concoction to restore liquidity for off-balance sheet entities called SIV's (Structured Investment Vehicle) ... because the credit crunch is not over, because things are not normalizing, and because markets are not functioning, etc.

It seems that everybody wants to sell their mortgaged-backed securities, except that nobody wants to see a price established in the marketplace because that would force them to mark down or sell their other holdings. We've seen this movie before, but the most recent version was in Japanese.

Before the Japanese real-estate bubble burst in 1991, it looked as though the island nation was well on its way to rivaling the U.S . as the preeminent economy on the planet. Even after the bubble had begun to deflate, Michael Crichton (who is turning out to be one of the better reverse indicators in the world) published Rising Sun, which painted a scary picture of an unstoppable, ruthless, rapacious Japanese machine.

So think: when was the last time you worried about the Japanese taking over the world economy? Even as Rising Sun scaled the best-seller lists, the Japanese machine was grinding down towards a wallow in deflation and anemic economic growth that afflicted the nation for the next fifteen years and continues today. A number of factors halted the Japanese juggernaut, but prominent among them was the reluctance of the banks and government to acknowledge and accurately price more than $1 trln in bad debts left behind as commercial real estate lost 80% of its peak value.

In a political economy dominated by cronyism, banks and government adopted the same "don't ask, don't sell" attitude that Prof. Mike Shedlock ascribes to the SIV bailout plan. Partly as a result, so-called "zombie" companies did not die, and the unacknowledged rotting corpses in the bank vaults cast a pall over lending that even zero interest rates could not lift. The cost to Japan's position in the world was far greater.

Back in the early 1990s, Japan was home to the eight largest banks on the planet ranked by assets. Now, only one Japanese bank – Mizuho Financial Group – remains in that elite group. In Asia, China has displaced Japan as the rising global player. That was probably going to happen anyway, but the Japanese graciously stepped aside when their government and business leaders opted to preserve their wealth and prerogatives at the expense of the health of the economy.

Of course, the Japanese experience does not necessarily provide a road map for what is going to happen in America (although housing is already well on the path to asset deflation). Also, Japan remains an economic powerhouse. But Japan entered its protracted period of asset deflation with enormous surpluses and savings, while Americans face housing deflation while already burdened with debt and leveraged to the hilt.

We also enter this period with the international community already speculating on how long the U.S. will (or should) continue to enjoy the prerogatives of issuing the world's reserve currency. London is challenging New York as the most important financial center in the world, and we've certainly lost moral authority and goodwill around the world as a result of the Iraq quagmire.

The best argument to maintain the U.S.' economic supremacy in the future will be the integrity of our markets. The last thing we need right now is to try an Occidental version of the Japanese razzle-dazzle, and exacerbate the uncertainty about the real prices of more than $1 trln in asset-backed securities. Actually, no one knows the real figure – according to the Wall Street Journal (page A12 on 10/12/07) there may be $25 trln in hard-to-price bonds outstanding.

Most definitely, there is the need for some type of structure to buy these securities, not just to supply liquidity but to establish prices. I proposed something along these lines back in August, but it differed in significant ways with what is on the table now.

In a nutshell, here's what I proposed:

"Most likely, the best we can hope for [with regard to the problems in the MBS market] is an orderly blood-letting with pain apportioned where it is deserved. The device that might help accomplish that might be a public-private corporation (largely funded by the big banks that promoted and profited from this mess) set-up to exchange currently illiquid CDO/MBS tranches for tradable notes in the enterprise. This will not solve the many other problems attending this credit contraction (including counter-party risk in the CDS market), but it will buy time, and time is everything when bills come due. We've done this before (Felix Rohayton's creation nicknamed Big MAC calmed markets during New York City's financial crisis in the 1970s), and it will help supply liquidity and price transparency in this vast market."

The problems with the M-LEC proposal have been well ventilated, and it could have some good features if the Treasury Department participates to ensure adult supervision. Still, it's still not clear whether the idea is to discover prices or hide them, and it sticks out that it will not buy the CDO/MBS assets most in need of pricing.

So, as we weigh the risks and rewards of addressing the pricing issue, it would be good to keep in mind the cautionary tale from Japan. The risks of getting this wrong extend far beyond bonuses and quarterly earnings.

No positions in stocks mentioned.

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