Can U.S. avert a Japan-style economic bust?

Similar crises have hit other nations, but Sweden bounced back far faster than Japan.

from the March 21, 2008 edition

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In any case, the US appears to be following a familiar pattern. Reinhart and Kenneth Rogoff of Harvard University have analyzed recent financial crises in advanced economies.

The common progression begins with a housing boom, money flowing in from overseas, and rising government debt. Then economic growth cools and banks see a rise in delinquent loans. The lenders tighten up on credit, further squeezing the economy. Often the result is a severe recession..

"The Japanese example is a terrific model of how not to do it," says David Beim, a former banker now at Columbia University's business school. "They had huge problems in their banks and they didn't face up to them."

For too long, experts say, Japanese regulators coddled ailing banks, hoping the problem would go away. The government tried to pump money into the system, but without demanding better management. Credit became largely unavailable to firms that could have used it productively.

That broke the rules of bank rescue.

"If the government must bail the bank out … it should basically wipe out the management and wipe out the shareholders," says Mr. Beim.

It sounds tough, but that's the point. It sends a signal that bad management won't be rewarded. And it conserves the bank's remaining resources – and taxpayer money – to restore sound lending for the economy.

Swedish regulators quickly determined that they would follow that path, as some of their largest banks collapsed in the early 1990s.

The US also did a decent job along these lines, Beim says, when many banks failed in the late 1980s and early '90s. (By contrast, earlier in the 1980s US policymakers tried to help ailing savings-and-loan institutions by altering regulations – and eventual mop-up became much more costly for taxpayers.)

Is a wave of bank implosions coming in the US?

"There probably will be some bank failures," Federal Reserve Chairman Ben Bernanke told Congress in February.

Much depends on whether a recession makes it harder for firms and consumers to keep paying off their loans.

Risks are already rising. The percentage of bank loans that are noncurrent is 1.39 percent, a six-year high, according to Yardeni Research Inc., citing federal reports. And banks' "return on assets" (another gauge of performance) was just 0.18 percent in the most recent quarter, the lowest since 1990.

A key concern for banks now is uncertainty over the real value of mortgage loans and the structured investments that contain those loans.

"There are losses buried everywhere" on balance sheets, Beim says. "It's all over the globe."

Faced with a comparable problem, Sweden "had a 'board of valuation' experts go in and value the assets," the loans at banks, according to David Rosenberg, chief economist at Merrill Lynch. And when a bank failed, the Swedish regulators reorganized the institution with "good" loans and "bad" loans under separate managements.

"Such a restructuring," he writes in a new report, "can provide an effective means for disposing of nonperforming loans and return the financial sector back to health."

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