NEW YORK: One day in the early summer of 2007, I received an email out of the blue from an erudite Japanese central banker called Hiroshi Nakaso.
“I am somewhat concerned,” he began in a typically understated manner, before warning that a financial crisis was about to explode because of problems in the American mortgage and credit market.
Tucked on the other side of the globe in Tokyo, he was working in the grey, fortress-like building that houses the Bank of Japan. His counterparts in the American and European central banks, close to the subprime markets, were not sounding concerned.
On the contrary, Alan Greenspan, the former chairman of the US Federal Reserve, had spent the previous decade celebrating the seeming triumph of western capital markets. And Greenspan’s successor, Ben Bernanke, had just declared that problems in the subprime mortgage market were so “limited” they would not create “significant spillovers”.
So why was Nakaso pessimistic? “Déjà vu”, he replied. A decade earlier, back in 1997, Nakaso had been working at the Japanese Central Bank when Tokyo plunged into its terrible banking crisis, sparked by US$1 trillion of bad loans left by Japan’s 1980s real estate bubble.
A BITTER EXPERIENCE OF BANKING HUBRIS IN 1997
By the time I left Japan, in 2000, the crisis had mostly passed; westerners considered it a footnote in global financial history that reflected a peculiarly Japanese failure. Nobody at the Fed or on Wall Street dreamt that American finance might ever suffer the same humiliation as Japan. Nor did the luminaries in the City of London.
But Nasako had learnt, from bitter experience, about the perils of banking hubris. He knew that government officials often downplayed problems — both to themselves and to voters — and noticed that money markets were behaving in ways that suggested that investors and institutions were losing trust in each other.
That created “striking similarities … with the early stages of our own financial crisis [in Japan],” he told me. “The crisis management skills of central banks and financial authorities will be truly tested.”
He was right. A few weeks later, in August 2007, the American and European financial systems did start to implode, as a result of the mortgage risk. By the autumn of 2008, a slow-burn crunch had turned into a full-blown global crisis, epitomised by the dramatic collapse of Lehman Brothers and rescue of AIG.
When I look back at that period now, I feel frustrated. The International Monetary Fund calculates that between 1970 and 2011, the world has suffered 147 banking crises.
Some were tiny: Few today remember the 1994 bank crisis in Bolivia. Others were huge: The US 2007 to 2008 crisis was so big that it raised public debt by 24 per cent of gross domestic product; for the 1997 Japanese crisis, the debt hit was 42 per cent.
But whatever their statistical size, crises share two things. First, the pre-crisis period is marked by hubris, greed, opacity — and a tunnel vision among financiers that makes it impossible for them to assess risks. Second, when the crisis hits, there is a sudden loss of trust, among investors, governments, institutions or all three.
If you want to understand financial crises, then, it pays to remember that the roots of the word “credit” comes from the Latin “credere”, meaning “to believe”. Finance does not work without faith. The irony, though, is that too much trust creates bubbles that almost inevitably burst.
Though it is 10 years since the Lehman Collapse, the questions are still pressing. Why do we appear destined to suffer crises over and over again? Why can’t we learn from the past?
And what does that mean for where the global system is heading today? After Japan and America, which part of the world will produce the next drama?
UNBRIDLED OPTIMISM BEFORE A SHOCK IN 2007
When I started writing about western capital markets in early 2005, I initially thought I was witnessing the financial equivalent of the internet revolution, a wave of wild innovation that would improve all our lives.
It seemed a reasonable bet. For centuries, the craft of banking has revolved around the relatively simple business of collecting deposits from companies, governments or consumers, and then using this money and additional leverage to fund loans.
In the 1980s, Japanese bubble banks lent money to real estate developments; so too in the Savings and Loans boom in America during the same decade.
But while previous generations of bankers had hung on to their loans, like farmers tending a crop, in the late 20th century financiers became more like butchers making sausages.
They started to buy loans from anywhere they could (including each other), chop these up, and then repackage them into new instruments that could be sold to investors with fancy names such as “collateralised debt obligations” (CDOs).
Every innovation revolution needs a sales patter, and this was no exception. Bankers told themselves that this slicing and dicing would make the financial system much safer. In the past, banks had gone bust when borrowers defaulted because the pain was concentrated in one place; slicing and dicing spread the pain among so many investors that it would be easier to absorb. Or so the theory went.
But there was a catch. Since the techniques that bankers were using to slice and dice the loans were desperately opaque, it was hard for anyone to know who held the risks. Worse still, because bankers were so excited about repackaging debt, they were stimulating a new mania for making loans, seemingly with government blessing.
What all this financial innovation concealed was an old-fashioned credit boom, particularly in American subprime mortgages.
Initially, few seemed concerned about these developments. This corner of finance was so geeky and tribal that most voters and politicians had scant idea that a revolution was under way. In any case, almost every unsustainable boom starts with the idea that innovators have found a new frontier.
“There is a dynamic which pushes banking and the penumbra of banking to excess, over and over again,” says Paul Tucker, the former deputy governor of the Bank of England.
“People actually have got fairly good short-term specific memories [but] they just haven’t got good long-term memories, particularly when the technology of banking changes.”
Complexity made this worse. At a conference I attended later that year, hundreds of bankers met in a concrete, mural-filled municipal hall in southern France to discuss the securitisation — aka slicing-and-dicing — game.
For two days they unveiled power-points drenched in Greek letters, algorithms and jargon, like a cult speaking a secretive holy language.
But as the presentations unfolded, it was clear that very few investors or regulators — or even the bankers themselves — truly understood how the products worked. To the outside world the revolution seemed to be driven by computers; but it was also driven by blind trust.
It was easy to see why the bankers accepted this: the bubble was making them rich. “There was huge complacency on all sides,” says Bill Winters, former co-head of JPMorgan Banking and now chief executive of Standard Chartered.
The governments threw a huge pot of honey into the middle of the table and told everyone we don’t have to think about the bees.
What was more surprising was that regulators also seemed reluctant to rock the boat. For some, the strength of the economy created a sense of complacency; for others, faith in free-market economics and pride in western finance made it inconceivable that Japan’s story might offer a warning lesson.
“I originally assumed that people would act in a wholly rational way,” Greenspan recently observed. “That turned out to be wrong.”
AMID THE CELEBRATIONS, CRACKS EMERGE
Fast-forward to 2007, and another financial conference in Barcelona. By then the mania was intense. Every room was filled to capacity with chino-clad financiers; the parties were studded with “champagne salutes”, toasting the innovations; the graphs in the triumphant power points only went up.
On the sidelines of the conference, some bankers had formed a reggae-style amateur band, called “Da Leverage”. “It’s a joke,” one banker said. It looked uncannily similar to the earlier days in Tokyo, when people sprinkled gold leaf on their sushi and nobody imagined that real estate prices might fall.
When trust in the system finally did start to crack, a few days after the Barcelona event, the first signs came not in America but in Europe. BNP Paribas in France and IKB bank in Germany each announced problems with their holdings of US mortgage bonds.
The technical reasons were complex. But essentially the problem was akin to a food-poisoning scare. As 2007 wore on, it became clear that significant numbers of American borrowers were defaulting on their mortgages; but because debt had been sliced and diced into new products, nobody knew where the poisonous risks sat in the financial food chain.
So investors simply shunned all sliced-and-diced products. That caused the markets to seize up.
The authorities tried to rebuild confidence. But shattered trust is hard to restore, particularly when governments or bankers try to sweep problems under the carpet, say with creative accounting tricks.
“You can put rotten meat in the freezer to stop it smelling — but its still rotten,” one Japanese official joked to me as he watched American attempts to reassure the markets, turning to some of the same tricks the Tokyo government had once tried and failed to use a decade before.
It was a hopeless task: The “slicing and dicing” process had left American, European and Asian markets so closely entwined that any panic was highly contagious. Month by month trust drained away: Investors lost faith in the value of mortgage bonds, the judgment of rating agencies and the balance sheets of banks.
NO INSTITUTION TRULY SAFE
When Lehman Brothers collapsed in September 2008, investors stopped believing that any institution was truly safe. For a terrifying couple of weeks credit vanished in America.
The crisis only stopped when eventually the government stepped in. It recapitalised the banks, forcing them to recognise their losses, closed weak lenders, stopped many of the crazy acronym-soaked credit practices and flooded the markets with liquidity.
In essence, this meant that Uncle Sam itself was now providing new pillars of faith and trust for the system.
The measures shocked many voters — and investors. But not my friends in Tokyo: Japan had eventually used similar moves itself to end its own 1990s crisis; so had many of the governments involved in the other 147 crises that the IMF has identified.
The only surprise of 2008, perhaps, was that American officials and investors were so deeply shocked to become just another chapter in this history.
Or as Ray Dalio, the creator of Bridgewater hedge fund (and one of the few who predicted it), observes:
These crises happen again and again. We can understand the mechanics, if we want. But can we learn?
HEALTHIER BUT NOT ENTIRELY FIXED
A couple of weeks ago I caught up with Nakaso again by phone. Since we first met in Tokyo two decades ago, a lot of financial water has flowed under the bridge. I have moved to America; he became deputy governor of the Bank of Japan, and then recently retired to join a research group in Tokyo.
“So do you think the financial system is healthier now?” I asked. Nakaso gave — as ever — a carefully balanced answer. Yes, some parts of finance were stronger: After the 2008 crisis the American government recapitalised their banks, and stopped the crazier practices of the credit boom.
“The US authorities never thought that the Japanese experience could happen in their own country, but they eventually did learn the lessons [from Japan] and they reacted quicker than the Japanese did,” Nakaso observed. They were also more resolute than the European authorities. “The Europeans have been slower to do the things they needed to do,” says Henry Paulson, the former US Treasury secretary.
But finance is still not entirely “fixed”: Non-bank investors have been taking dangerous risks, partly because super-loose monetary policy has made borrowing so cheap. And then there is the issue that the bankers joked about in Barcelona with their “Da Leverage” band: Debt.
One remarkable feature of the past decade is that between 2007 and 2017, the ratio of global debt to GDP jumped from 179 per cent to 217 per cent, according to the Bank for International Settlements.
This borrowing binge has not occurred in the areas of finance that caused the last crisis, such as subprime loans. Instead, the debt boom is among risky companies and governments, ranging from Turkey (which already faces a financial crunch) to America (where borrowing has accelerated under the administration of Donald Trump.)
CHINA COULD SPARK THE NEXT CRISIS
Meanwhile in China, gross public and private debt has doubled in the past decade to about 300 per cent of GDP. This surpasses even Japan’s wild 1980s debt binge.
So will China spark the next crisis? After all, I suggested to Nakaso, there are so many echoes of 1980s Japan: Hubris, opacity, ambitious elites and breathtakingly rapid economic change.
“Maybe not,” Nakaso observed. He pointed out that while the debt numbers look worrying, China has some powerful strengths. Fat currency reserves and a government that can act in a deft, resolute manner to fight a crisis, without being distracted by voters. He said:
Using a central bank’s balance sheet is problematic for democratic countries.
China has another crucial weapon: Government officials in Beijing are obsessively interested in history; they want to understand other peoples’ disasters, to work out how to avoid them.
“One of the great strengths of China today is that they are very thoughtful,” Timothy Geithner, the US Treasury Secretary under Barack Obama, recently observed. Or as Dalio echoes: “The Chinese are great at history — the [government] understands the mechanics of crises and it’s so much easier for them to make decisions, politically, than in the United States.”
“The Chinese have come to see us a number of times to talk about the Japanese financial crisis,” Nakaso observed, over the phone. What advice did the Japanese officials give?
The key message was prepare for the worst — [and] be vigilant. If you see the crisis you have to be quite bold.
Will it be enough? Can China learn enough lessons to avoid the fate of Japan in 1997 — or America a decade ago? That trillion-dollar question will not be answered for several years.
But the one thing that is already crystal clear is that if Beijing does ever succumb to its own boom and bust, the implications for the global economy could be devastating.
“The world is much more dependent on China today than it was on Japan in 1990s,” says Winters. Never before have those financial history books mattered quite so much.
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