In our March 2001 overview “Will the Sun Ever Rise Again?  …” comment was made on the unrealistic expectations placed on Japanese asset values during the bubble period of 1985 through to the 1990 bust, AND on the problems created by too loose credit policies.  Just to recap, very loose monetary conditions in Japan during the mid to late 1980’s encouraged massive loans by both individuals and companies.  These loans were re-invested into the stock market and property, with the collateral being the land and securities invested into.  Even the banks, whose credit exposure (risk) was accelerating fast could not resist matching their borrowers example and increased their own balance sheets to property and securities.  Due to the then new paradigm ….. 'Japan’s wonder economy’, bankers happily lent up to 90% or more against the value of land, property and securities!  It was seen as being “As Safe as Houses”.  There was a boom in mortgage lending and the rise and rise in asset prices and low unemployment levels encouraged a sharp rise in consumer spending and a corresponding drop in the savings rate.  So far, this sounds fairly similar to the US (and West) from the mid to late 1990’s, so what comes next?

After the bubble burst in late ’89, the Nikkei crashed from a near 40000 level to 14000 within a couple of years, even though the Bank of Japan slashed interest rates from 6% to 2½%.  Land and property values started to fall, and they have been falling ever since.  Land values in Japan are now 70-80% lower than they were in the late 80’s, even though interest rates continued to fall to zero!  The main problem with this is that the loans outstanding (debt) are still there.  Low to zero interest rates allowed anyone in Japan to re-finance whatever loans they had, thus cutting the cash flow to Japan’s banks.  So Japan’s banks stopped lending and the Japanese stopped borrowing.  Furthermore, such is the mistrust and fear of the financial system in Japan; Japanese households are hoarding cash under the mattress rather than deposit it at the banks.  This, in the world’s second largest economy, not some basket case such as Argentina.  With the land collateral diminished and the Nikkei struggling to hold the 10,000 level, the banks are very wary of extending new credit, particularly to smaller companies.

In an attempt to ‘help’ matters, Japan’s government began an orgy of deficit spending in 1992 and has continued since.  Moody’s, the global credit ratings agency, is on the verge of downgrading Japan’s international debt rating to that of just above “Slovenia”.  If Japanese interest rates rose to say 2%, the entire tax revenue in Japan would be needed to service to current debt level.  Credit overstretch taken to its limit?

Now, as then, the US appears to be fast approaching the moment of truth, the inevitable consequences of too much debt.  Like Japan, the US credit expansion from the mid to late 1990’s was huge.  Money supply was aggressive in each and every year, encouraging the very same over investment as witnessed in Japan, also collaterised on land, property and securities.  The bubble burst in March 2000, since when Uncle Al has massively cut interest rates and may well go to zero!  The debt still remains and needs to be serviced.  That last comment is not necessarily true.  There are basically three ways of dealing with debt …. 1. Continue to sell assets to reduce/service the debt 2. Direct more income into servicing the debt or 3. Default on it.  Japan has been following 1. and 2. for most of the past decade and increasingly following 3.  The US (and West) is following all three, hardly conducive for the much vaunted V shaped recovery!

In the West there has been a ‘lagged’ effect between the fortunes of the equity markets and that of property.  The latter has been viewed as more secure than those volatile stock markets, so the financial institutions have been eager to accommodate a surge in refinancing and an increase in mortgage lending required by individuals, who seek the higher returns and safety from property investment rather than suffer from falling interest rates or volatile markets.  Just as people had thought that the economic cycle had been beaten (the late 1990’s new paradigm) so have folk chosen to ignore the natural correlation between property and the economy.  One cannot go the opposite way to the other, at least not for very long!

Recent comment from the US ‘real estate entities’ is worthy of comment.  Freddie Mac and Fannie Mae, both AAA quoted securities have aggressively expanded their mortgage book over the past few years to the extent that they have become …. The market!  Unfortunately these entities are known as Government Sponsored Enterprises (GSE’s) and their AAA rating has much to do with the perception that should either of them get into trouble, then the government will bail them out.  On numerous occasions, Uncle Al has been at pains to insist that the government does not underwrite them.  We shall see no doubt at some future date, which is correct.  Either way, in its recently released ‘Housing and Refinance Survey’, Freddie confirmed that “As mortgage rates continued to fall …. And average home values continued to rise, many home owners found it advantageous to increase the amount of their loans when they refinanced”.  An executive stated that on average, an additional $34,000 was taken out against the average house value of $190,000!.  No doubt it is this that has kept consumer spending up until just recently. 

Meanwhile, the National Association of Realtors report that September home sales have dropped by 12% from the August level and are 5% lower than a year ago.  In the key North East and West regions, September new home sales were down 8% and 10% respectively on a year ago … and average house prices are weakening.

For the US (and other Western economies) the days of easy credit appears to be succumbing to job losses, a fall in confidence and faltering economies.  Debt is hard to repay, particularly when individuals' (and corporates') net worth has contracted.  This is particularly true when the equity share owned on their property has fallen.  In Japan’s case, land and property values had to revert to levels to where wages were stuck.  In the US and West, the mortgage lenders continue to state that the ‘affordability ratio’ supports higher prices.

We hope that they are right but some how feel that Japan should be a lesson to us all!