A Brief History of Doom

by Richard Vague

  Analysts blamed many suspects—turmoil in the Middle East, a higher trade deficit and the resulting fear of higher interest rates, larger amounts of “risk arbitrage” owing to the highly active M&A market, and the more widespread use of computerized trading and portfolio insurance strategies that automatically triggered selling in a declining market. Indeed, some at the time viewed the crash as a technical rather than economic event (a theory belied by the fact that it took almost two years for the market to return to its 1987 highs).

  But one factor was more telling than any of these. A few days before the crash, the House Ways and Means Committee had previewed a “takeover-tax” bill that would have taken away many of the tax breaks related to M&A activity. Since the expectation of continued M&A activity was a key ingredient of high valuations, this threat hurt the market.

  Once again, high stock market valuations came with an accelerated expansion of lending. When the conditions for that were challenged, the stock market plummeted. As in most financial crises, the stock market crash was first a symptom—albeit a dramatic one—and not the cause itself. Whatever the precipitating event, the high level of margin debt left stocks vulnerable. The sharp decline in prices brought forced selling to meet record margin calls. Futures market margin calls were so high—estimated to have been a tenfold increase—that lenders to members of the Chicago Mercantile Exchange worried that they would exceed their statutory lending limits. It all helped transform a decline into a rout. Citibank, encouraged by a request from the president of the New York Federal Reserve Bank, increased lending to securities firms for this purpose from $400 million to $1.4 billion in a day.48

  The stock market crash was a stern test for the new chair of the Federal Reserve, Alan Greenspan, who had been on the job only four months. But the Fed had been studying the issue of a stock market drop intently for decades and was well prepared to flood the market with liquidity to counteract the fall. The Fed moved quickly to expand open market operations, which meant buying government securities from banks to infuse them with cash and thus push the federal funds interest rate down from 7.5 percent to 7 percent. It liberalized rules for Treasury securities lending, extended its hours for bank transactions, and increased its supervisory presence. To help reassure market participants, it publicized these efforts and its commitment to providing liquidity.49

  The decline in stocks came to an end, but stocks truly rebounded only after the early 1990s recession. In the aftermath, the New York Stock Exchange implemented what became known as “circuit breakers,” rules that suspended trading for fifteen minutes in the event of a 7 percent decline and suspended trading for the rest of the day in the event of a 20 percent decline, all to give traders time to react in the midst of turmoil.

  In early 1989, Reagan’s vice president, George H. W. Bush, took office as the new U.S. president, and in an irony he little understood, inherited the soon-to-be-rampant consequence of the 1980s excess. The massive overcapacity and bad loans of the 1980s had led directly to a spate of failures, and a major pullback and recession in the early 1990s. He had won the 1988 presidential election over Michael Dukakis with the mantra “Stay the course,” counting on the Reagan aura for victory. But he had not appreciated how fraught and perilous that “course” had been, and as the 1980s came to a close, those 1980s’ chickens came home to roost, with a full-on recession and a slew of bad news. When Bush took office, unemployment was 5.2 percent. Two years later it had reached nearly 8 percent. Real GDP growth fell by 1.33 percent from July 1990 to March 1991. Junk bond defaults went from a mere 0.8 percent in 1984 to 10 percent in 1991. In 1990, 325 S&Ls failed, and the number would stay high until 1993. In 1989, 531 banks failed, and they would continue to fail at a high rate until 1993. Mortgage delinquency peaked in 1986, but foreclosures tripled between 1981 and their peak in 1991. While far less onerous than the mortgage credit problems of the Great Recession, this added to the duress. Credit card delinquencies reached 5.5 percent in 1991, and while credit card loans were a small part of the private debt totals, this evidenced consumer stress.

  After years of investigation by the Securities and Exchange Commission, Milken himself pled guilty to six counts of securities and tax violations in 1990, served twenty-two months in jail, and paid over $600 million in fines and customer restitution. Drexel filed for bankruptcy in 1991, but junk bonds and LBOs lived on. After a period of relative dormancy, by the 2000s they were growing robustly again. Banks and thrifts were both deeply entwined with the junk bond explosion, and it was no coincidence that the period of greatest 1980s bank and S&L troubles coincided with the heaviest period of junk bond delinquency.

  Bush blamed the Fed for the economic woes, claiming that rates were too high—though at 8 percent they were well down from their Volcker-era highs of roughly 14 percent. As the problems worsened, Bush and Congress enacted an S&L bailout plan in 1989 known as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which replaced the FHLBB with the Office of Thrift Supervision (OTS),50 provided $50 billion in borrowing authority for the S&L cleanup, melded the FSLIC into the FDIC, and created the Resolution Trust Corporation (RTC) to manage and dispose of troubled thrift loans and assets.51 The solution and the end of the crisis were now finally in sight.

  Other countries misbehaved in the same time frame, including Japan, as we will see in the next chapter, the United Kingdom, France, Italy, and Spain. Margaret Thatcher presided over a massive expansion in private debt from 59 percent to 126 percent of GDP during her tenure, powering an economic expansion and driving up housing prices. But once overcapacity was too great, it brought the paradigmatic recessionary aftermath as unemployment skyrocketed again to more than 10 percent and corporate and financial institution earnings plummeted in the early 1990s. The banking industry of France followed suit, with private debt levels rising from 107 percent of GDP in 1987 to 127 percent of GDP in 1992 with bank failures that followed. Few countries were able to resist the siren song, but Germany was one; although it was buffeted by the economic trauma of its neighbors, it didn’t go on a lending binge of its own in this period. Countries are better served not to get caught up in a lending frenzy in the first place.

  Table 2.2. U.K. Crisis Matrix: 1980s and 1990s

  In the five years leading to 1990, Britain’s private debt grew by 141 percent, leading to rising loan losses, a decline in real GDP, and plummeting corporate and financial institution earnings. It reignited rising unemployment after a brief period of relief from early 1980s unemployment.

  Figure 2.7. United Kingdom: Private and Public Debt as a Percentage of GDP, 1981–1995

  In the United Kingdom, private debt increased by £590 billion ($827 billion) from 1981 to 1990.

  Why didn’t the financial crisis of this era reach the 2008 level of calamity?

  The crisis brought plenty of pain, to be sure. But in the United States, several factors were very different in the 1980s than in 2008. For one thing, even though private debt grew almost as rapidly, the overall level of private-sector leverage reached was far lower in 1989 than in 2008. In ratio to GDP it reached only 124 percent versus 169 percent in 2008. With that, the amount of bad debt in the 2000s was greater in relation to GDP than in the 1980s. And since private debt to GDP is effectively the same as the private sector’s debt-to-income ratio, the private sector had more capacity to repay in this period than it did after 2008.

  Another notable difference was that the industry kept increasing overall loans. Though business debt did contract in 1991 and 1992, overall private debt continued to expand. The pain of a crisis is worst when total private debt contracts. Lending in the early 1990s kept growing partly because the pain was more regionally concentrated and because the household sector was less affected. In contrast to the Great Depression and Great Recession, there were still many regions of the country where banks were less affected and could continue to lend more freely.

  Another factor that kept the 1980s crisis from “going to scale” and
achieving the grim calamity benchmarks of 2008 was the absence of large totals of derivative contracts to amplify the impact of bad loans. In the 2008 crisis, a huge market in a derivative known as “credit default swaps” (CDSs) had emerged specifically to place bets against the credit quality of mortgage securities. In 1987, the CDS market did not exist. By 2007 that market was $61.2 trillion. In the crisis of the late 2000s, buying CDSs would allow banks and insurance companies, especially AIG, to collectively place trillions of dollars of bets for and against the quality of mortgage-backed securities. That would add hundreds of billions to the cost and destruction wrought in the 2008 crisis. It would cripple and bring down mammoth institutions that had not been directly involved in mortgage lending. With large-scale use of derivatives similar to the credit default swaps of the 2000s, the 1980s crisis would have been far more devastating.

  Memory is always selective and sometimes kind. The 1980s, indelibly chronicled in such best sellers as Liar’s Poker, Bonfire of the Vanities, and The Predators’ Ball, was a period of rampant, profligate lending that turned into one of the most tumultuous economic periods of the past century. George H. W. Bush shouldered the brunt of these consequences, and in 1992, Bill Clinton reaped the political benefit, besting Bush in the presidential election by characterizing the period as a “decade of greed.” His strategist James Carville reminded everyone that the key issue in presidential elections was the financial well-being of voters, proclaiming, “It’s the economy, stupid!”

  CHAPTER 3

  Denial and Forbearance

  The 1990s Crisis in Japan

  In 2016, as I was beginning to think concertedly about this book, my wife, Laura, and I found ourselves in Hawaii. I had with me The Bubble Economy, Christopher Wood’s excellent book on Japan’s 1990s financial crisis, and was reading it as I looked out over the ocean. I came to a passage about the Japanese luxury hotel craze of that period and realized that a neighboring hotel, the just-opened Four Seasons Resort at Ko Olina, had been part of that building frenzy.1 Japanese developers had built the building as a high-end luxury hotel and ambitiously created its artificial ocean peninsulas—but the hotel had been shuttered or used for less than its original high-end purpose for almost twenty-five years. Nothing close to the demand for luxury hotels projected by the Japanese had materialized. The hotel was built because banks were making loans hand over fist and not basing their decisions on realistic projections of use.

  Vestiges of Japan’s 1980s lending frenzy remain in other places: in old American magazine cover stories, such as the February 2, 1987, issue of Newsweek, which intoned, “Your next boss may be Japanese”;2 or with adults who grew up in the 1980s and can still remember bits of Japanese because their ambitious parents enrolled them in Japanese-language courses as children to prepare them for the new economic world order. America seemed in the grips of a Japanese corporate takeover. As the Japanese bought more and more high-profile U.S. properties, outraged old-school columnist Paul Harvey warned that Japan’s growing financial presence in the United States was “an economic Pearl Harbor.”3

  The hotel in Hawaii, like empty skyscrapers in New York and Chicago in the late 1920s, was a relic of an explosion in private lending that was all but unprecedented in the twentieth century. From 1985 to 1990, Japan’s private debt—business and household loans—catapulted from 143 percent to 182 percent, an increase of ¥343 trillion, or $2.4 trillion. That percentage increase was far higher than in the years leading up to the Great Depression or Great Recession.

  Japan’s runaway lending was concentrated in commercial real estate, the profligate construction of office buildings, hotels, and apartments and the development of tracts of land both in Japan and abroad. From 1985 to 1990, commercial real estate (CRE) loans more than doubled from ¥75 trillion to ¥187 trillion. Japan’s loans of this era created building after building that would not be sold or filled for years and even decades. But Japan’s use of real estate as collateral went far beyond CRE and conventional household mortgages. It extended to trillions of total yen in household nonmortgage loans and small- and medium-sized business loans.4 Even bank loans for finance and leasing companies were largely tied to activity in the real estate industry.

  Further, Japanese banks were eager, often naive participants in the financing of U.S. leveraged buyout transactions. Japan’s lending frenzy drove up real estate prices by an astonishing 300 percent in that compressed period and created a short-term economic surge that Japan and the rest of the world misconstrued as an economic miracle. Its banks, businesses, and households became overleveraged, and the country was fully overbuilt by 1990, as were other markets, such as California and Hawaii, targets of Japan’s hyperactive lending.

  By the late 1980s, five of the world’s ten largest commercial banks by total assets were Japanese. In the 1990s, Japan’s economy reached 18 percent of world GDP, yet by 2007, it was a mere 7.9 percent. Japan followed the well-trodden boom trajectory in the 1980s but then distinguished itself by delay, denial, and delusion in the bust in the 1990s. Japan’s struggles with its crisis and efforts at bank recapitalization took as long as fifteen years—a distinct inflection from the Great Depression. Japan’s financial crisis is a parable of when, and how, policy decisions matter in the postboom phases of financial crisis.

  The story of Japan’s meteoric 1980s began decades earlier, just after World War II. Japan had become an industrial powerhouse in the early twentieth century, but that war had reduced its industrial centers to piles of bombed-out rubble. Japan’s national reputation could be recovered in a robust economic recovery, and the government and its departments, especially the powerful Ministry of International Trade and Industry (MITI) and the Ministry of Finance, focused almost single-mindedly on abetting growth. The U.S. Dodge Plan of 1949 had fixed the exchange rate at 360 yen to one U.S. dollar to keep Japan’s export prices low, helping to power those exports. Japan helped supply the U.S. war efforts in Korea and Vietnam, which critically boosted the Japanese economy, as did the trade benefits granted by the United States in exchange for Japan’s support.

  Table 3.1. Japan Crisis Matrix: 1980s and 1990s

  aFor 1992.

  In the five years leading to 1990, Japan’s private debt grew by 72 percent. It was primarily business debt with a concentration in commercial real estate, though Japan was also an active participant in the U.S. leverage buyout lending market. There was widespread use of real estate as collateral for household non-mortgage and small- and medium-sized business lending. Note, in the absence of complete sector information, this matrix applies bank sector lending percentages to all private debt.

  Figure 3.1. Japan: Private and Public Debt as a Percentage of GDP, 1964–2016 From 1985 to 1990, private debt to GDP grew 28 percent. The private debt data for the Bank for International Settlements shown above is nominally greater than Bank of Japan’s data cited in the crisis matrix, but both show equally rapid growth, with the latter showing 27 percent growth during these years.

  The United States encouraged Japan’s export-led growth as a means of consolidating and demonstrating the superiority of capitalism in the Cold War era. Japan made a vigorous comeback as an industrial powerhouse, well ahead of other Asian and European countries. Starting with very low postwar levels of private debt, its growth from the late 1940s to the late 1980s was the most sustained high-growth trajectory of any economy in the twentieth century.

  In the 1960s and 1970s, rapid loan growth in Japan had generally translated into commensurate GDP growth because Japan was vastly underbuilt as it emerged from the war. Workers were driven to succeed, and “bankers’ hours” had extended to the point where employees of lenders were expected to work from 8 a.m. to 9 p.m., if not later. The premium on hard work and success was so pervasive that at Fuji Bank’s centenary celebration in 1980, “employees were urged to keep working until they ‘urinated blood.’ ”5

  There was a palpable sense that Japan had “arrived” in the 1980s: all those decades of extrao
rdinary dedication and hard work had paid off. They had achieved a century-long ambition: to “catch up” to the West and perhaps surpass it. The new ethic was kokusaika, which means “internationalization.” In the mid-1980s, emboldened and driven Japanese lenders ventured into riskier projects. In 1984, Japan’s financial institutions, which had already begun to make loans for projects with less certain returns, began to reach overseas, especially toward acquisition targets in the United States. That year, Fuji Bank bought Heller Finance of Chicago; Sanwa Bank bought the leasing subsidiary of Continental Illinois and later established Sanwa Bank California; and Mitsubishi Bank acquired the Bank of California.

  Japan’s already high loan growth accelerated in 1985 to compensate for the adverse impact on trade when the United States called on Japan to strengthen its currency in the Plaza Accord. For many years, Japan’s currency had been a weak relative to the U.S. dollar, giving it an advantage in the export of cars, textiles, and other goods. Immediately after the accord, the yen rose 50 percent in value, which stunted Japan’s trade advantage (the Louvre Accord two years later largely halted the rise in the yen). Traditional exporters instantly reported less revenue in yen terms, making loans to them less profitable. Rather than accept a lower growth rate, Japan compensated by building up other, nonexport-dependent sectors of its economy, namely, and momentously, real estate. This was falsely viewed as a safer category of lending.6 Japan was ripe for real estate growth. Societies often esteem ownership of land and believe that land values will not decline, but this was particularly true in Japan. Notably, “inheritance tax and corporate income tax favored unrealized capital gains in real estate.”7 And while exporters were hurt because of the Plaza Accord, it increased the buying power of the yen and made others in Japan quite wealthy.