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Monday, Aug. 25, 2008

JAPANESE PERSPECTIVES

Subprime-mortgage crisis in third stage


The subprime-mortgage problem has entered a third phase.

The first phase, needless to say, involved the decline in housing prices in the United States that crippled many homeowners' ability to repay their loans. Subprime lending schemes were based on the assumption that housing prices would continue to rise and interest rates would stay high. The collapse of both conditions created a sharp increase in sour loans.

The second stage was marked by the emergence of financial uncertainties surrounding housing loan securitization and collateralized debt obligations (CDOs) that in- corporated complex financial products. This phase affected not only financial institutions, but also the individuals and hedge funds who bought the products. Its global reach was so extensive that it affected Europe and some developing countries.

The third phase is the overall decline of the U.S. economy. The fall in the American housing market continues, despite a looser monetary policy, tax cuts and a law that makes it easier to use public funds to deal with the crisis.

The U.S. economic malaise has pushed down the dollar, which prompted oil producing countries to hike dollar-denominated prices for crude, pushing food prices up further. What this means is that the risk of stagflation spreading on a global scale — with economies facing deflationary and inflationary pressures at the same time — has increased.

What can we learn by comparing the subprime loan crisis with Japan's economic woes in the 1990s? Both had the same elements, including major bank and company collapses and the use of taxpayer money.

Japanese authorities dealt with the bubble economy's collapse by injecting public funds into the "jusen" mortgage lenders that collapsed in the mid-1990s. The U.S. recently passed a law to bail out home-mortgage giants Fannie Mae and Freddie Mac. While developments in the two countries look quite similar, there is a also a major difference.

Japan's late 1980s bubble boom was mainly led by an upsurge in "stock economy" prices, such as for land and housing, that was caused by excess liquidity spilling into land speculation, while consumer prices stayed relatively stable. This was the main reason why the Bank of Japan, which was concerned about domestic uncertainties from the sharply stronger yen and very focused on "flow economy" prices (such as for consumer goods), at the expense of the stock economy, failed to tighten monetary policy in time.

In recent years, Japan has seen the market for real estate investment trusts grow. But the market in 1990s Japan couldn't formulate prices for land, commercial buildings and housing in a transparent manner, making it hard for financial institutions to dispose of collateralized real estate assets. This crippled the banking sector's ability to dump nonperforming loans — the main cause of Japan's "lost decade."

In contrast, the U.S. economy has watched land and housing prices fall while consumer prices rise due to surging food and energy prices. As foreclosures continue to rise, real estate prices are still falling in most parts of the country despite federal aid, hurting the real economy. At the same time, prompt action by the government to deal with the bad-loan mess has raised hopes the U.S. won't take as long as Japan did to recover from the crisis.

One of the difficulties in dealingwith the third phase of the subprime-mortgage crisis is that two contradictory problems must be addressed: the risk of global stagflation (recession and inflation at the same time), and the U.S. phenomena of stock economy prices falling while flow economy prices rise.

Macroeconomic measures to deal with these problems can have contradictory effects. An interest rate hike to contain the rise in flow economy prices will further dampen economic sentiment and trigger further declines in real estate prices. In such circumstances, microeconomic steps — such as one Japan adopted during the bubble years to control real estate-related lending — ought to be more effective.

Regulations have already been introduced to control speculative trading in stock and commodities futures. It is essential that countries stay in contact with one another and steadily implement microeconomic steps that fit their own conditions.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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