As we wait on pins and needles for the Obama administration's finance-sector rescue plan next week, investors, moguls, and nearly everyone who pays taxes in the United States seem to have an opinion on how it should look. Of course, no matter what kind of banking bailout Washington proposes, people will fight about it from here until a bull market and beyond. But the two biggest crisis-induced nationalizations in world history—Sweden in the early 1990s and Japan in the middle of that decade—suggest that how the bailout works might be less important than when it works. And the longer we wait, the worse off we'll be.
Sweden succeeded in large part because of its speed, and Japan failed for its sloth. Together they offer an object lesson, says Adam Posen, deputy director of the Peterson Institute for International Economics: once the government offers certain promises, banks with dwindling capital that are allowed to remain in private hands just make things worse. "It's heads bankers win, tails taxpayers lose," says Posen. They roll over bad debt, appraise assets dubiously and make myopic business calls to keep their employers alive.
The decade-long Japanese financial crisis is a case study in the error of trepidation. As in America before the 2007 onset of the subprime-mortgage crisis, Japanese banks had become very aggressive about lending to less-than-worthy debtors in 1990, goaded on by a thriving economy that made blowback seem like fanciful dystopian cynicism. Loanees included hyperleveraged corporations and inflated real estate, such as luxe golf courses whose long membership waiting lists suddenly evaporated as clients lost interest in rounds for $400 during a slump.
When Tokyo's stock and real-estate bubble collapsed in 1991, debt overwhelmed these companies, and they began missing bank payments. (Before tougher disclosure laws were enacted by Parliament in 1998, banks were not forced to report loan defaults.) Instead of declaring bankruptcy or petitioning the government for cash, distressed companies asked for credit extensions—which, overwhelmingly, the banks gave to them. Regulators knew what was happening but didn't want to induce a panic, so they took a "wait and see" approach, hoping the market would recover and the companies could pay back their loans, according to Ulrike Schaede, an expert on Japanese business at the University of California, San Diego.
Of course, banks weren't extending any new credit while they weren't making money, and the market didn’t turn around. In order to not frighten shareholders, they overstated the value of assets and the reliability of debtors, and companies—seeing that banks would backstop them in perpetuity (with tacit government support)—refused to make large write-downs that would have overwhelmed balance sheets. It was like a scene from "Weekend at Bernie's": to protect shareholders and their jobs, they pretended like their clients weren't actually dead.
Tokyo worried that reassessing the assets "would make banks close nonperforming loans by forcing a sale of these assets, creating a glut of real-estate offers and driving prices down even further, thus increasing the number of bad loans," says Schaede. Nationalization early on would have allowed the government to phase the loans out slowly over time. Only five years into the crisis, realizing Bernie wouldn't come back to life, did Tokyo take over the banks, write down the loans and privatize the recapitalized institutions—by which point it had condemned the economy to 10 years of sluggishness and credit stinginess.
Compare that with Sweden, whose central bank, like the Fed, immediately handed out cash in 1991 on an ad-hoc basis to banks in need. In 1992, as recession began to settle in, it erected an agency to administer the crisis, which heard petitions for cash from individual banks. Unlike the Fed, it scrutinized the books carefully before deciding which candidates were worthy. That way, investors knew that banks denied liquidity didn't really need it, and Sweden staved off a panic.
When the country's two biggest banks, Nordbanken and Gota Bank, got into irrevocable trouble—bad loans again—in 1993, the crisis agency stepped in at once and took them over. It issued a blanket guarantee to creditors and, after stripping the toxic loans and wiping out shareholders, shored up the balance sheets with ample cash. The agency replaced the top brass with executives more committed to risk management, but Parliament had ordered that Sweden couldn't interfere with daily operations as long as the banks met solvency goals. Two years later, it began selling off the recapitalized banks—for a profit.
Stockholm never let Nordbanken and Gota Bank throw good money after bad, and the loans weren't simply extended until the market improved, as they were in Tokyo, according to a paper by Knut Sandal of Norges Bank. Close study of the balance sheets showed what needed writing down and just how much assets were worth (rather than trusting the banks' own estimates). And because of quick government action, executives weren't allowed to sell off what valuable assets remained in order to raise cash—a move that would have left the banks in even worse position and depressed the price of good assets by flooding the market with them. That's still something American bankers could do if they get desperate.
The key in every Swedish success was haste, and the flaw in every Japanese mistake was patience. And if policymakers in Washington want to learn from these case studies, they'll quicken their debate about how to nationalize. Until they decide, one example they could follow is Stockholm's decision to storm every distressed bank with accountants and see just how bad their balance sheets are. That way, investors would know whether to trust banks and might even pony up equity for institutions that weren't preparing to write down colossal sums. Until Washington finalizes its plan, the TARP money is enough oxygen to keep banks on life support, but not enough to get them breathing—let alone lending—on their own.