Sunday night, the White House and the Congressional leaders agreed on the Emergency Economic Stabilization Act of 2008 (EESA), which includes the Troubled Assets Relief Program (TARP) as its central piece. Although the details of the program are still left to be specified by the Treasury, buying troubled assets is not the most effective nor efficient way to address the capital shortage of the financial system, as many observers, including Nouriel Roubini correctly points out.
But, this at least shows that the U.S. government candidly admits the seriousness of the financial crisis and is ready to act quickly to solve the problem, unlike Japan in the 1990s. Right? NO.
The TARP, in setting up an entity to buy troubled assets from financial institutions to stabilize the financial system, is essentially the same as the creation of the Cooperative Credit Purchasing Corporation (CCPC) in Japan established in late 1992. The following discussion on the CCPC draws on my earlier paper with Anil Kashyap (“Solutions to Japan’s Banking Problems: What Might Work and What Definitely Will Fail” in Hugh Patrick, Takatoshi Ito, and David Weinstein (Eds.) Reviving Japan’s Economy: Problems and Prescriptions. Cambridge, MA: MIT Press, pp.147-195, 2005.)
The CCPC’s goal, like that of the TARP, was removal of non-performing loans from bank balance sheets by purchasing them. Unlike TARP, the CCPC was funded by major private sector banks. Originally, the government floated the idea of creating a government-funded institution to buy up the collateral of non-performing loans, but the government backed down faced with the criticism from non-financial industry that public funds should not be used to bail out the banks.
The CCPC was to collect on or sell the purchased loans eventually. If the CCPC incurred a loss when a loan was sold, the original bank was supposed to pay for the additional loss. Thus, the scheme did not entirely eliminate the originating bank’s exposure to the transferred loan.
The banks, however, had tax-related motivation to sell loans to the CCPC. The Japanese tax authority did not allow banks to deduct loan losses from taxable incomes until a borrower’s bankruptcy procedure starts. A loan sale to the CCPC was an exception. For the loans transferred to the CCPC, the banks were allowed to deduct the difference between the appraised and the face value of the loans.
The CCPC continued to buy loans till March of 2001. In total, the CCPC bought non-performing loans of ¥15.4 trillion (about $146 billion) in face value and ¥5.8 trillion (about $55 billion) in appraisal value. The sales of the purchased loans proceeded very slowly and happened mostly after 1998.
We now know the CCPC did not stop the financial problem in Japan. Japan had to go through a serious banking crisis in the late 1990s, establish a mechanism to allow insolvent but systematically important banks to fail in an orderly way, force the banks to dispose of non-performing loans, recapitalize the banks, and restructure the borrowers underlying the non-performing loans, before the financial system started recovering.
We can identify a couple of key problems of the CCPC. First, the CCPC was not able to force banks to sell all the non-performing loans. So the CCPC had to wait for the banks to bring in those loans. In the early 1990s, many banks were afraid of disclosing the sizable amount of non-performing loans they held, and decided to hold on to those bad loans. Thus, the amount of the non-performing loans sold to the CCPC was perhaps just a small portion of the bad loans in the financial system. Second, the disposal of loans purchased by the CCPC was very slow. Until the late 1990s, the CCPC just warehoused these bad loans without restructuring or selling those.
There is no guarantee that the TARP will be able to avoid those mistakes that the CCPC made. There are no tools that the Treasury can use to force the financial institutions to sell substantially all troubled assets. Even with the tax-related motivation, the Japanese banks were reluctant to sell bad loans to the CCPC. With the TARP, the restrictions on executive pays and others may discourage some financial institutions from coming forward. Similarly, how the Treasury will dispose of the purchased assets is not clear, yet.
The US government response on this aspect is not quicker than that of Japanese government. The TARP is set up about two years after the peak of housing prices in the US. The CCPC was also established about two years after the peak of land prices in Japan. One difference between the TARP and the CCPC is that the CCPC did not involve public funds. The US government today is quicker than the Japanese government in the 1990s only in asking taxpayers to pay for the mess created by the financial industry.