U.S. Department of the Treasury

(Archived Content)

Thank you.

I would like to thank Hal Scott - a student of mine some years back at the University of Chicago - for inviting me to speak to you tonight.

The title of this symposium is ambitious. I should probably tell you at the outset, that over the course of the next twenty minutes, I don't intend to reveal a new plan for Building the Financial System of the 21st Century. Nor do I intend to lecture my Japanese colleagues on what their financial reform agenda should be. The United States has made that mistake before.

Instead, President Bush has made it clear that he wants to build a new relationship with our friends in Japan. We want to exchange ideas, not impose them. And we want to exchange them broadly, with all aspects of Japanese society: its people, academics, representatives of the media, business leaders and government.

So, while I don't intend to reveal a blueprint for the Financial System of the 21st Century, I do hope to continue a discussion - a society-to-society dialogue, if you will - about some of the important economic and financial issues now facing Japan and the United States.

To be sure, much has been said about the positive steps Japan has taken to strengthen its banking system in recent years. Japan has made great strides in reforming its bank supervisory system. It has enhanced transparency and disclosure requirements, improved bank resolution techniques, and recently put in place a new bankruptcy regime. These are important and necessary reforms.

But clearly, there is still much left to do. If Japan is to achieve the 3 to 4 % real growth rate that Secretary O'Neill and I believe it can, the massive overhang of non-performing loans in the banking sector needs to be resolved swiftly and efficiently.

We've all heard the advice. Japan should follow the example the United States set in dealing with its savings and loan crisis in the late 1980s and early 1990s. Japan should act quickly to recapitalize or otherwise resolve failing banks and sell their non-performing assets, the conventional wisdom holds.

While I certainly agree with that advice, I'd like to shift the dialogue away from what seems to be an obvious answer, and instead talk about some of the specifics. I'd also like to broaden the dialogue to include not only the U.S. experience, but also the experiences of Sweden and Korea.

Let me be clear though. I am not just talking about disposing of non-performing loans. The disposal of non-performing assets is equally, and in many cases, more important. Real assets - be they real estate, capital goods or viable divisions of failed conglomerates - must be put to effective use to revitalize Japan's economy. The process is far less important than the result: putting real assets back to work in the real economy.

In the United States, we tried everything to avoid the process of resolving bad loans and swiftly disposing of assets. We lowered minimum capital requirements for our financial institutions. We allowed them to defer loan losses. We averaged certain liabilities over 5-year periods. We even tried injecting good will capital into merged institutions. Of course, the more we put things off, the harder it was to get started.

There were reasons the United States was slow to start the loan resolution and asset disposal process on a large scale. For one thing, there were serious budgetary constraints. As you know, our federal budget deficit grew rapidly during the early 1980s. And the U.S. Congress lacked the political will to divert revenues being spent on traditional government programs to a national financial bailout. Compounding our budgetary constraints were legal constraints, like the Gramm-Rudman Act, which limited our ability to increase total spending.

Once we came to grips with the size and cost of resolving our banking problems, the fear that assets from failed financial institutions might be sold below market prices dragged out the resolution process even further. To prevent this, the 1989 law that established the Resolution Trust Corporation required the RTC to sell assets for no less than 95% of the appraised value and to minimize the disruption of local real estate markets.

The result-predictably-was less than impressive. The RTC disposed of real estate holdings worth only $1.8 billion in 1989 and $3.5 billion in 1990. By the end of 1990 the RTC's real estate inventory grew to $18 billion. At the time, many criticized the RTC for failing to sell loans and property - warehousing was the term used in the United States - especially because the loans and property typically fell in value while under government management.

Then, in 1991, we stopped focusing exclusively on appraised value and started thinking about actual value. We realized that the longer our real assets stayed locked up on the RTC's books, the more they would deprive the economy of their productive value and the more they would depreciate in value. As one farsighted critic put it, junk rusts. Congress mandated that the RTC dispose of assets as quickly as possible and divest real estate below the appraised value if necessary.

This set the RTC in motion. It disposed of $5 billion in real estate in 1991, $7.3 billion in 1992, and $7.8 billion in 1993. The RTC also disposed of good, performing assets held by failed institutions. In fact, total RTC asset disposals increased from $25 billion in 1989 to $122 billion in 1991, before tapering off. The RTC nearly disposed of its entire asset portfolio by 1995-$450 billion-before closing up shop.

An interesting thing happened along the way. Once we committed to selling the RTC's real assets quickly, we discovered that the prices, while initially weak, began to improve rapidly.

In its first regional loan auction in Dallas in July 1991, for example, the RTC got an average of just 20 cents on the dollar for 22 loan pools with a total book value of some $25 million. At a May 1992 auction in San Antonio, the RTC got just 17 cents on the dollar. Some investors who bought assets at these initial auctions quickly resold them and made huge profits. While that exposed the RTC to some criticism, it also attracted more buyers at future auctions, and the prices improved. Greed proved to be a valuable incentive.

Many also feared that if the RTC sold assets quickly, the sales would overwhelm demand with supply and drive prices down. It turned out, that the market already had discounted prices to account for future asset sales by the RTC. The overhang of bad loans and collateral had already depressed prices. As sales began trimming the overhang, market expectations reversed. Prices could only rise once the RTC started selling assets.

Indeed, the rebound in the distressed loan and property markets was dramatic. The RTC got 36 cents on the dollar at its next San Antonio loan auction - an increase of more than 100% in just three months. At its next Dallas loan auction, in October 1992, the RTC got 62 cents on the dollar - a 200% increase from 1991. After the success of these regional loan auctions, the RTC shifted to national loan auctions, and by December 1995, it was capturing 70 cents on the dollar.

The results from asset securitizations and other disposal methods showed a similar trend. RTC officials have said that local property owners and investors initially begged the RTC not to sell property in their area out of concerns that such sales would depress prices. But after a while, those same people would visit the RTC and beg for asset sales in their areas to get the property market moving again. I believe the same can happen in Japan.

The experience of other major industrialized countries, who have had financial crises similar to - or even greater than - the U.S. savings and loan debacle, reinforces the notion that aggressive asset disposal is the best course.

During the early 1990's, Sweden suffered a systemic banking crisis. During the crisis, Sweden's seven largest banks, which held 90% of the banking sector's total assets, suffered heavy losses. These losses were so staggering that five of the seven banks were forced by equity requirements to seek capital from the private sector and the government. As the magnitude of its banking problems became more apparent, the Swedish government had to act quickly to avoid a systemic breakdown.

First, the Swedish government announced that it would guarantee the total liabilities of its banking system. Secondly, and more importantly, Sweden empowered its government asset management corporation, Securum, to investigate and assess all loan losses, to assign realistic values to any underlying collateral, and to dispose of non-performing assets quickly and efficiently. Securum also hastened restructuring in the real estate sector by acting as a lead agent for creditor coordination.

In the face of a weak economy, Sweden then pressed forward with aggressive asset sales and restructuring that helped put it back on the path of long-term economic growth. Within six years, Securum had disposed of assets amounting to 8% of Sweden's banking sector.

Since 1997, Sweden has grown by more than 3.5% each year and unemployment recently fell to a 10-year low of 4.7%.

Korea's recent experiences also show that aggressive asset disposal can help restore economic growth. In Korea, 7% of GDP has already been spent to clean up the balance sheets of its financial institutions and indications are that more progress is being made. In Korea, aggressive asset disposal has had a direct impact on overall corporate profitability.

Aggressive asset disposal has been effective in helping to deleverage Korea's corporate sector. The numbers speak for themselves. Lower financing costs have translated into higher corporate profits, as the debt-to-equity ratio in Korea's corporate sector fell from over 300% in 1998 to less than 200% in the first half of this year. This, in turn, has translated into higher corporate profitability. Recurring corporate profit margins for the first half of 2001 were 3.7 percent compared to 2.6 percent for the first half of the 1990s.

Like the United States, Korea has also experimented with various asset disposal methods, from holding domestic and international auctions to individual corporate loan sales. On this point, I'd like to emphasize the importance of using the market to optimize the disposal of collateral. In the 1990's, the RTC was blessed to be able to unload assets into competitive and deregulated marketplaces. This all but ensured that inert assets would be put to their most productive and efficient use. In Korea, the same has largely been true.

But Korea's experience highlights an even more important theme. Since we know that non-performing loans freeze the productive value of real estate as much as they do corporate assets - even whole divisions of large conglomerates - real financial reform requires that aggressive action also be taken to improve the environment for corporate restructuring.

In my opinion, there is a clear linkage between financial sector restructuring, or the removing non-performing loans from bank balance sheets, and corporate restructuring, the need for corporations to deleverage and shed marginal divisions.

I understand that a successful restructuring program is not easy. It involves reaching agreement between debtors and creditors on both debt write-down and operational restructuring. And from a policy viewpoint, corporate restructuring, by its very nature, is not conducive to a top-down approach. While government can and should create an environment conducive to restructuring - for example, by improving accounting and disclosure standards and streamlining bankruptcy and disclosure regimes - corporate restructuring works best as an organic process. The parties to restructuring - creditors and debtors - must see that completing the restructuring process is in their own best interests.

As some of you may know, a number of countries have adopted some variant of the London approach to out-of-court restructurings of unsustainable corporate debt. Promoted by the Bank of England, the London approach encourages debtors and creditors to follow procedures that protect the interests of creditors while avoiding value-destroying courtroom delays and inexorable liquidations of potentially viable debtors.

It was encouraging to see that the out-of-court multi-creditor corporate workout guidelines developed by the Japanese Bankers' Association and the Keidanren follow the principles outlined by the International Federation of Insolvency Professionals (INSOL). These Guidelines have the potential to help resolve Japan's bad loan problem by providing an alternative to lengthy legal proceedings. However, the Guidelines appear rather strict relative to legal procedures under the Civil Rehabilitation Law and the Corporate Rehabilitation Law. Hopefully, the relevant parties will apply these Guidelines flexibly so that they can be used to maximum advantage.

In mentioning the experiences of the United States, Sweden and Korea, I do not mean to suggest that it will be easy for Japan to swiftly take the bulk of its non-performing loans and non-performing assets to market. In some ways, I think it will be harder.

For one reason, the size of Japan's problem is larger. U.S. problem loans were only about 5% of GDP. Some estimate the magnitude of Japan's problem loans to be 20-30% of GDP.

Second, the rate of out-and-out failure of financial institutions in Japan is slower. During the U.S. crisis, interest rates were much higher than they are now in Japan. Under-performing loans quickly became non-performing loans, and more institutions failed at a faster pace. Over 1,000 institutions failed during the U.S. crisis from 1986 to 1995. In Japan, this number has been much smaller. Since 1995, only 116 Japanese financial institutions have failed. Ironically, our faster rate and larger number of failures may have helped us recognize that we had to get started more immediately.

Third, the fall in commercial property prices in Japan is more pronounced. Commercial property prices in Japan's major metropolitan areas are down 83% from their peak in the late 1980s. Land prices are now back down to their 1980 level -- six years before Japan's asset price bubble began -- and they're still falling, more than 10% each year. This pronounced fall in asset prices has also exacerbated fear about selling loan collateral at too low a price. But this is not a reason to wait. More likely than not, the market has already factored these sales into current prices. If anything, the dramatic fall in prices is a reason to sell. Keeping assets - in this case, real estate - locked up in non-productive hands only deprives the Japanese economy of their real value.

In closing, Secretary O'Neill and I believe that Prime Minister Koizumi and his government are on the right track toward creating a system that appropriately values assets and puts them to their most productive use. We also believe that it won't be easy, and that it will require honest dialogue between Japan and the United States. We do take comfort, however, in knowing that the hardest part of the process is just to get started.
Thank you.