A Global, 20-Year Garage Sale. Ugly for “Safe” Asset Values.

Today’s FT brings a tidy, cogent, Japan-based example of the risks of so-called low risk assets when demographics turn against you.

We Are All Japanese Regional Banks.  We Just Don’t Know it Yet.

The (paper) Financial Times has a great article on page 7 about a Shimane Bank – a regional bank in Japan.  If this were just a Japan problem, this would still be useful forewarning (Page 8’s main article is “US Banks to Warn Investors of Grim Outlook [Driven by Falling Interest Rates]“).  Anyone who’s driven through quaint, semi-abandoned towns in Italy, Spain, or Trump country in America is seeing the same dynamic.  Most of us just haven’t connected the dots.  I’m going to pull some selected quotes/facts to tell a broader story.

In order to return to profit, Shimane Bank plans to ramp up higher-margin lending to “medium risk” companies, which did not meet its financial standards in the past. But in a prefecture where the population is already 25 per cent below its peak, and projected to fall another 15 per cent by 2045, good credit risks are hard to come by

…the problem [may be] more severe than just a declining net interest margin in their home market. He believes past forbearance has left the regional banks stuck with many loans to small companies where the owner is about to retire or the collateral has dubious value.

A Conclusion As Clear As a 2% 30 Year Treasury Rate.

Returns on a lot of “low-risk” asset classes are going to suck.

  1. There are a whole lot of nominally populated spots on the map that are in terminal decline.
  2. There are a whole lot of still nominally worth-something assets in those areas.
    1. Most obviously the unwanted homes themselves (quaint in Italian/Spanish villages, less quaint in dying US farm towns).
    2. Less obviously the nominally operating businesses in those towns – the car dealer, the grocer, the gas station.
  3. All those assets are still carried at a positive dollar value on someones books.  It might be a bank that’s lent them money.  It might just be the informal books of Grandma and Grandpa.  That is just an accounting detail.  Collectively, we are still pretending these places are worth “something.”
  4. In fact, they are worth nothing or less-than-nothing.  If/when it comes time to sell those assets, you will get pennies on the dollar at best, more likely zero, and at times someone will have to pay to exit (e.g. all those underground gasoline storage tanks won’t un-dig themselves).

Ask Not For Whom the Bell Tolls, It Tolls For Thee.  Garage Sale.

Abandoned towns make dramatic examples, but the less dramatic are also obvious and MUCH larger in scale.  Consider the carrying value vs the real-world re-sale value of the toys and diversions of early retirement.  We are on the cusp of the largest. longest-running garage sale the world has ever seen.

  • Motorcycles (Harley Davidson sales have sucked for years as used bikes flood the market).
  • RV sales dropped 4% from 2018 vs 2017 in the middle of a strong economy.  That may just be a blip, but a lot of used ones will be coming back on the market soon.
  • Second homes.  The Grandkids are grown up and the Kids can’t afford the upkeep given their stagnant incomes.

We aren’t into the mega garage sales when primary homes and their contents start selling.  Downsizing is only starting up.

And it isn’t just toys.  Think of all those rotting strip and enclosed malls that can’t find tenants.   The bridges that need upkeep,  The 1960’s school buildings and town halls that need a re-build.  It isn’t just the boomer’s personal possessions.  It is the whole infrastructure built for the education, upkeep, and entertainment.  Most of it needs substantial renovation and some of it just isn’t needed at all as population shrinks.

As all those individual assets get sold, the mark-to-market reality of carrying cost vs actual “value” is going to be ugly.  Less obvious but more worrying, that “safe” bond debt pile the boomers are buying into (to fund their retirements) is at least partially supported by those same fantasy asset values.  The Japanese regional bank problem writ large.

The Increasingly Desperate Search For “Safe” Assets.  Individually Sensible.  Collectively Self-Destructive.

For this, I’ll go back to that FT article.  The Japanese Regional Bank dynamic in it is worryingly reminiscent of the US Savings and Loan debacle of the early 90’s.  Faced with dead-man-walking loan books, banks rational move it to make otherwise insane bets in the hopes for a one-in-a million reprieve from disaster.  Individually sensible, collectively disastrous.

…In provincial towns across the country, bankers are looking at relentless declines in their income, leaving dozens of teetering institutions with an incentive to gamble on risky property loans or exotic investments overseas.

“Japan has built up the world’s largest net foreign lending position. Japanese financial institutions pump this capital out to the rest of the world: they are the beating heart of international capital flows,” said Shannon McConaghy, an asset manager at Horseman Capital in London, who follows the regional banks.

“The reduction in their return, due to negative rates, has forced the heart to take on more and more risk to keep on beating. The problem arises when this risk stresses the heart so much that capital stops beating out.”

Holding more than $3tn in assets, Japan’s regional lenders are bigger than the Italian banking system, and their excess deposits make them a crucial buyer of everything from collateralised loan obligations in the US to covered mortgage bonds in Denmark.

If this were just a Japanese bank problem, it would be worrying enough.  The S&L crisis was ugly.  But the same zombie asset army is walking in Europe and creeping into the US.  Note the increasing gloom in European banking (Deutsche Bank goes splat) and now US banking (FT’s page 8 article).

What I’m wrestling with is the above doesn’t necessarily mean that so-called “risk” assets are doomed as well.  The trite example is that we are still in the middle of a massive Technology revolution.  There is real value creation there – often via creative destruction of the old.  I know and live that every day.  So how do we reconcile that obvious value accretion with the broader trend of asset value write-downs?  That awaits more thinking and another post.

Also a few caveats/clarifications.

  1. US boomers may be particularly navel-gazing, but they aren’t unique.  The post-war baby boom happened across the developed world.  Europe and Japan hold useful lessons and shouldn’t be ignored.
  2. I’m a cranky Generation X member myself, but the views expressed here are not part of some generational warfare agenda.  I’m just trying to make sense of a time that seems out of joint.
  3. The boomers like to personalize everything.  And yes, this is (still) all about them.  But only to the extent that boomers exist in large numbers, are pushing towards 70, and will collectively shuffle off this mortal coil over the next 20-odd years.  As they trod that path, their scope for collective or individual action becomes increasingly limited and/or irrelevant.
  4. Confronting that increasingly limited scope for personal action at the end of life is a hard thing for any one person to face.  That whole generation’s existential crisis will (negatively) color the cultural zeitgeist/tone of the next 20 years as much as the harder facts below.
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