U.S. Banks and the Tokyo Drift

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You already know the story, but perhaps it may happen again. It's that familiar.

A nation reeling from popped real estate and financial collapse mopes through a recession and struggles with a crisis of confidence, its president making pledges that everything will be okay.

It sounds like a broken record, doesn't it?

Well, except I'm talking about Japan and the president in question is not Barack Obama but Junichiro Koizumi, and the year in question was 2001, not 2010.

But it is 2010, and parallels to Japanese banking in the 1990s and our banks in the "oughts" now abound.

Four words: bad loans and deflation risk.

That's five words, but it's important to note that recently, U.S. banks such as BB&T and Sun Trust both set up special panels to explore potential exposure to deflation.

Deflation is the general decrease in the price level of goods and services across the board, usually due to a systemic downturn and the resulting desperate effort to cut prices to compete. Deflation also sometimes results from monetary policy that overdoes it in an effort to avoid inflation. Ironic, isn't it?

According to Reuters:

BB&T ran its books through a stress test to gauge the bank's performance in a scenario in which there is deflation for the next 10 years, as part of the bank's own internal projections of various economic scenarios, Chief Financial Officer Daryl Bible said."

Why does Japan in the 1990s keeps coming up?

At the outset of the U.S. crisis in early 2008, the American Enterprise Institute examined Japan's lost decade, about which the think tank says that an "economic cycle driven by a collapse in the market for an asset — such as land or housing — to which the banking system is heavily exposed is a dangerous beast."

That "dangerous beast" was Japan 20 years ago and it ended just 10 years ago. That dangerous beast could also loom here in the U.S. today. The common denominator: bad bank loans were, by and large, the culprit.

As the Reuters piece points out, Japanese banks discovered what is now known as the "lost decade"; deflation means that loan collateral values decline, exacerbating already under-performing loans.

The article goes on to say:

Loans may become more likely to fail, as borrowers tire of paying high rates of interest to finance assets that are worth much less than they had been previously. A second credit crisis could emerge."

If regional powerhouse U.S. banks such as Sun Trust and BB&T — both of which received TARP money and both of which are present in areas hit by rising foreclosures — are either thinking about or hedging against deflation, then it's only a matter of time before cheap money and sluggish economic growth increases the possibility of making widespread deflation an actual reality.

Indeed, the risk of continued deterioration of already bad loans continue to scare U.S. banks, which have a danger of falling further into hock on outstanding loans to say nothing of the continued "quantitative easing" at the U.S. Federal Reserve and currently low Treasury yield curves.

Who better to explain what might happen than Bank of Tokyo-Mitsubishi UFJ, Japan's largest bank and "lost decade–bad loan" poster child?

According to a Bloomberg piece earlier this summer, the bank's proprietary trading chief Kenichi Imai had this to say:

With the effect of government stimulus measures wearing off, the U.S. economy may face a prolonged soft patch, rather than a double bottom."

Soft Patch? Opposite of a hard patch? Flaccid? Sounds maybe a little bit, I don't know...deflated, even.

Let's hope not.

As Bill Isaac, chairman of LECG Global Financial Services and a former FDIC chairman, points out, deflation is not good given that U.S. banks are still assessing non-performing and under-performing loans and testing their balance sheets against deflationary scenarios.

Think you've heard this already? Just wait.