Don’t forget that SVB’s depositors bear responsibility too

There’s been a vast discussion of Silicon Valley Bank and it’s failure over the past week. It has been of extremely high quality, and I owe great thanks to all those who have both produced and guided me to useful information including Frances Coppola, Dan Davies, Morgan Ricks, Peter Conti-Brown, and with my apologies too many others to name them all.

On the academic side of the discussion (but less so on the finance side), I see a tendency to dismiss the depositors’ role in the crisis. For example:

In fact, much of the current discussion expresses an extremely critical view of banking itself, including for example Morgan Ricks who views deposits as inherently government guaranteed and Matt Klein who writes “Banks are speculative investment funds grafted on top of critical infrastructure. This structure is designed to extract subsidies from the rest of society by threatening civilians with crises if the banks’ bets are ever allowed to fail.”

I do not rely on the current US (or European) banking structure for my model of banking, so I worry that these approaches risk throwing the baby out with the bath water — while at the same time acknowledging that especially in the US (with which I am more familiar) the current banking system is deeply corrupted by government guarantees leading to just criticism that it privatizes the gains and socializes the losses.

Banking, when it works well, always involves a remarkable balance of public and private risk-bearing, interests and power, and is a delicately structured coordination problem in which government, banks, non-bank businesses and other bank creditors all play a role.

The US, however, since the end of Bretton Woods, seems to be on a particularly dangerous path of using its monetary and financial system to gain power on the international stage — at the expense of slowly but surely eliminating the private risk-bearing capacity of the financial system itself by providing ever broader public guarantees to the ‘so-called’ private sector. The loss of the risk-bearing capacity of depositors with more than $250,000 in their accounts is just one more step along that path.

So let me relate some history in hopes of reframing the understanding of what banks are meant to do when they operate well. Consider the development of English banking in the years when banking spread throughout the length and breadth of the country, 1760 to 1824.

Bankers had unlimited liability and were typically well-to-do landowners, i.e. people with something to lose in the event of bankruptcy. Their clients were all in business — although after 1797 small banknotes could sometimes circulate at the retail level. During this period the number of English banks outside London grew from about 12 to 780 declining to about 550 just before the 1825 crisis (in which more than 10% failed).

The key to success in this foundational banking experience was that everyone understood the relationship between ‘depositors’ and their bankers. In the event that a well-run bank faced a liquidity crisis, the large merchants in the town where the bank was located would get together and announce their support for the bank. Why did they do this? Because as a contractual matter they were not depositors, they all had credit lines to draw at the bank, and they were only ‘depositors’ when their account balance was not in the red. They knew the importance of the bank’s credit lines to their local economy, and that their fortunes were closely tied to those of the bank. So it was a matter of course that they supported their local bank (Pressnell 1956).

The fact that each banker was a wealthy businessman with unlimited liability ensured that it was rarely non-bank creditors of the system who incurred the ultimate losses on a badly managed bank. (The exposure of other banks to a bad bank that forced them to bear the losses of a bad bank was a different matter.)

This culture of banking played a crucial role in government finance, because in 1797 when the Bank of England went off gold, it was a matter of course that it was able to assemble the London merchants and get their support. It was almost certainly because of its highly developed culture of banking that England was able to shift smoothly to a paper monetary standard in 1797 with minimal adverse effects on the economy — indeed to avoid adverse effects financial conditions became loose and the economy boomed for more than a decade.

While this model of unlimited liability banking with ‘depositors’ who understand the need to support a bank in crisis is a very idealized model of banking, it does make clear why banking exists: businessmen want to borrow money, and a well-run bank can support a much higher level of borrowing than an entity that does not fund using monetary instruments. Businessmen understand where their bread is buttered and therefore stand behind the bank.

(Note that this model of banking was wiped out in 1825. Monetary mismanagement of a government debt conversion caused the Bank of England to whipsaw the money supply, increasing it by more than 10% in October 1824, and more than reversing the increase over the course of the next 4 quarters. The costs of the crisis that ensued were borne by the bankers — even though true to the expectations of their day and the realities of the situation they faced, they stood by the Bank of England: when the government refused to permit it to go off gold, they accepted paper instead anyhow. After the crisis entry into unlimited liability banking collapsed. Those bankers who stayed in the business were very cautious about their lending. The economy did not thrive. The Bank of England was subject to intense Parliamentary scrutiny — and blamed the crisis on the bankers. Joint-stock banking was authorized and over time banking would be dominated by limited liability joint stock banks.)

This history does not provide any immediate solutions for how we address the current problems with the banking system, but it does provide a few reminders: 1. Depositors are part of the complex system that makes a banking system work. Is there any historical evidence that replacing them with government is a reliable solution?
2. With the knowledge of how the British capacity to issue debt was so closely tied to the banking system and the banking system’s support of that capacity, should we not worry that sovereign state capacity may also be part of a very complex equilibrium and that it might be better not to test the boundaries of that capacity?
3. And we must certainly ask, why did the depositors of Silicon Valley Bank, most of them closely tied to Venture Capital funds that should have been able to provide sophisticated financial advice, not do a better job of bearing risk? As the historic example above demonstrates, the answer definitely is not because bank depositors are never capable of bearing risk.

The savings glut or the death of Schumpeterian growth

In general, I read Michael Pettis, Brad Setser and Matthew Klein and am amazed by what I learn. They are experts in the best sense of the word: inquisitive, open to argument and very effective at presenting complex ideas. Based on recent posts (Klein, Setser) and an old post (Pettis), I see a gap in the analytic approach being used. (NB: I was unable to watch the Geoeconomics plenary yesterday, so this post is not informed by that discussion. Nor have I read Trade Wars are Class Wars – but only because my ‘must read’ list is too long.)

Both Pettis and Klein are explicit that in the context of endogenous money their analytic framework is based on drawing a distinction between an economy with slack and an economy without slack (or at full employment). And it is because of this distinction that “One country’s trade deficit is another’s excess production (or under-consumption/under-investment). There is no financial system capable of removing this real resource constraint.”

What I think is missing from this analytic picture is Schumpeterian growth. (Which BTW was also missing from Keynes and as a result Business Cycles was Schumpeter’s response the General Theory IIRC.) The theory of Schumpeterian growth starts from bank credit. Creative destruction can take place because the elastic flow of bank credit very fluidly and continuously redirects the flow of the economy’s resources into innovative activity that is thus enabled by the system of financing to challenge and then ‘destroy’ incumbent firms. It is essential to this theory that this finance be a monetary, bank-based activity because that is what allows a fluid, unobserved shift in the price system away from dying firms and towards innovative firms. It is bank finance that ensures that we do not notice how easy it is for consumers to choose the better product simply because its there. In Schumpeter’s world that product is there, because some banker made a decision to finance it – and to facilitate the destruction of its competitors.

The problem with the slack/no-slack framework for understanding the economy is that it misses the whole point of the modern economy, which is not full employment but creative destruction and the continuous creation of economic slack due to the continuous changing of what it means to be at full employment. From a Schumpeterian point of view ‘full employment’ is a static and somewhat bewildering concept, because in fact if the economy is doing what it should be doing, then the ‘full employment’ boundary is always dynamically changing.

Thus, a competing explanation for the savings glut is the death of Schumpeterian growth. Our financial system has been so dramatically reformed that it no longer is very effective at financing creative destruction, but instead is geared towards financing incumbent firms. In this environment there is no impetus for firms to invest; the goal instead is for firms to entrench the ‘moats’ around their market power. Thus, the ‘corporate savings glut’ – which is also necessarily a corporate investment famine – accompanied the ‘global savings glut.’ It is this fact that makes ‘savings’ as a causal driver of the contemporary world’s dynamics open to significant question.

An alternate narrative to explain the same facts is that financial reform has had the effect of promoting financialization and discouraging productive investment. What we are experiencing is in fact an investment famine due to the fundamental dysfunction of our financial system. The focus on the savings glut as a causal factor is therefore misleading – because in fact the savings glut exists, because we have broken our financial system.

In practice, most likely there is some truth to both causal narratives. But no one should be surprised when a causal narrative that appears to have convincing evidence is challenged by an alternate causal narrative. This duality exists at the very heart of economic analysis (cf Vincent Grossman-Wirth).

Taxonomy of liquidity III: modeling liquidity

The fundamental problem that economics should seek to solve is what I will call the primary liquidity problem:

• An individual, S, has a good that she wants to sell
• There exists a buyer, X_H, with the highest valuation, H, for the good
• However, because finding X_H is difficult, S may end up selling the good at a low valuation, L

The first task of economics is to organize trade in the economy so that every individual, S, can realize the high valuation, H, of that individual’s assets. Fundamentally the primary liquidity problem is a problem of trading across time and space. Note that the economic model of competitive equilibrium does not address this problem at all, but assumes it away, substituting for the primary liquidity problem the trope of the centralized market.

The primary liquidity problem can be addressed by borrowing. If S can borrow H, the value of the asset to X_H until such time as S can find and trade with X_H, then S will not sell at valuation L. Thus, there is a secondary liquidity problem, which only exists if there is a primary liquidity problem. This is the problem of borrowing the value of the asset until it can be sold.

Historically, banking developed to address the secondary liquidity problem. Banking in its 17^th to 19^th century origins developed to monetize the value of trade bills, where trade bills represent what in modern terms are called Accounts Receivable: a transaction has taken place, delivery has been made, and all that remains is for the buyer in the transaction to make the final payment. By standing ready to encash claims for payment held by sellers, the banking system provided traders with the time and space to locate their highest value counterparties.

Indeed, given the timing of the development of the competitive model in economics over the course of the late 18^th and 19^th centuries – in an environment where advances in banking had solved the secondary liquidity problem – there is every reason to believe that the competitive model could be conceived only after banking had developed and successfully addressed the primary liquidity problem. That is, the capacity to abstract from the primary liquidity problem was developed, because people were living in a world where bank credit made the primary liquidity problem irrelevant.

Note that there is a related, but in fact very different problem, which is the financing problem. Unlike the liquidity problem, which is a matter of realizing the highest value of a good that already exists, the financing problem is one of funding the development and production of a future good. While the ability to borrow against future income has implications for economic activity, this problem is of second-order importance to the primary problem of realizing the value of the goods that already exist. If the primary problem cannot be solved, then future incomes will be affected and have higher variability than when the primary problem can be solved. Thus, the financing problem is a tertiary problem, to be addressed only after the liquidity problem has been addressed.

Observe that in a post-banking world, the liquidity problem is often framed as a payments problem. A payments-type liquidity problem occurs when someone with an obligation to pay does not have the means to pay it. Note that payments-type liquidity problem can reflect either a primary liquidity problem, where the debtor is having difficulty realizing the value of the debtor’s assets, or a solvency problem, where the debtor does not have enough assets to pay the debt even when the assets are valued at their highest value. The concept of a solvency problem goes beyond the scope of this post, because instead of focusing on how to realize the value of individual assets, the solvency problem is evaluated at the level of the borrowing entity and requires a comprehensive examination of that entity’s assets and liabilities.

Bottom line: the competitive markets model should not be viewed as a model of the efficient allocation of resources, instead it should be viewed as a model that shows what happens when institutional factors exogenous to the model allocate resources efficiently (i.e. to their highest value use).

Last paragraph added 8-8-20

Money market funds, repo, and monetary policy: A mechanism design problem for the Fed

Before there were money market funds — and their finance of banks and big corporations borrowing on commercial paper and other wholesale markets — monetary policy in the US used to be implemented by starving banks of funding and thereby constraining the credit they could provide to the economy (Burns 1979).

How is this possible, you ask, in a world where the money supply is endogenous? This was an environment where current accounts were required by law to pay 0% interest, bank time deposit interest rates were capped at 4-5% and all bank funding in the form of publicly issued debt was legally classified as deposits. When the Federal Funds rises to, say 6%, and other short term rates also rise, (i) the banks don’t particularly want to have to borrow reserves because they are a relatively expensive source of funding, and (ii) holdings of bank deposits become a hot potato, and banks have to adjust to a world where outflows of funds are faster and more variable, so at any given level of lending the risk of having to borrow reserves increases. Historically, banks chose to reduce their lending in this situation, making monetary policy very effective. This is well documented.

This world was completely transformed starting in the late 1960s, when so-called market-based finance first began to develop. Banks were now allowed to use Eurodollar and commercial paper markets for funding. Of course, only a select group of large banks had easy access to this “market-based” funding. These banks facilitated the development of money market funds that could invest in these market-based instruments, thereby freeing the banks from regulatory constraints associated with deposit-based funding. This created a two tiered monetary system in the US, the “money center banks” that were funding on “markets” through money market funds and through their relationships with corporations and their treasury departments, as well as earning income from providing services that made it possible for corporations to fund directly on these markets. In the meanwhile, the rest of the commercial banking system had little or no access to “market-based” funding and was thus still constrained by the regulations governing deposit based funding.

This two-tier system might not have lasted very long, had markets been allowed to function. However, in 1974 when the post-Bretton Woods monetary system had yet to prove itself, the Federal Reserve created “too big to fail” by bailing out a fraudulent bank, Franklin National, in order to stabilize the Eurodollar market — and to preserve the dollar’s position in the post-war monetary system (Sissoko 2019; Spero 1980). In fact, this was just a way of covering up the gross inadequacies of the US bank regulatory system, which continue to this day. (Allowing banks to choose their regulator is not an intelligent way of designing a regulatory system.)

In this era, the Fed’s traditional tools of monetary policy did not have much effect on the money center banks, which after the Franklin National bailout had access to funding at LIBOR, the interest rate on the Eurodollar market, and this funding was understood to carry an implicit US government guarantee. Thus, the reason people like Arthur Burns (1979) doubted that Paul Volcker could tighten monetary policy enough to control inflation was because the Fed had traction over only a portion of the banking system — and not the part of the banking system that provided funding for the biggest US corporations. What Paul Volcker proved was that monetary policy could control inflation even if it was only small- and medium-sized domestic enterprises and the general public that suffered from a significant credit contraction, while the biggest enterprises just faced an incremental increase in the cost of funds.* (Through the worst of Volcker’s interest rate hikes from December 1980 to August 1981, Libor was running 3 to 5% below the Federal Funds Rate.)

This two-tiered banking system continued to operate with the “too big to fail” money center banks receiving ever expanding forms of government support (the bailout of the banks on the backs of LDC countries, the Greenspan Fed’s regulatory lifting of the Glass-Steagall restrictions, the deregulation of derivatives and the hobbling of the CFTC, etc.) so that they grew to make up an ever increasing fraction of the banking system over the course of three decades. While monetary policy was operated as interest rate policy, monetary control was for the most part ceded to the money center banks which were allowed free reign to monetize assets by covering them with “off-balance-sheet” bank guarantees, thereby making them eligible assets for money market funds and so-called market based finance. (Money center banks were able to dominate this activity, because the credit rating agencies explicitly viewed them as having an expectation of government support.)

In 2008, the contradictions at the core of this “market-based” monetary system were exposed. Money market funds are pass-through vehicles. Under no circumstances should they ever be treated as a reliable source of funding for any asset, because it is in their DNA that they are every bit as unstable as money demand itself. The 2007 ABCP crisis took place because this fact was not understood by regulators. On the other hand, the credit rating agencies do apparently understand this instability and as a result, when MMF funding exits the market, the banks have a contractual obligation to support the assets — and as long as the banks in question are “too big to fail” that obligation will fall to the government in extremis. This is the basic structure of “market-based” finance, at least as it applies to the funding of private sector assets on money markets.

Interest rates on money markets are inherently unstable. The most basic task of a central bank is to stabilize the funding of “good” short-term assets, while taking care not to support the value of “bad” short-term assets. The former is important because a lot of very valuable economic activity will be discouraged in an environment where short-term funding rates have a habit of spiking upwards. On the other hand, providing universal access to cheap short-term funding with no credit discrimination at all is a recipe for disaster, because the funds will be misused and bankruptcy and financial instability will result. The short-term funding system has to have some mechanism for distinguishing “good” assets from “bad” assets.

In the pre-2008 monetary policy regime, the problem of distinguishing “good” from “bad” assets was delegated to banks. The Fed ensured that banks could borrow at a stable rate. In theory, a bank that used that facility to lend “badly” was at risk of failure and being closed or sold off. In practice, of course, only small banks were subject to this discipline — and as we saw most “too big to fail” banks engaged in lending practices — including providing contingent guarantees that they were unprepared to meet without regulatory forbearance — that were at best unwise.

Now the Fed is looking for another means of implementing monetary policy. The key problem is, as it has always been, how to stabilize interest rates in a way that is consistent with financial stability goals. Or in other words, to provide stable funding for “good” short-term assets, while avoiding the funding of “bad” short-term assets.

The risk here is that the Fed still seems to be prone to assuming that “markets” will do its job for it. It was caught flat-footed in September, when it learned that “markets” will not stabilize rates by themselves (See BIS 2019 and Coppola 2019 on this).

Now the Fed appears ready to step in to stabilize rates in the repo market. The question is whether the Fed understands that there must be some mechanism for distinguishing “good” from “bad” assets, or whether once again it is expecting “markets” to solve this problem — despite the fact that (i) “too big to fail” is far from having been laid to rest; and (ii) so many businesses have been operating for decades in an environment where it is very cheap to extend and pretend that there has likely been too little feedback and the standard learning process for managing business debt may not be operating effectively. To make the latter point by analogy, just as regular small fires are essential to a healthy forest, so it is important to the economy that regular business failures take place to engender a healthy measure of caution in business decision-makers. As Frances Coppola puts it: “Why are we once again allowing the Fed to provide an implicit backstop for risky non-banks, thus enabling them to misprice risk and gorge on leveraged trades without fear of market penalty? Have we learned nothing from the past?”

In response to Frances, David Andolfatto asks whether a Standing Overnight Repo Facility that serves to cap interest rates in the repo market (as was proposed here and here) is an adequate solution. Unfortunately it seems that an overnight facility is likely to be inadequate to address interest rate volatility on the repo market, since the BIS discussion makes it clear that intraday repo demand was also very high.** Zoltan Poszar’s most recent Global Money Note (#26) explains that this demand for intraday liquidity is likely to due to the fact that Basel III requires the systemically important banks to prefund their intraday liquidity needs. Unsurprisingly this leads a hoarding of reserves in order to preclude the risk of being in violation of Basel III.

Furthermore, simply establishing Fed lending that ensures that money market rates don’t spike seems to be in line with the Fed’s historical tendency to rely on stop-gap measures that have not been thought out at all in terms of their effect on financial stability, but even so become permanent. The Fed needs to think long and hard about what mechanism is going to ensure that the liquidity that it provides is going to the right kind of short-term borrowing. Sixty years ago the answer to the problem was easy: the Fed provided liquidity to the banks and if the banks made bad loans, it was the bank shareholders that were going to eat the loss. Since the rise of market-based lending and bank creditors whom the Fed perceived as needing to be protected at all costs, in the US both the managers and the shareholders of money center banks have been coddled outrageously for decades, and after the experience of 2008 not many people have much faith that they even know how to distinguish good from bad assets any more.

So the real problem is that the Fed has a mechanism design problem that it needs to solve: How is it going to design the market through which monetary policy is implemented to ensure that it is no longer perverted by “too big to fail” and to ensure that any losses on bad assets fall in a way that fully aligns incentives in the market?

* I think it is possible to both approve entirely Martin Wolf’s assessment of Paul Volcker, the man: “Paul Volcker is the greatest man I have known. He is endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country.” and yet at the same time to feel that the legacy he left us is very complex indeed. We need great public servants like Paul Volcker, but we need to recognize that they cannot save us when the underlying problem is systemic.

** In fact, the degree to which the Fed is currently providing intraday liquidity (anybody know where this data can be found?) is probably a good clue to whether the stressors in the repo market are mostly overnight or also intraday.

 

 

 

The Dismantling of the US Economy’s Legal Infrastructure

1. The Background
2. Hedge funds and private equity funds: How vast pools of money escaped regulation
3. Derivatives and the enforceability of margin
4. Mortgage lending and investment banking: 1930s reform and the post-war years
5. Mortgage lending and investment banking: The evolution of bank balance sheets
6. Mortgage lending and investment banking: An aside on the financial economics of 30 year mortgages
7. Mortgage lending and investment banking: The era of “pro-competitive” reform
   1. The transformation of mortgage finance in the 1980s
   2. The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail
      1. The development of the Eurodollar market in the early 1970s
      2. The Growth of LDC Loans
      3. The Bailout of First Pennsylvania Bank
      4. The LDC Debt Crisis
      5. The Growth of Leveraged Buyout Loans
      6. Continental Illinois
      7. Proposed solutions
   3. The era of regulatory reform: The Greenspan years
   4. The era of regulatory reform: Leading up to the crisis
8. The Crisis
9. Policy implications

References

References for Dismantling Series

Last updated: September 18, 2019

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Dismantling the economy’s legal infrastructure V-5-e: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 5: The growth of leveraged buyout loans

A consequence of the special protected status granted by the US government to the money center banks was that even after the LDC crisis they continued to raise money with ease and at low cost relative to smaller banks on both international and domestic markets. Thus, despite their demonstrated inferiority to smaller banks in managing their loan portfolios, vast sums were available – due only to their government-supported status – for them to lend. Furthermore, due to that same protected status, these banks would have the capacity to extend their loans indefinitely. Under these circumstances it is not surprising that money center banks sought out a new source of earning assets to replace the much reduced LDC loan market. Syndicated lending turned to “leveraged loans,” that is, the loans that are used to load corporations up with debt in leveraged buyouts.

Recall from a previous post that the Small Business Investment Incentive Act of 1980 had shifted the SEC’s mandate from one of protecting investors (both wealthy and non-wealthy) to one that also promoted the capital formation of small businesses. This was adopted in the name of helping the small businesses that were struggling due to the shift to “market-based lending” that favored big banks and big firms at the expense of SMEs. This law encoded into legislation the concept of the “accredited investor” and allowed large classes of investors to be exempt from the protections that had in the past been held to cover even the wealthy. Subsequently, in 1980 the SEC promulgated Rule 506 of Regulation D, which unlike all the rules that preceded it, permitted firms to use private offerings to raise an unlimited amount of funds from an unlimited number of accredited investors as long as the there was no “general solicitation.” (In the past, all of the SEC’s private offering rules strictly limited either the amount that could be raised or the number of investors from whom funds were raised.)

Regulation D made the leveraged loan market possible. Whereas junk bonds are issued in public offerings that meet the stringent requirements of SEC registration, leveraged loans are issued in private offerings and are subject to only a very limited set of investor protections. According to the SEC the adoption of Regulation D was motivated by a desire to promote the capital formation of small businesses. Ultimately, however, the “small businesses” that were able to grow due to the creation of the leveraged loan market were financial firms, not the non-financial SMEs that the legislators had in mind in when they passed the 1980 Act.

Private equity firms (also known as leveraged buyout firms) would use leveraged loans and a technique known as the “leveraged buyout” to either facilitate a management buyout or a hostile takeover of a corporation. In a management buyout private equity assists a corporation’s management in the purchase of the corporation’s assets from the owners of the corporation, subject to a majority vote of the corporation’s shareholders. Because the corporation’s management has a fiduciary duty to the firm’s owners and management’s interests are directly in conflict with the shareholders’ interests in these transactions, such transactions may be motivated by managers and private equity professionals who are arbitraging weaknesses in the law governing corporate management’s duty to shareholders.

In a hostile takeover the private equity firm is able to literally force debt on a corporation whose management believes such debt is not in the interests of the corporation. A hostile takeover is typically executed by the private equity firm making a conditional offer to shareholders to purchase their shares at a price above the market price – the condition is that the offer will only be executed if enough shareholders accept to give the private equity firm control.

To explain fully how buyouts operate it is important to review the well-established effects of taking on leverage. When an equity holder leverages her investment by borrowing to fund the investment, she increases the risk of her investment making it more likely that the project will go bankrupt and she will lose money, but at the same time in the event that the project makes money she increases her potential return. Because a firm is unlikely to go bankrupt immediately upon increasing its debt load, the immediate effect of leverage on the share price of a corporation is often an increase in the price. The cost of that increase is however the increased price volatility inherent in a leveraged investment – and the increased likelihood of a total loss or bankruptcy.

Both management buyouts and hostile takeovers typically take place in an environment where share prices are low relative to the value of firm assets, since this is the environment in which an increase in leverage is likely to result in a short-run positive effect on the share value. Both types of leveraged buyout then have the effect of paying an immediate higher return to current shareholders who are bought out and who give up their claim to the firm’s assets and the possibility of a future even higher return. They also both have the effect of significantly increasing the likelihood that the firm in question goes bankrupt.

What makes these deals of questionable economic value is the fact that the private equity firms (and in some cases the corporate managers) who organize these transactions are not simple equity investors in the new firms – and their incentives are typically not aligned with that of making sure that the firm that has been loaded up with debt will continue to be a going concern. Instead these organizers of leveraged buyouts are able to extract upfront fees and payment from the transactions, and thus have an interest in keeping a flow of leveraged buyouts going even if the end result will be a rush of bankruptcies, layoffs, and economic dislocation (Applebaum & Batt 2016).

Thus, the Small Business Investment Incentive Act and Regulation D had the effect of creating a leveraged loan market that was arguably designed to enable private equity firms to arbitrage weaknesses in the legal and regulatory structure governing corporate governance. Where do the money center banks fit in this picture? This new lending market was opening up just at the time that the money center banks were finding that they needed to cut back on the LDC loans, as the borrowers were close to default. The extraordinarily cheap funds that were available to the money center banks due to their government-guaranteed status could be put to use in the syndication of the leveraged loans that financed private equity and corporate buyouts.

Consider this new perversion of the financial system: The money center banks use their access to funding which due to government support was available at low cost in almost unlimited amounts in order to promote the development of a new type of financial firm which specializes in arbitraging weaknesses in the law governing US corporations for the purpose of loading US corporations with debt. The end result has been a massive leveraging of US corporations – even in circumstances where corporate management believes the debt is not in the long-run interests of the corporation. On the one hand, the threat of hostile takeover pushes corporate management to take a less and less conservative approach to debt, and, on the other, money center banks and private equity firms are able by charging fees on this process to profit generously from their arbitrage of corporate law. Effectively, the extraordinary leveraging of corporate America is a consequence of government-guarantees provided to money center banks and the banks’ search for a way to profit off of this this vast source of funds.

It’s worth pausing a moment to compare the post-Bretton Woods financial environment with the one that existed at the height of Bretton Woods. When banks were at risk of failure and did not have access to significant sources of so-called “market-based” funding, they had to behave like traditional banks that could only keep their liabilities in circulation by lending – prudently. There was in this traditional model a tight connection between lending, the circulation of bank deposits, and bank funding. This tight connection was broken by market-based lending with the 1970s growth of the Eurodollar market and the commercial paper market. Suddenly the largest banks were able to finance themselves on markets (in fact as we have seen due to a government guarantee) and no longer needed to worry about lending in order to put deposits into circulation. Indeed, due to the government guarantee the incentives for these banks to lend prudently had declined dramatically. They turned to lending to foreign countries and to lending on a term basis to corporations in a way that served to increase debt on corporate balance sheets and the flow of funds from nonfinancial corporations to the financial sector without in fact having much of a transformative effect on the activities of the corporations. In short, the growth of market-based lending is closely associated with the growth of bank lending, that is not productive, but instead seeks out borrowers who can be induced to make interest payments as a form of tithe to the financial sector. Indeed, this transformation of banking post-Bretton Woods may explain the puzzlingly high cost of financial intermediation in the current era (Philippon 2012; see also Philippon 2015).

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

Dismantling the economy’s legal infrastructure V-5-d: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 4: The LDC crisis

The LDC Debt Crisis

By the end of 1981 Paul Volcker had demonstrated success in controlling inflation – having allowed the Federal Funds Rate to rise over 20%. 1982 would, however, prove to be a difficult year for financial markets. July saw two significant bank failures, one Italian bank and one US bank. And then there was the LDC debt crisis: in August the Mexican government defaulted on its debt, followed by a series of additional defaults.

The Italian Banco Ambrosiano roiled the Eurodollar market when it failed and neither the Italian nor the Luxembourg government was willing to support the Luxembourg branch of the bank. The losses this policy imposed on the Eurodollar market once again caused two-tier pricing in the market to the disadvantage of small banks (Kapstein 1994: 54).

Penn Square Bank was an Oklahoma bank that financed oil and gas exploration and after its failure turned out to have been engaged in fraud (Sprague 1986: Ch. 6). Penn Square had sold $2 billion in participations in its oil and gas loans to other banks, so once again the Federal Reserve pushed the FDIC to protect the creditors of the bank. Only after the FDIC made clear the extent of the fraud and the fact that a sale of the assets to another bank would be likely to destabilize the purchaser did the Fed concur that the only legal alternative was a liquidation of the bank. The bank was closed on July 5, 1982. Its books were in such disarray that it would take the FDIC almost a year to come up with an estimate of the losses to uninsured creditors of the bank of 35%. The Penn Square liquidation would play a role in the failure of the seventh largest US bank due to Continental Illinois’ $1 billion in exposure to this fraudulent bank.

Mexico was an oil-exporting country and the decline in oil prices that began in 1981 and continued through early 1983 eroded its capacity to carry dollar-denominated debt (Broughton 2001: 283).[1] The country’s problems were exacerbated by the fact that it maintained a fixed exchange rate – that was growing ever more obviously unsustainable, and thus Mexico experienced massive capital flight in the years leading up to the 1982 debt crisis (Kapstein 1994: 84, 88). Capital flight, of course, just exacerbated the pressures driving a devaluation. The immediate cause of the crisis was, however, the decision by US money center banks not to roll over a substantial principal payment that was due on August 16, 1982 – despite having agreed to a significant increase in lending just seven weeks earlier (Boughton 2001: 286, 290).

In the period since the second oil price shock, the exposure of the money center banks to LDC debt – and Mexico in particular – had been increasing, so that by the end of 1981 LDC loans made up more than 10% of their assets and 2.6 times their capital (FDIC 1997: 196, 199; Boughton 2001: 283-86). A Mexican default would force the biggest banks in the US to recognize significant losses, and almost certainly result in one or more bank failures – especially immediately following the losses associated with the Penn Square liquidation. Once again, the stability of the international financial system was at risk – just two years after the First Pennsylvania bailout.

Arthur Burns had foreseen this danger (see previous post) and Paul Volcker (1980: 21, 27, 31-32) too had expressed concern in early 1980 that having “muddled through” the first oil price crisis by relying on the lending capacity of the commercial banking system without sufficiently addressing the underlying problems, the temptation would be to continue along the same path, “overloading the commercial banking system” and failing to serve the long-run interests of either borrowers or lenders. Both Fed Chairmen believed that an effective solution would require an expansion of IMF lending and more balanced emphasis on adjustment to the new cost of oil in addition to financing.[2]

Volcker (1980: 26) also observed, however, that adjustment in the developing countries would mean a decline in developed country exports – and a shift in the current account deficit toward the developed countries. For this reason, it is perhaps unsurprising that other US policymakers – notably not those involved in bank supervision – were actively encouraging developing countries to borrow (Kapstein 1994: 85, quoting Deputy Secretary of State Elinor Constable). In this environment, one begins to understand why the inaccurate euphemism “recycling of the OPEC surplus” gained so much currency (id). This was a way to use language to imply that bank loans to LDCs were just a way of efficiently reallocating resources, while avoiding acknowledgement of the dangers of this massive increase in debt to both the borrowers and the lenders. Bank regulators were naturally focused on the latter, and much less concerned about the effects more prudent bank lending might have on the balance of payments.

When Volcker was giving his speech the Federal Funds Rate had barely breached 17%. He could not have known that it would ultimately take many months of interest rates in excess of 17% to control inflation. (Indeed, this was understood at the time as evidence of a remarkable decline in the effectiveness of monetary policy, Economist 1984: 62.) From the oil-importing countries’ perspective, there was not just an oil “tax” during this period, but also a debt “tax.” Adjustment would have been devastating, and many countries chose to borrow their way through 1981. There was a major difference this time around: whereas the first oil price hike was accompanied by inflation that reduced the real burden of the debt, the “debt” tax instead had the effect of ending the US inflation and thus making the dollar-denominated debt burden that was being taken on heavier than expected.

Why the banks were willing to accommodate the growth of LDC debt during 1980 and 1981 is not entirely clear. In June 1981 Fed Governor Wallich (1981) was publicly calling on the banks to limit their exposure to LDC debt just as Volcker had done a year earlier, but to no effect (GAO 1982). Was the First Pennsylvania bailout interpreted by bank management teams as evidence that the Fed was willing to do “whatever it takes” – a view that shifted only when Penn Square was liquidated? Were the bank supervisors – despite Volcker’s and Wallich’s warnings – not paying enough attention? Did the Fed, or some part of it, have a policy, like that during the First Pennsylvania bailout, of avoiding bank failures due to LDC debt exposure during the Volcker disinflation?[3] Given how clearly the Fed saw the risks in 1980, how publicly the Fed discussed its’ concerns, and the fact that formal capital requirements were developed in this period to constrain LDC lending (Wallich 1981: 13; FDIC 1997: 89), the evidence indicates that the expansion of LDC lending by the money center banks in 1980 and 1981 was a decision made by the banks despite the bank regulators’ efforts to restrain this growth.[4]

Bank management had a responsibility to both shareholders and the bank corporation more generally to run the bank in a responsible manner with a view to future solvency and profits. Given that the seven largest banks accounted for significantly more of the growth in US bank loans to LDCs during this period than the rest of the banking system,[5] there is strong evidence that the credit backstop (improperly labeled “lender of last resort” support) provided by the US to the Eurodollar market had the indirect effect of interfering with the operation of traditional market-based restrictions on this LDC lending. In other words, the presence of moral hazard has to be part of the explanation both for bankers’ willingness to take on excessive exposure to LDC debt and more importantly for these bankers to continue to have access to funding on interbank markets despite their significant and increasing exposure to this debt. Indeed, even if evidence eventually arises to support the view that regulators were promoting the extension of LDC debt during the Volcker disinflation, moral hazard would have to be part of the explanation for bankers’ willingness to comply with such non-economic pressures.

Due to the money center banks’ massive exposure to Mexican debt, in August 1982 the international financial system was put at risk. Prompt recognition of losses on the debt would have caused the failure of seven or eight of the ten largest US banks at the time. To avoid this outcome, the banks were granted regulatory forbearance and given time to earn their way out of their losses (FDIC 1997b: 207). Just when default was imminent, the US government stepped in to prevent it (Boughton 2001: 292-93). The measures taken, however, were stopgaps, designed only to buy time for a longer-term solution to be worked out. Due to the limited resources of the IMF what was viewed as a viable program for restructuring the debt and reforming the economy required a $5 billion increase in private sector loans. While the outstanding loans were concentrated in the money center banks, syndication meant that more than half of the debt was held by about 500 additional banks. The smaller banks had managed their exposures much more carefully than the large banks and stood ready to take their losses – they did not need a bailout. Of course, if the small banks walked away the burden on the large banks of the proposed restructuring would be much heavier, increasing the concentration on their balance sheets (Broughton 2001: 305-07, 312).[6]

The solution to this problem was “officially sponsored concerted lending” (Broughton 2001: 312): the IMF began to meet repeatedly with the Chairmen of the largest banks in order to determine the best way to bring hundreds of banks on board with the extension of new loans. The big banks asked the IMF to help persuade domestic bank regulators to both pressure the smaller banks to participate in the loan extension and also provide regulatory forbearance for bank LDC loans.[7] The money center banks were also able to use the fact that the smaller banks needed to be induced to participate to wrangle very favorable terms from Mexico for the loan extension – which of course the bigger banks with their larger exposures also benefited from (Broughton 2001: 309-11). The net effect would be that the bank creditors would receive large net transfers from the debtor countries, while the official creditors made large net transfers to the debtor countries (Kapstein 1994: 95-96, quoting Sachs 1986).

In short, the money center banks were first able to profit from their aggressive lending practices in the lead up to the crisis, and then to negotiate a restructuring with the Mexican government as representatives of the much more cautious lenders who could easily walk away. This was the effect of forcing Mexico to deal with an officially-sponsored cartel of lenders that was working hand-in-hand with the IMF, which in some cases was even willing to act as an intermediary presenting the bankers’ objections to Mexican regulations to the Mexican government (Broughton 2001: 308). If the Washington Consensus-based austerity policies imposed on the LDCs by the IMF had actually been the formula for economic success that they purported to be, there might have been an excuse for this dirigiste approach to the LDC debt situation. In retrospect, however, it is obvious that these policies served only to strengthen the money center banks at the expense not just of the developing countries, but also of the non-money center banks in the developed countries.

After the Mexican debt crisis, “spontaneous” new lending to Latin America dried up entirely, replaced by “officially sponsored concerted lending” that combined bank and IMF loans with IMF adjustment packages that imposed austerity on the developing countries (Kapstein 1994: 91, 96). Indeed, because the banks were expected to work with the IMF and to promote its adjustment programs, it seems that independent lending by the banks might well have met with policymakers’ disapproval. In the International Lending Supervision Act of 1983 the US (finally) increased its funding for the IMF.[8] With new bank lending slowing to a trickle, and massive outflows from the LDCs to the banks in interest payments, by the mid-1980s the Latin American economies were not just stagnating, they were suffering (Kapstein 1994: 88, 97).

By 1987 the money center banks had largely recovered from the crisis. The developing countries, however, had not. In that year Brazil declared a moratorium on the interest payments on its debt, and the banks began to realize most of the losses on their LDC debt (Kapstein 1994: 99). Only in 1990 did the reality of the developing countries’ economic regression finally result in a policy of debt reduction. In practice, however, the developing countries had to negotiate the Brady Plan reductions with the banks, and the amount of the reduction was generally small (Kapstein 1994: 100-01).

Overall, in the years leading up to the 1982 crisis the capacity of the money center banks to continue to receive market-based funding despite the reckless risks they were taking can be explained only by the moral hazard created by the US policy of protecting bank creditors from losses. That this was distorting the banking system’s capacity to allocate credit efficiently should have been obvious by 1982 when the Mexican debt crisis broke out, as it is a clear cut case of gross mismanagement by the largest US banks. Instead of recognizing that the government-guaranteed funding of the largest banks was undermining the banking system’s capacity to exercise careful judgment when underwriting loans, in the face of abundant evidence to the contrary the money center banks were treated as if they were inherently endowed with good judgment. The result of this experiment was aptly predicted by Bagehot (1873): “aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”

In addition to the evident moral hazard aspects of the 1982 debt crisis, it also seems to mark a turning point in the relationship between developed country governments and the money center banks. Instead of responding to the banks’ gross errors in lending judgment by disciplining the banks, insisting that management be replaced, that business lines be sold, that the worst-managed banks shrink their balance sheets, the governments entered into a confederacy with the mismanaged banks to extort concessions from the debtors. These debtors who had traditionally borrowed on the London market, where banks had for more than a century been required maintain high lending standards or fail,[9] were completely unprepared for the change in regime. The non-money center banks were being treated as subservient to policymakers and were called upon to make loans “for the good of the banking system,” instead of being treated and respected as independent entities, responsible for their own decisions. Starting with the 1982 crisis, the IMF regularly refused to lend unless its lending was accompanied by new commercial bank loans, and policymakers and bankers were careful to work together and present a united front to debtors (Kapstein 1994: 96).

In short, if in the 1970s the credit guarantees provided on US money center bank liabilities set the stage for the growth of a massive government-supported international financial system on the weak foundation of moral-hazard-ridden bank decision-making, in the 1980s the system evolved so that these same fundamentally compromised banks were treated not just as the partners of official institutions, but as cronies who generally had the right to favorable terms by comparison with those earned by the government. In less than a decade the rot in the international financial system had settled very deep indeed. This set the stage for the Asian financial crisis fifteen years later – and also for the savings glut that was a response to the crony capitalism that lay at the heart of the international financial system post-Bretton Woods.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] Mexico is a clear example of the fact that the LDC crisis was not generated by the “recycling” of oil-based earnings to oil-importing countries.

[2] “Let us not delude ourselves: financial flows cannot fill indefinitely a gap that must be covered by conservation, production, and new forms of energy.” (Volcker 1980: 33).

On the other hand, as Spiro (1986: 141-42) observes, political decision-makers in the US chose not to provide the IMF with enough funds to play the role envisioned by the Fed Chairmen.

[3] Kapstein (1994: 76-77) indicates that the Economist reported that central bankers pushed the banks to extend their loans during this period, but in context it is far from clear that the Economist is making this claim for 1980 and 1981, rather than for the period after the debt crisis broke in August 1982 (Economist 1984: “To make the [IMF’s] case-by-case approach work, several central banks have been ready to twist arms, persuading their commercial banks to keep lending to Latin America. With hindsight they agree that the lending went too far and too fast in 1978-82; foresight warned them that too big a slowdown would make it harder for debtors to service their debt.

Though commercial bankers dislike being bullied by their central banks many admit it was necessary.”)

[4] It is interesting that Volcker (1980: 29) observed that “the record since 1973 has shown that outright defaults by borrowing countries are virtually non-existent,” perhaps indicating that he understood very well that LDC default might be avoided with the help of multilateral institutions like the IMF.

[5] The seven largest banks accounted for 56% of US bank loans to LDCs in 1980 and 60% in 1982 (Madrid 1990: 59; see also FDIC 1997: 199).

[6] On October 15, 1982 with the passage of the Garn-St Germain Act statutory limits on lending to a single borrower were increased to 15% of capital or 25% when backed by collateral. Given the timing this section appears to have been designed to facilitate an increase in commercial bank lending to Mexico and other LDCs.

[7] Thus, when the Economist (1984) discusses central bankers “bullying” the banks to extend their lending to LDCs, it may well be referring to this episode late in 1982 when there is no question that a great deal of pressure was put on the banks to extend their loans.

[8] The same law created congressionally mandated capital requirements for banks and called for international coordination of such requirements.

[9] Indeed, the Baring crisis of 1890 is an apt comparison. When Baring Bros. failed due to reckless lending in Argentina, the managing partner was left impoverished and offered a stipend by a relative who had retired from the firm and had no liability for the losses (Sissoko 2016).

Dismantling the economy’s legal infrastructure V-5-c: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 3: First Pennsylvania bailout

The Bailout of First Pennsylvania Bank

In the last months of 1978 the Iranian Revolution triggered a second dramatic rise in oil prices, and by 1979 US inflation was beginning to spiral out of control. As the Federal Reserve struggled with the problem of monetary control, regulators were very aware that non-bank liabilities and the Eurodollar market with its 20% per annum growth rate were part of the problem (Hawley 1984: 148). As the nature of the money supply was transformed, the Fed began to have control over only a portion of the de facto money supply: the Fed had traction over local domestic markets, but not the Eurodollar market; it had traction over bank-reliant SMEs, but not large firms that could raise funds on the commercial paper market (which was of course also bank-reliant, but off-balance-sheet and subject to little or no monetary control). The changing nature of the money supply meant that by the end of the 1970s the tools of monetary policy mostly affected local domestic markets and SMEs, that is those with no or limited access to Eurocurrency and commercial paper markets (Hawley 1984: 149, 153).

As a result, in early 1979 Fed Chairman Miller, New York Fed President Paul Volcker, and Treasury Undersecretary Anthony Solomon (who would succeed Volcker as New York Fed President) sought (i) to bring non-banks within the purview of the Fed’s control and (ii) to control and regulate the Eurodollar market (Hawley 1984: 151).[1] The Depository Institutions Deregulation and Monetary Control Act of 1980, which is discussed in a previous post, was (mistakenly) expected to address the first agenda item.[2] The second item required coordination with foreign regulators. This type of coordination had been initiated in 1974 with the formation of the Basel Committee of Bank Supervisors (“BCBS”). The US policymakers in 1979 had two policy objectives: the systematic collection of data on Eurocurrency markets and the imposition of minimum reserve requirements on Eurocurrency deposits (Hawley 1984: 152-55). The BCBS was, however, composed of regulators with very different interests and thus was unable to frame a common approach to the problem, much less a common solution. Neither of the regulators’ goals was achieved (Kapstein 1994: 52; Hawley 1984: 158-59). Acknowledging defeat, US regulators ultimately stopped advocating for controls on the Eurodollar market and settled instead in 1981 for a policy that attempted to draw the offshore accounts onshore by permitting international banking facilities (IBFs) – with their minimal level of regulation – to be located in the United States (Hawley 1984: 156; 46 FR 32426). This was a solution the biggest banks had been lobbying for since 1978 as a step towards deregulation of the domestic market (FRBNY 1978).

The bank regulators imposed the first mandatory capital requirements on banks between 1980 and 1981 without Congressional prompting, presumably due to concern over the deterioration of bank balance sheets during Volcker’s interest rate hike (FDIC 1997b: 89. Prior to this policy, regulators were described as “attempting to persuade” banks to improve their capital ratios, Gilbert et al. 1985: 15.)[3] Notably the distinction between primary (now called Tier I) and secondary (now called Tier II) capital, that is the treatment of subordinated debt of more than seven years as secondary capital, was incorporated into these early requirements.[4]

By mid-summer 1979 there was a sense that the economic situation was spiraling out of control and that President Carter might not have what it takes to deal with the situation (Greider 1987). Carter reconfigured his cabinet and, after moving the Chairman of the Federal Reserve to Treasury, appointed Paul Volcker to the Federal Reserve. There is no question that Volcker’s job was to restore economic confidence – or that Volcker was going to take aggressive measures to stem the rise in prices. Note that Volcker was aware that one of the reasons interest rates would have to be raised to unprecedented levels was because the Fed’s monetary control had been eroded by the growth of thrift transaction accounts, money market funds, and Eurodollars (Volcker 1979: 54-56).[5] This also meant that when monetary policy was used to slow the economy, local domestic markets and SMEs bore the brunt of the burden, while firms with access to international markets bore less of it. Volcker viewed the oil price hike as a stimulus to inflation that was forcing him “to push harder against inflation than ever before and risk damage to economic activity here and abroad” (Volcker 1980: 33).

In order to force inflation back under control, Volcker initiated a policy of raising short-term interest rates as high as was necessary to complete the task.[6] Early 1980 was a moment in Fed history when the path set by the Fed was designed to shift the future performance of the economy onto a better path. As a result, the last thing the Fed needed was to set off a banking collapse. And Paul Volcker knew that the Fed had the capacity to keep a troubled bank alive indefinitely. Thus, a little recognized aspect of Volcker’s monetary policy was a commitment to support banks through the tight money period – in order to ensure that the seeds of confidence that Volcker was sowing could take root.

Just eight months into Volcker’s chairmanship, the sharp rise in interest rates triggered the failure of an incompetently managed bank.[7] (This discussion is based on Sprague 1986: Ch 5.) In 1968 First Pennsylvania Bank, one of the nation’s oldest banks, had appointed a CEO who sought to join the ranks of the largest banks by embracing a policy of aggressive growth based on volatile funding sources such as brokered certificates of deposits and Eurodollars, together with not-so-careful loan origination. Increasingly intrusive Fed supervision starting in 1969, had led the bank to convert in 1974 to a national charter and OCC supervision. Finally, in 1976 the bank had tried to gamble its way out of its difficulties by investing heavily in long-term Treasuries that were paying unprecedentedly high yields, funding the purchases with short-term borrowings.

By the start of 1980 the OCC, whose Comptroller was a member of the three-man FDIC board, was sure that when First Pennsylvania reported another quarter of massive losses, a run on its market-based funding would ensue. The FDIC had spent the previous year preparing for the failures of mutual savings banks that were doomed in the contemporary high interest rate environment through no fault of their own. Thus, the remaining two FDIC directors were acculturated to imposing market discipline on banks, and had to be convinced that there was a good reason to make an exception for First Pennsylvania. Their resistance was worn down in no small part because the Fed was lending ever increasing amounts to the bank and Fed Chairman Paul Volcker told the FDIC board that he was committed to continue doing so. At the same time, the Fed alongside the Comptroller (and FDIC Board member) pressured the remaining two members of the FDIC board that “there was no alternative” to an FDIC bailout as a crisis of confidence would follow. The FDIC, of course, knew that the Fed could keep the bank alive indefinitely – at increasing cost to the insurance fund as more and more uninsured depositors withdrew their funds.

The FDIC finally settled on a bailout via a below market-rate loan together with warrants that would provide a controlling interest in the bank. In this case, the bailout was successful: within five years First Pennsylvania had paid off the FDIC loan and bought back the warrants.[8]

Observe what had taken place. In market-based lending’s first decade, it had been used to hold financial regulators hostage, not once, but twice. At least in response to the Franklin National failure the Fed Board had recognized that the bailout was a very dubious way to socialize private losses and therefore sought to dramatically expand control over the banks. The First Pennsylvania bailout, although it took place only six years later, did not generate a similar reaction. Bailouts of poorly managed banks – at least those that were financed on the Eurodollar market – had become the usual course of business for the Fed.

One can only speculate as to what had happened within the culture at the Fed that made possible this shift in policy in favor of bailouts. Two factors, however, stand out. It seems very likely that the turnover that was taking place at both the Fed Board and the Fed’s General Counsel’s office played a role in the normalization of the use of the Fed to socialize private losses. And it is noteworthy that banks were using the language of the new portfolio theory to frame their activities: in federal testimony they presented the “competitive advantages” provided by Eurodollar markets as promoting “efficient” allocation of resources; they described the Eurodollar market as “simply an efficient intermediary between national markets,” denying the evident capacity of the Eurodollar markets to create money; they portrayed the offshore interbank market as something that should be ignored when calculating monetary aggregates – despite the fact that Eurodollar markets were funding banks that could not get domestic funding; at the same time they argued that the central banks as lenders of last resort were “responsible not only for the banking systems, but … for the totality of financial markets” (Weatherstone 1979a, 1979b; Ogden 1979).[9] In this environment where the instability being generated by Eurodollars and other forms of so-called market-based funding was not being acknowledged as a problem, the coming bailout of Continental Illinois National Bank had been made inevitable.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] Eventually Governor Wallich got on board, worried that Fed could lose control of monetary aggregates (Hawley 1984: 153).

[2] DIDMCA made the thrifts subject to the Federal Reserve’s reserve requirements, eliminated Regulation Q interest rates caps, and increased the level of deposit insurance in hopes of giving deposits a competitive advantage over money market funds. As was noted in a previous post, regulators at this time apparently underestimated the importance of structural separation and simply assumed that deposit insurance was the key stabilizing innovation of the 1930s.

[3] The International Lending Supervision Act of 1983 also mandated the imposition of capital regulations (Pub. L. 98-181 §908; FDIC 1997b). Wallich (1981) indicates that the early capital requirements that were being implemented by examiners were still not very effective and served mostly to put a bank’s management and board on notice that a problem was brewing.

[4] The treatment of subordinated debt as capital dates backed to Kennedy’s enterprising Comptroller of the Currency, James Saxon, who was the first regulator to approve the issue of subordinated debt by banks. At the same time he ordered its treatment as capital (Mayer 1974: 397-400). By 1970 all the federal regulators permitted the issue of subordinated debt (Mayer 1974: 237). On Saxon, see also Kettering 2008: 1667.

[5] Note also that Volcker had a more sanguine view of the severity of the effects of Eurodollars and nonbanks on monetary control than, for example, Anthony Solomon, but also deferred to Treasury on international monetary matters (Volcker 1979: 33).

[6] Technically, there was a “monetarist experiment” first, but it is still being debated whether this was only a front to make Volcker’s aggressive policy more palatable (see e.g. Stigum & Crescenzi 2008: 377).

[7] The FDIC was able to force out the CEO, but not to undo the “golden parachute” he had negotiated prior to the collapse.

[8] In 1998 First Pennsylvania merged into First Union National Bank, which later changed its name to Wachovia. Wachovia failed in 2008 and was taken over by Wells Fargo.

[9] Hawley (1984: 132-34) describes the contradictory positions taken by the money center banks with respect to the Federal Reserve and the banking system as “policy schizophrenia.”

Dismantling the economy’s legal infrastructure V-5-b: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 2: The growth of LDC loans

The Growth of LDC Loans

Starting in late 1973 the Eurodollar market saw a significant inflow of funds as the first oil price crisis directed an extraordinary flow of funds to the OPEC member states, and they turned to the Eurodollar market as a safe savings vehicle that paid relatively high interest rates. As a result, funding costs plummeted for the large banks active in these markets. At the same time, these banks were losing their biggest commercial borrowers to the commercial paper market, supported with off-balance sheet guarantees from the money center banks. These banks had no desire to restrain the growth of their off-balance-sheet activities which both faced limited regulatory oversight and were protected from the competition of smaller banks. (Smaller banks couldn’t issuer off-balance-sheet guarantees as easily as large banks, because even in the 1970s a large bank failure was far less likely to impose losses on unsecured creditors since regulators always did their utmost to sell off a large, failed bank together with its liabilities, whereas small bank creditors were often handled more harshly.) Thus, the money center banks, faced with an unexpected windfall in funding and having shifted their traditional clients to off-balance-sheet financing, needed to find earning assets that were alternatives to their traditional commercial lending (FDIC 1997b: 196-98).

They turned to syndicated loans: in the late 1970s and early 1980s these loans typically financed the dollar-denominated debt of developing countries.[1] After the LDC debt crisis of the early 1980s, syndicated “leveraged loans” would be used by the banks in partnership with takeover specialists to load conservatively run companies with debt. At the same time, mortgage lending was opened up to banks and this would become another avenue for non-traditional on-balance-sheet lending.

Despite the common claim that in the 1970s the banks were “recycling” petrodollars from oil exporting countries to oil importing countries, that was more the job of the multilateral institutions, such as the IMF, which was willing to lend to countries with significant credit risk. Although the Eurocurrency markets tripled in size from 1973 to 1978, less than 30% of the $325 billion increase was accounted for by the OPEC surpluses (Volcker 1980: 9, 15).[2]

Furthermore, the banks were lending to a select group of developing countries, some of which were oil exporters (Spiro 1999: 70-71). This is explained by the support provided by the developed countries to their export industries in response to the oil crisis. By increasing the provision of government guarantees on the debt incurred by the buyers of the exports many developed countries were able to keep their current accounts from going heavily into deficit (Kapstein 1994: 62, 68).[3] As a result, the deficits created by the transfer of value to the largest oil exporters were shifted towards developing countries. Indeed, by 1978 the OECD country current account surplus was greater than the OPEC surplus (Volcker 1980: 34). As the goods exports of developed countries increased in response to the export guarantees that were expanded during the oil crisis, even those developing countries that were oil exporters experienced deficits. Since the countries with a robust source of export earnings were naturally viewed as particularly creditworthy by the banks, these countries had generous access to the syndicated loans provided by the banks that operated in the Eurodollar market. Thus, Spiro (1999: 130-31) questions the standard narrative which assumes that finance does not have a causal role in driving trade flows and asks instead whether it was the banks’ willingness to fund a developing country’s debt that made it possible for that country to run a trade deficit.[4]

By 1976 divisions were showing amongst the developing countries. In May at a UN Trade and Development conference the G-77 countries were seeking a moratorium on debt. They did not, however, have the support of the biggest and richest developing countries, which were the beneficiaries of the money center banks’ syndicated loans and as a consequence had the most to lose from being shut out of international lending markets (Kershaw 2018: 303) – or so they thought at the time. In fact, over the course of 1976 US banks would seek to reduce their exposure to Mexican debt in the face of a growing expectation that currency devaluation would be necessary in order to address the current account deficit. Needless to say, such prophecies are self-fulfilling. As market-based credit became scarce, Mexico was forced to turn to the IMF which imposed currency devaluation as a condition of its loan (Kershaw 2018). In the months before the IMF loan was concluded, the Federal Reserve provided a $360 million credit line to Mexico and then repeatedly rolled it over in order to avoid a moratorium on the Mexican debt and the consequent damage to the US commercial banking system (Kershaw 2018: 307). Overall, at the behest of the IMF and the US government in 1976 the Mexican government chose to embrace austerity in order to maintain access to international credit markets.[5]

How then should the government role in the banks’ lending to developing countries be characterized during these early years of the LDC lending boom? For this early period, I have been unable to find clear evidence that “the U.S. government encouraged the American banks to recycle petrodollars to borrowers in Latin America” as Feldstein (1991) claims. In particular, there is little evidence that government officials attempted to direct the flow of funds to particular borrowers (Madrid 1990: 44). On the other hand, government officials created an environment where syndicated lending – and the LDC lending associated with it – was facilitated (Braun et al. 2019). First and foremost, as was discussed in detail in the previous post, US policymakers prevented a significant collapse in the Eurodollar market when they bailed out international creditors from the fraud perpetrated by Franklin National Bank. This was strongly reinforced by the September 1974 declaration of the G-10 central bankers that they were ready to support Eurodollar markets (see Kapstein 1994: 66 and Kershaw 2018: 305). When combined with the US refusal to support an expanded role for multilateral institutions to address the balance of payments problem, the effect was to place the burden of managing the balance of payments problem on the banks and the Eurodollar market (Spiro 1999: 141-43; Kershaw 2018: 305).[6] Add when one then adds to this situation the Federal Reserve’s role in the 1976 Mexican debt crisis,[7] one can easily conclude that LDC lending was the natural consequence of the environment created by US policymakers during the oil crisis when they demonstrated in 1974 and 1976 that they viewed instability in the international monetary system as a threat to US hegemony and were therefore willing to take unprecedented actions to avoid such instability by bailing out the money center banks, both directly and indirectly and with no exception for cases of fraud. It is equally unsurprising that in this environment the LDC loans were high margin and very profitable during the boom years of the 1970s (Madrid 1990: 46 -52).

While one can take the position that the Franklin National bailout and the role played by the Fed in the 1976 Mexican debt crisis served to “encourage” US banks to lend to developing countries, it is worth pausing a moment to consider what this approach implies. The Federal Reserve had demonstrated (i) that it was committed to protecting the Eurodollar market creditors from the failure of a US bank and (ii) that together with Treasury it was willing to intervene in a case of sovereign default to protect the interests of US banks. To the degree that these actions are treated as “encouragement” to the banks to increase their loans to risky sovereign borrowers, the mechanism at work is clearly moral hazard, or the tendency of insurance to cause an increase in risk-taking. In short, when people like Martin Feldstein claim that the US government encouraged LDC lending by banks in the early years of the lending boom, what they are actually acknowledging is that the Federal Reserve’s protection of interbank markets was creating a serious moral hazard problem and driving a significant increase in bank LDC lending.

To the degree that such “encouragement” existed, it was not at all uniform. By 1977, the Federal Reserve was expressing concern that the syndicated loans to developing countries would cause problems for the banks (FDIC 1997b: 198-99).[8] The regulators gathered data so that they could track bank lending to LDCs carefully and so that the banks had appropriate data with which to refine their underwriting techniques (Volcker 1980: 13). On the other hand, in keeping with its history of lax regulation the OCC issued a Final Rule in 1979 that had the effect of increasing the exposure that a bank was permitted to have to any single country.[9] Overall, regulatory demands that banks control their foreign lending were moderately successful in 1977, restricting the growth of LDC loans to 11% (Burns 1977b; Madrid 1990: 59).[10] But by 1978 US bank loans to developing countries were growing by 17% per annum, a rate that more or less continued until the 1982 debt crisis (Madrid 1990: 59).

In the meanwhile, in response to the unprecedented role played by the Federal Reserve in the bailout of Franklin National Bank, the Fed was seeking a significant expansion of the regulators’ statutory authority over both bank holding companies and bank management. The legislative reforms demanded by the Fed included (i) authority to regulate foreign banks operating in the US, (ii) establishment of a Council to set uniform bank regulations in the US, (iii) monetary penalties for violations of banking laws and regulations, (iv) authority for the Fed to compel divestiture of a nonbank from a bank holding company if it poses a serious financial risk to a subsidiary bank, and (v) an expansion of the grounds for removal of bank officers and directors to include continuing disregard for safety and soundness (Burns 1977a).

This legislative wish list was largely granted in the Financial Institutions Regulatory and Interest Rates Control Act of 1978 (“FIRA” Pub. L. 95-630).[11] By the time FIRA was passed, however, Thomas O’Connell, the long-time Fed attorney, who likely shaped the law’s provisions, was just two months away from his death, Arthur Burns’ term as Fed Chairman had expired, and President Carter had appointed a new Chairman. Furthermore, this was an era of particularly rapid turnover not just of attorneys in the General Counsel’s Office, but also of Federal Reserve Governors. As a result, by 1978 there was only one Fed Governor and not one General Counsel attorney who had been in office through the events of 1974.[12] Thus, it appears that due to the lack of continuity in the leadership of the Fed, several aspects of this substantial expansion of its statutory powers were never actually put to use.

Note: Many thanks to Benjamin Braun for helping guide me through some of this literature.

LINKS
Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois
Implications

[1] LDC lending by commercial banks rose by $120 billion from 1973 through 1979 (Volcker 1980: 10-11).

[2] One should also note that on the bank funding side of this equation, a significant portion of the OPEC surplus was processed through the domestic US and European banking systems. Only about one-third of the “petrodollar” funds flowed through the offshore Eurodollar markets (Spiro 1999: 58; Kapstein 1994: 67).

[3] Note that Kapstein’s source for this is Wellons (1987).

[4] The facts that the non-oil LDCs import prices rose faster than their export prices and that their export trade with developed countries grew slowly (Volcker 1980: 18) may support Spiro’s claim.

[5] Because, as was acknowledged at the time, Mexican exports had little room to grow and were already effectively priced in US dollars, the devaluation was not likely to increase the revenue from exports, but instead would have to work by reducing Mexican consumers’ demand for imports (Kershaw 2018: 307).

[6] In addition, the relaxation of capital controls in the US made it possible for the petrodollars that flowed into the domestic US banking system to flow out again (Kapstein 1994: 68).

[7] The role of the Fed and the Treasury in the 1976 Mexican debt crisis likely explains Madrid (1990: 70-72)’s finding that bankers expected official intervention in the event of a sovereign default.

[8] Fed Chairman Arthur Burns (1977b) offered a particularly astute evaluation of the risks to the global economy as it was adjusting to the oil price hike (together with an unrealistic assessment of the benefits of IMF loan conditions to developing countries). Because he understood that many countries were being forced to borrow heavily and that banks were likely to “be tempted to extend credit more generously than is prudent,” he saw significant risks to the international credit structure, especially in the event of another large recession or “a new round of oil price increases.” In the absence of such challenges, he was optimistic that an increase in official lending, better data collection on developing country credit risk, and the benefits of IMF conditionality – supporting not just the repayment of IMF but also private sector debt – would together result in a successful adjustment of the world economy. He encouraged private lenders to avoid undercutting the IMF and more particularly to coordinate with the IMF in demanding loan concessions. He also called out oil-importing countries that were running persistent surpluses for the costs they were imposing on the rest of the world. (A refrain that has been resonating for nearly a century now.)

[9] There was a statutory limit on loans to any single “person” to 10% of capital, and regulators had traditionally treated all foreign loans to any government entity as loans to that country’s “government” as a single person for the purposes of the statute (Kapstein 1994: 77). In the Final Rule depending on how the loan was to be used and on the means of payment available to the borrower, this aggregation would not be required (44 FR 22712, 1979). Paul Volcker, President of the New York Fed at the time, apparently took a positive view of this regulatory change describing it as “a Solomon-like judgment” (Kapstein 1994: 77).

[10] Note, however, that in this year non-US banks apparently stepped into the breach, so total LDC debt to private creditors increased by 33% (compare Kapstein 1994: 71 to Madrid 1990: 59).

[11] The authority to force a BHC to divest a subsidiary is encoded in 12 USC s. 1844(e), the authority to force termination of an officer or director is encoded in 12 USC s. 1818 (e), and the Federal Financial Institutions Examination Council was formed in 12 USC 3301.

[12] Henry Wallich was the Governor. Philip Coldwell had arrived at the Board late in October 1974. Two attorneys in the General Counsel’s office had been hired over the course of 1974, Charles McNeil and Allen Raiken.