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.

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

[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.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s