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).

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