Dateline Wall Street: Faustian Finance
The current solution to the international debt problem is disturbingly similar to the policies and processes that created the crisis in the first place.
On Friday, Aug. 13, 1982, as one U.S. Treasury Department official describes it, Mexico’s Finance Minister Jesus Silva Herzog "showed up on our doorstep and turned his pockets inside out." His arrival marked the beginning of an international debt crisis that by Christmas had swept through more than a dozen debtor countries and a thousand creditor banks and placed more than $300 billion in international loans in jeopardy.
Poland’s and Argentina’s debt-servicing difficulties had preceded Mexico’s, to be sure, but did not have the same systemic impact. Mexico’s liquidity crisis has in a few short months altered the way in which banks and governments now deal with international debt problems, and more important, how they deal with each other.
For the first time, the International Monetary Fund (IMF) is applying conditionality to lending banks as well as to borrowing countries. IMF Director Jacques de Larosiere announced in November 1982 that the Fund package for Mexico could not progress until the banks had agreed to provide $5 billion. Indeed, he refused to take the program to his board of trustees until the banks committed themselves on paper. The United States and other member governments supported him, and the banks agreed. This pattern was repeated in assembling rescue packages for Argentina, Brazil, and Yugoslavia.
Such IMF activism contrasted sharply with the Reagan administration’s vision of the Fund’s role. President Ronald Reagan came into office pledging to reduce U.S. financial support and participation in the IMF, the World Bank (International Bank for Reconstruction and Development), and related financial organizations, which he regarded as insufficiently responsive to U.S. foreign-policy directives. But as the magnitude of the Mexican debt problem became apparent and as other countries of strategic concern to the United States approached the financial abyss, the administration turned to these same organizations for help in containing the debt crisis.
The debt crisis has also changed the attitudes and practices of the commercial banks, which historically have resisted attempts to intervene in their international operations by their governments and by international agencies. Now hailing a new era of cooperation with officialdom, the banking community is actively lobbying Congress to support the IMF quota increase and funds for the international development banks.
How did this dramatic transformation come about? What does this change portend for the future management of the international monetary system? The agreement governments and international agencies reached with the banks resembles nothing so much as a Faustian bargain, in which the governments may pay too high a price to secure the cooperation of the banks.
The Bounty of Petrodollars
Many have hailed the recycling of petrodollars-the lending of hundreds of billions of dollars from the wealthier oil-exporting countries to Eastern Europe and to the less developed countries (LDCS) that are not part of the Organization of Petroleum Exporting Countries (OPEC) by U.S. and other private commercial banks-as the economic success story of the 1970s. The ease with which countries were thus able to finance chronic and growing balance-of-payments deficits, rather than having to reduce imports and slow growth, created the illusion that no lasting economic costs attended the quintupling of oil prices in 1973 and their more than doubling in 1979.
The larger U.S. and British banks led the way, but other banks quickly realized that they would have to join in the recycling effort or become uncompetitive. In the mid-1970s the return on foreign loans was substantially higher than on domestic loans. In 1976, for example, Chase Manhattan Bank classified 48 percent of its assets as international and attributed 78 percent of its earnings to those assets. Loans to Latin America produced 20 percent of Citicorp’s earnings though they represented only 6 percent of its assets. Later, when regional banks joined the fray, and West European, Japanese, and eventually Arab banks began fighting for a share of the market, the competitive scramble pushed profit margins on foreign loans sharply lower–with notable exceptions, such as loans to Brazil. But in this era of aggressive bank expansion, growth of assets was more important than return on assets.
Floating rather than fixed interest rates, that is, interest rates adjusted about every six months to reflect changes in market rates — protected the banks against the risk that the cost of funds would rise more rapidly than income from the loans. But the banks all but discounted the possibility that sovereign borrowers would default. As Walter Wriston, chairman of Citicorp, argued, countries never go bankrupt. And the narrow spreads between what the banks had to pay for funds and what they charged for these loans provided little insurance against this eventuality. For sound credit risks like Mexico, this spread could be as little as 0.5 percent over the London interbank offered rate (LIBOR).
The governments of the industrial countries applauded the banks’ recycling successes. Unwilling or unable to confront OPEC over the oil prices, these governments were only too happy to be relieved of responsibility for managing the resulting international financial dislocations.
Some bankers now claim that their governments pushed them into this lending. This charge has some validity with regard to loans by West European banks to East European countries. But more generally, it is fair to say the central banks, finance ministries, and bank regulators in the United States and other major creditor countries at each stage of the emerging crisis did nothing to moderate the pace of international lending by the banks. Indeed, each time a problem arose that might discourage this activity, governments rushed to restore confidence in the markets and to make the world safe for more lending.
In the early 1970s, for example, the IMF tried desperately but in vain to keep foreign banks from supplying unlimited credit to Pertamina, the Indonesian state oil company, in clear violation of that country’s standby agreement with the IMF. When Pertamina eventually found itself unable to service the $8 billion in foreign bank loans it had accumulated, the U.S. State Department and U.S. bank regulators nevertheless intervened to keep a Dallas, Texas, bank from calling a formal default. They then pressured the Indonesian central bank into taking over Pertamina’s bank debts to save the banks involved from any losses.
Early 1977 saw a forerunner of the later crisis. Peru, Turkey, and Zaire were experiencing debt-servicing difficulties. On March 15, David Rockefeller of Chase Manhattan Bank warned in a speech: "Bank debt to a number of these countries has been expanding at a rate that should not — and cannot — be sustained."
Briefly, there was talk of governments’ having to assume more of the burden of recycling. Instead, IMF members, including the United States, established a $10-billion Supplementary Finance Facility, arguing that it would restore confidence in the marketplace and encourage the banks to continue lending.
From late 1977 to mid-1982, loans to non-OPEC LDCs tripled, from $94 billion to $270 billion. Yet the Carter administration continued to consider debt problems manageable. Anthony Solomon, then undersecretary of the Treasury, confidently asserted that "there is absolutely no prospect of a debt rescheduling in regard to Mexico and Brazil."
In November 1979 the Carter administration froze Iranian bank deposits and then conveniently allowed major American banks, which feared repudiation of the Shah Mohammad Reza Pahlavi’s debts by the revolutionary Islamic regime, to use the frozen deposits to offset — that is, to pay of — the loans.
In each case, the governments clearly had broader policy objectives in mind than just helping the banks. The U.S. government hoped to prevent destabilization of the Indonesian government or deterioration of relations with this important oil producer; the Iranian asset freeze was also retaliation for the seizing of American hostages in Tehran. But the cumulative effect of these actions was to reinforce the banks’ perception that lending to sovereign states meant no-risk lending: Whenever a serious problem arose, the banks’ own governments would rush to the rescue. But the system could not absorb the multiple shocks of the 1979 oil price increase. Governments were unprepared for the unthinkable — a simultaneous debt crisis in the two biggest sovereign borrowers, Mexico and Brazil.
Mexico’s financial collapse has badly shaken both the international credit structure and confidence in the recycling process. Federal Reserve Board Chairman Paul Volcker appears to have been the key actor in the latest debt drama. A White House official says Volcker "thought the banking system was about to collapse" when the Mexican crisis broke.
The Federal Reserve system (Fed) knew that the Mexicans were in trouble as early as winter 1981 to 1982, during the final months of Jose Lopez Portillo’s presidency. That February the Mexican central bank drew on its swap line with the Fed, which allowed it to get dollars for pesos without buying them in the market. The drawing was quickly repaid, but the Fed interpreted the Mexican action as an indication that Mexico’s dollar reserves were running low and that the country was experiencing a significant cash-flow problem. A February devaluation apparently did not solve the problem. The Bank of Mexico continued the pattern: It drew $600 million on April 30 and repaid; drew $200 million on June 30 and repaid; drew $700 million on July 31 and repaid; and drew $700 million on August 4. U.S. and foreign commercial banks continued to lend to Mexico through most of this period, although a huge loan syndicated in May and June met with some market resistance. Yet the Fed did not discourage the banks, fearing that a halt in bank lending would only aggravate the situation. Like the banks, the Fed thought the problem could be managed until a new administration took charge in Mexico City in December.
Unfortunately, while foreign bankers retained confidence in Mexico, the Mexican people had lost theirs. They were shipping dollars out of the country faster than the government could borrow them back. It was this outflow of foreign exchange, far more severe than either the commercial banks or the U.S. government realized at the time, that precipitated the crisis in August and forced Silva Herzog to make his humiliating pilgrimage to Washington.
The Treasury moved with uncharacteristic speed in putting together a $2 billion U.S. emergency financing package for Mexico during that first critical weekend. At the Fed’s urging, Mexico decided to declare a 90-day moratorium on the repayment of the principal of its foreign debts and threw itself at the mercy of the IMF. On the other side of the equation, by emphasizing the peril to the international economy, Volcker managed to reverse the Reagan administration’s strong ideological bent against official intervention either to help the banks or to pump more money into the international lending agencies.
While Volcker worked with Treasury in Washington to construct the U.S. aid package for Mexico, the New York Federal Reserve Bank joined major creditor banks, Citicorp and Morgan Guaranty Trust, in gathering more than 100 of Mexico’s commercial creditors for a meeting in New York the following Monday. Ostensibly, the Mexicans called the meeting. Nevertheless, Anthony Solomon, the president of the New York Federal Reserve Board, opened the gathering to explain the short-term aid that the U.S. government had extended over the weekend and to express strong U.S. government support for Mexico. Silva Herzog then took the floor to justify Mexico’s 90-day moratorium and to ask for time to work out a restructuring package. The selection of a 12-bank advisory committee to conduct negotiations with Mexico on behalf of the hundreds of creditor banks was announced. No one from the IMF was present.
From the banks’ perspective, the Fed has been the chief U.S. government policy-making agency throughout the debt crisis. Secretary of the Treasury Donald Regan and Secretary of State George Shultz have both been active in the cabinet-level Senior Interagency Group, which Regan chairs and which has been meeting weekly on the debt situation. And Undersecretary of State Lawrence Eagleburger has carried a message to the banks that cutting off credit to Yugoslavia and Mexico, in particular, would be contrary to national security interests. But the Regan Treasury is held in low regard by the banking community. One banker, expressing what seems to be a widely shared sentiment, comments that "in this Administration, there really is no one at Treasury to talk to." And many bankers say they are not swayed by foreign-policy arguments. "State Department appeals to patriotism affect us very little. These are appeals to values on which management doesn’t get graded or rewarded by the Board," explained Charles F. Turner, senior vice president of Comerica Bank of Detroit, Michigan.
The United States also pushed the IMF into a more assertive role in managing the international debt crisis. Says one IMF insider, there was "big pressure from the United States to get a big package for Mexico." Pressure was necessary because at first the West Europeans held back, apparently to remind the United States that it should have been more forthcoming in dealing with Poland’s debts. Both Volcker and Solomon, says this source, strongly urged the Fund to take the lead in rallying the banks to come to Mexico’s aid. This new activism seems compatible with de Larosiere’s own instincts.
De Larosiere personally took charge of the next large bank meetings on Mexico and Brazil and laid down the terms for a joint solution. By December, Brazil had also run out of cash and was unable to service its $87 billion foreign debt. The IMF director told the banks flatly that the IMF would not support the restructuring proposed by the Brazilians unless the banks agreed to put up $4.4 billion in new money.
The banking community’s reaction to this official intrusion in their affairs can best be described as one of relief. Leeds Hackett, senior vice president at Marine Midland Bank in New York, said: "At first we said, ‘Hey, wait a minute, you’re [de Larosiere] telling us we have no choice.’ Now we realize we must all be in this together." Another New York banker, recalling the many months of bitter wrangling over Poland’s 1981 debt rescheduling, says: "Left to themselves the banks will squabble. Someone has to say, ‘You do X.’ " Says Turner of Comerica: "The IMF’S aggressive role signals a new era and a welcome one. A private sector entity can’t command the necessary steps to get Mexico to put its house in order."
It is not difficult to determine why the banks are pleased with the new crisis-management process. Their principal concern is to protect their balance sheets and their earnings. The quick extension of bridging loans from various central banks and subsequent IMF drawings have prevented any significant disruption of the flow of interest payments from the debtor governments to the banks. Indeed, the Fund is acting as enforcer of the banks’ loan contracts because continued access to IMF funds is contingent on the debtor’s regular payments on its commercial interest. Moreover, the IMF’s austerity programs are designed to free foreign exchange in order to service debts.
Although the banks are not happy about being asked to commit new money to troubled borrowers, they realize that unless they supplement what the Fund and the governments provide, some countries will be unable to keep up the crucial interest payments. Mexico, for example, owes the banks about $8 billion in interest in 1983 but will get only $1.3 billion from the Fund this year.
Moreover, the Fed and the IMF have given the banks a free hand in setting the terms for new bank loans and rescheduling. The banks have seized this opportunity to triple the spread charged on new money for Mexico and to tack on further substantial fees. They have also sharply increased the interest margin charged on rescheduled loans and extracted additional fees. Spreads and fees added to the base interest rate either LIBOR or the U.S. prime rate will cost Mexico about $800 million in 1983. Consequently, loans to troubled borrowers like Mexico and Brazil are for the moment among the most lucrative assets the banks have on their books. Bank earnings in the last two quarters have swelled. As one banker crowed in an unguarded moment about one recent reschedulee: "That country is a cash cow for us. We hope they never repay!"
Not everyone is so enthusiastic. Martin Feldstein, chairman of the president’s Council of Economic Advisers, has acknowledged these high rates make economic recovery and continued debt servicing by the debtor even more difficult. Volcker agrees but argues that "we can’t force terms on the banks without creating another crisis of confidence."
The Fed and the IMF have also been quite helpful in insuring that the large U.S. banks that have the most at stake in Latin America are not abandoned by regional banks or by West European banks that believe they have enough on their hands with Poland. According to West European banking sources, Volcker, for example, made a midnight call to Fritz Leutwiler, chairman of the Bank for International Settlements in Basel, Switzerland, and president of the Swiss National Bank, to insist that he pressure recalcitrant Swiss banks to contribute their fair share of new money to Brazil. De Larosiere has reportedly also intervened with West European and Japanese banks.
Volcker admits: "We’re all being induced to close our eyes to loose banking practices."
It was not the IMF but the bank advisory groups that decided to allocate contributions to the new package the IMF had ordered the banks to lend to Mexico on a pro rata basis among all banks with exposure in Mexico. The advisory groups were set up to formulate policy for each of the major debtor countries and are dominated by the biggest banks. The Fed and the IMF, however, have officially endorsed the loan packages designed by the bank advisory groups.
Some smaller American banks are complaining that the big banks are giving orders and that the Fed and the other regulators are supporting them. Richard Cummings is vice chairman of the board of National Bank of Detroit, which has a $200 million Mexican exposure. The bank has refused to increase its exposure by the mandatory 7 percent, despite "low key" calls from the Chicago Federal Reserve Bank, from Federal Reserve Board staff members, and from the comptroller of the currency. Says Cummings: "The role of the Fed and the comptroller of the currency is to protect the soundness of U.S. banking. I’m not sure that requires leaning on me to roll over my Mexican exposure and extend maturities. When they tell me to lend more, I ask, ‘Is it guaranteed by you?’ "
Of course, the large banks are not without leverage themselves. Each U.S. bank belonging to one of the new country advisory committees is put in charge of a group of regional American banks, to keep them informed on negotiations with the debtor and to keep them in line. The big banks call it "baby sitting."
Dennis Weatherstone, chairman of the executive committee of the board at Morgan, who has been in charge of raising new money for Brazil, says there have been no threats against smaller banks. Nevertheless, banks that refuse to cooperate without a good reason, banks that are "seen as being bloody minded, will be remembered."
Under this pressure only six banks of more than 500 took no part in the new loan for Mexico, although there is some resistance to maintaining short-term credit lines. William Lamoureux, vice president of Rainier National Bank of Seattle, Washington, says his bank has no choice but to participate in the rescue effort. "No one is going to buy us out and Mexico can’t pay. The bank advisory group rep who called us said: ‘It’s like Butch Cassidy and Sundance Kid, let’s all hold hands and jump.’ "
Finally, although both banks and government officials vigorously deny it, there is an implied, if not an explicit, government guarantee for the new loans to Mexico, Brazil, and other presently uncreditworthy borrowers. The loans are, after all, part of a comprehensive rescue package assembled under the auspices of the IMF and individual governments.
Bank supervisors have already granted the new loans privileged status. Volcker admits: "We’re all being induced to close our eyes to loose banking practices." Private Mexican borrowers, for example, fell badly behind on their interest payments to U.S. banks in 1982 because of a lack of foreign exchange. But U.S. regulators allowed the U.S. banks to treat pesos deposited by Mexican companies in escrow with the Mexican central bank as current income for 1982 even though there was no assurance when, if ever, dollars would be available to complete the payments. The central bank committed itself to nothing more than making "best efforts" to find the dollars. One New York banker says his own accountants were quite reluctant to treat the peso payments as income to the bank even though the Fed had given its approval. Normally, 90-days’ arrears on interest payments means a bank must put a loan on a non-accruing basis and treat subsequent interest payments as a reserve against losses rather than as income.
New and rescheduled loans to troubled debtors are exempt from loan loss reserve requirements. While differing accounting practices and domestic loan portfolios make a precise comparison difficult, so far U.S. authorities do appear to have been less rigorous than their West European counterparts in requiring banks to build reserves against foreign loan losses. The eight largest British banks doubled their reserves in 1982, and some West German banks have tripled reserves. By comparison, the four largest banks increased loan loss reserves by 56 percent or less compared with the levels they maintained in 1981, regulators have also apparently stretched the legal lending limit-no more than 15 percent of capital to anyone borrower — to accommodate banks that might exceed the limit if they were to extend new loans to troubled debtors. In at least one case, a responsible bank official admits that regulators "looked the other way" when his institution, which had reached the limit on Mexico, engaged in a little creative accounting by putting the new loan on the books of the bank holding company rather than of the bank itself.
Volcker defends this regulatory flexibility on the grounds that the first priority is to keep the situation from unraveling, and that goal means inducing the banks to lend to Mexico and the other large debtors. The Fed and other more reluctant regulators are willing to let the banks engage in what Federal Reserve Board Governor Henry Wallich several years ago condemned as Ponzi finance-schemes in which banks lend the debtor the money it needs to pay interest on existing loans.
But does this approach really solve the problem? Who assumes the risk if the loans that the banks have extended in response to specific entreaties from their governments have to be written off? How easy will it be to reverse the loose banking practices now condoned?
A breakdown of the international financial mechanism, in which both lending and debt servicing come to a halt, has been averted. But there are reasons to worry about the longer-term — and even the near term — implications of the process by which this was accomplished and the policies that were adopted to achieve it.
The banking system may be more vulnerable to shock than it was before the salvage effort. First, most banks have increased their exposure in the biggest debtor countries — by 7 percent in Mexico and Brazil, by 10 percent in Yugoslavia. Second, the risk is now more concentrated because loans to the private sector are being replaced by loans directly to central governments or guaranteed by governments.
Further, by giving free rein to the banks’ most rapacious instincts in pricing reschedulings and new loans to troubled borrowers, the IMF and the creditor governments have increased the likelihood that these additional sums will not be enough to carry Mexico and Brazil or others through 1983. As Feldstein told a recent gathering of specialists on Latin America: "The risk premium [being charged by the banks] increases the risk of the loan. Lenders have to realize that at some point the risk premium becomes self-defeating."
But whose risk is it? Government officials interviewed say the risk belongs entirely to the banks. "We haven’t twisted arms or told the banks to stay in," says Wallich. "We have merely pointed out that it is a matter of ‘enlightened self-interest.’" Many bankers profess agreement. "Our decisions to lend or not to lend have nothing to do with what the Fed says," according to Frank Stankard, senior vice president in charge of international lending at Chase. Hackett of Marine Midland agrees: "We feel there is absolutely no government guarantee for new loans to Mexico."
But the banks are not well-equipped to carry the additional risk. Regulators have allowed U.S. banks to understate the riskiness of restructured foreign loans by not requiring banks to build reserves against them. And they have allowed banks to overstate the profitability of these loans by taking rescheduling fees and interest down to the bottom line as income rather than applying them against principal to reduce loan exposure in these countries.
Either the government has created a very dangerous situation, or it does not mean what it says and is, in the end, prepared to put up more money to keep the banks’ foreign loans from ever going sour. In that event, today’s decision to persuade the banks to continue lending means a far costlier bail-out in the future.
What of the longer-term lessons from this crisis? "If they [the banks] learn not to lend to Mexico, that is wrong. If they learn that ‘what we did was O.K., someone will always help out,’ that is wrong, too," says Wallich. For the moment the banks are acting cautiously. Lending to Latin America outside IMF restructuring plans virtually came to a halt in the last half of 1982. The banks also rejected embryonic Turkish and Filipino plans to raise substantial syndications in the eurodollar market in early spring 1983.
But banks do not appear to have lost their appetite for international lending. When the Latin American loan market collapsed, banks began "scrambling to lend to Malaysia and Indonesia," says Hackett. Marine Midland expects its international lending to grow by 10 to 12 percent in 1983. "Events have demonstrated that the world is much more volatile than it used to be," says Weatherstone. But Morgan has no plans to alter its international lending strategy significantly. Gerard Alifano, senior vice president of Pittsburgh National Bank, of Pittsburgh, Pennsylvania, says in the short run his bank expects modest growth in foreign loans. But he notes that "opportunities appear in times of crises too. It gives banks an opportunity to solidify relations" with potential customers.
There appears to be no interest whatsoever among U.S. banks for a government buy-out of their international loan portfolios along the lines proposed by some economists. Stankard says, "The buy-out will never happen. There is no need for it." Chase plans to maintain its international lending levels, he notes, and argues that so long as the IMF, the governments, and the banks continue to cooperate, the situation is manageable.
Bankers see no need to alter their lending practices radically because they do not think they have overlent or acted imprudently. They contend they were caught by unforeseeable changes in the world economy — deep recession, a weak oil price, and the Federal Reserve Board’s tight money policy, which pushed interest rates higher in the eurodollar market as well as at home.
Volcker disputes this argument: "It was obvious two years ago that Mexico was going to be in trouble, but the banks were all over Mexico, pushing loans." Nevertheless, Volcker’s own institution, which is one of three principal bank supervisory agencies in the United States, did little to discourage the banks from lending. Says Volcker: "We got into a lot of trouble classifying countries in the mid-1970s, so we left it to the banks to diversify their lending." Eventually, "when all this is over" the only solution is much tighter regulation of international banking, according to Volcker.
The problem is that by the time the crisis ends, the regulatory authorities may be so deeply compromised by the concessions they have made to the banks that there is no return. This dilemma is manifest in the feeble regulatory reform proposals the Fed, the comptroller, and the Federal Deposit Insurance Corporation (FDIC) jointly submitted as draft legislation in April 1983 in response to pressure from Congress. A flat lending limit per country was ruled out, for example. How can the regulators set a meaningful country limit when the claims of the nine largest U.S. banks on Mexico. Brazil, and Argentina already equaled 112 percent of their capital in June 1982, and when the government has since told them to lend more? And the Fed clearly feels it has to live up to Volcker’s promise not to subject new loans to these countries to supervisory criticism.
Therefore, although the FDIC argued for earlier and larger reserves against loans to troubled debtors, the joint proposal will make reserve rules uniform, but not necessarily tougher. Reserves 10 percent of the loan would be required only when a country has paid no interest for six months and has no immediate prospect of doing so. By that definition, no reserves would be required against loans to most Latin American governments. Only Zaire, which most banks have already written off completely, Sudan, and perhaps Poland meet that description. The proposed public disclosure requirement is something the banks have already conceded and that clarifies rules already adopted by the Securities and Exchange Commission. The provision requiring that lending fees be amortized over the life of a loan is a rule the bank accounting profession was about to adopt anyway.
With a doubling of IMF lendable resources in the offing, the government safety net under the banks seems more tightly strung than ever. But regulation of banks’ foreign lending will, if anything, be more lax than before. The current solution to the international debt problem is disturbingly similar to the policies and processes that created the crisis in the first place.