Latin America: The archetypal financial crisis
Back when it was threatening to destroy the global financial system, newspaper editors joked that any headline with “Latin America” “Debt” or “Crisis” guaranteed that readers would turn the page. Too bad. The Latin American debt crisis remains the best teaching tool we have to explain the workings of the modern financial system. Understand its causes and consequences and much of our current travails become illuminated. Had we paid attention back then we might not be in the mess we are today.
Our story begins in the days of disco, the 1970s. OPEC raised its prices and a barrel of oil that cost $3 in 1972 shot up 1200% in seven years. Oil rich nations were floating in a pool of money, more than they could spend so they deposited their excess funds in the big American money centre banks. Back in the 1970s, few domestic investments yielded enough for the banks to capture a significant spread on their petrodollar deposits. Meanwhile, the developing nations that didn’t have oil were slammed with higher import costs. As the price of oil rose, but the price of their own exports did not, they needed to borrow in order to maintain their consumption of fuel.
The solution: petrodollar recycling. Money earned by Iran or Saudi Arabia, deposited in New York City banks was lent to Poland, Argentina, Brazil. Walter Wriston, the CEO of Citibank, clearly a man with little knowledge of financial history, declared “sovereign nations cannot go bankrupt” and the party was on.
For much of the 1970s, more than half of Citibank’s profits were made from Latin American lending. Without those loans, it would have been unable to pay a dividend. Since they were a vital profit centre, Citibank and its friends sent a slew of bankers down to Buenos Aires and Sao Paulo to crank up business. Their clients didn’t need much tempting.
For the military governments of Argentina and Brazil, it felt like free money. As sovereign states, they didn’t have to put up any collateral. Whenever the principal came due, the banks just rolled over the loan. And if the borrower found it difficult to pony up cash to pay interest, the banks were happy to lend them more money just to let the countries meet their nut. It was win win. Argentina got extra cash and didn’t even have to dig into its pocket to pay it back. The banks got huge paper profits, and the bankers in charge of this reckless lending got big bonuses.
Now in traditional finance, as it is described in the textbooks, a loan is supposed to fund an investment in capital goods (factories, machines, infrastructure, training and education) that will create a cash flow with which the loan can be repaid. Brazil’s military government did use its borrowing to upgrade its infrastructure but Argentina and Mexico, the two other big Latin American borrowers, used their free money for white elephant projects that merely shored up government popularity with important interest groups but did little to improve the economy.
Some sensible bankers worried: how will we get paid back? If they worried too loudly, they were fired, or reassigned to safer, less profitable projects. The banks needed these loans. How else were they to profit from their big petrodollar deposits?
Here we espy the first moral to be gleaned from this tale. Banks don’t need you to be able to pay back your debt, just as long as you can roll it over when it comes due. When your mortgage is up, you don’t pay it off, you refinance and that is what Argentina, Mexico, and Brazil did as well. The banks were happy to refinance. They kept working loans on their books, generating paper profits and received an immediate revenue boost in refinancing fees. Of course, they (like your bank when you refinance your mortgage) were happy to lend even the refinancing fees. No money actually changed hands, but the debt increased, as did the paper interest payments.
Happy happy days. Everybody is a winner. The bankers enjoyed their paper profits and gave themselves big bonuses, the military dictatorships got free money and didn’t even have to pay the interest.
In 1980, Fed Chairman Paul Volcker, determined to squeeze inflation out of the American economy, raised interest rates. Volcker was successful beyond his wildest dreams. The world economy shrank more in the early 1980s in response to the Fed rate hike than it has anytime between the 1930s and 2007. Unemployment skyrocketed to levels unheard of since the Great Depression, but inflation did fall. Phillips was right. There is a trade-off between inflation and unemployment. Workers don’t demand cost of living increases when they fear for their jobs. Volcker succeeded in crushing inflation. To this day it remains infinitesmal, at rates unimaginable during the high inflation 1970s. It was a great achievements but it had a cost.
For the Latin American military dictators and their banker enablers, Volcker’s rate hike had two pernicious consequences. The first is by slowing the world economy, it drastically reduced demand for their exports. Ultimately, all debts between countries need to be paid back through export earnings and those earnings had collapsed. The other consequence was their interest payments skyrocketed. The banks had covered themselves by making their loans on variable interest rates, generally fixed to LIBOR, the London Interbank Overnight Rate. As the fed policy rose, so did LIBOR and so did the monthly nut the dictators had to pay.
Their interest payments rose, their ability to pay declined. No problem, as long as the banks kept rolling over the debt as it came due. But higher rates at home meant that Citibank et al didn’t have to go all the way to Latin America to make a decent spread on their deposits, they could just buy T bills from the US government. They were only hungry for Latin American debt when domestic yields were unsatisfying. With risk free Treasuries paying close to 16% the banks figured they were safer lending closer to home. So when Mexico had a big payment coming due and asked their creditors to extend the loan, the banks said no.
On August 1, 1982 Mexico declared it did not have the money on hand to pay the money it owed and would default on its obligations. Remember J. Paul Getty’s witticism: “If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.” As long as a debtor doesn’t default, the bank can keep the loan on its books at full value. No accountant can tell them it isn’t worth bubkas. But, should the debtor miss even one payment, and the loan goes into default, then the asset side of the bank’s balance sheet takes an immediate hit. And since the loans outstanding were so huge, they were far greater than the bank’s own capital. That is to say, should the Latin American countries default on their debts, Citibank and its friends would be bankrupt.
A bankrupt Mexico, the world could deal with. A bankrupt Citibank would be the financial equivalent of the apocalypse.
Volcker is widely admired for crushing inexorable inflation. Perhaps saving the world banking system from collapse during the Latin American debt crisis was an even greater achievement. His actions in the early 1980s have been repeated ever since whenever financial markets splutter, so understanding what he did and why is vital.
First, he had to prevent default. If the Latin American loans were recognized as worthless, all hell would break loose. The biggest banks in the world would be insolvent. But as long as the truth could be masked, the financial system could be saved. These days, we often hear the cliché “You can’t borrow your way out of a debt crisis.” Back in 1982, Volcker proved the opposite: the only way out of a debt crisis is to borrow more. Mexico had to make its payment or it would default and Citibank and the world financial system would go bust. But Mexico did not have the cash on hand. The only solution: the banks lend enough so Mexico could meet its interest payment. So Volcker’s first step was to convince the banks to roll over Mexico’s debt. A bit of arm-twisting, a bit of common sense and loans were secured, generally with a huge penalty the debtor would pay straight away.
This obviously was only a temporary solution. At some point in the future, the actual truth would have to be acknowledged: that those dumb loans, which had funded a fortune in bankers’ bonuses would never be paid back in full. The key, then and now, was to only admit that truth when bank balance sheets were strong enough to withstand it.
The next step was to make interest payments more affordable. For that rates had to go down. For several years, even as inflation had begun to fall, Volcker resisted cutting interest rates. He feared inflationary expectations were so deep rooted that ending the recession too early would mean all the pain would have been for naught. When millions of Americans were losing their jobs, Volcker did not flinch. He knew that defeating inflation required sacrifice and he was willing to sacrifice the jobs of steelworkers and truckers to achieve it. When businesses all over the country went bankrupt, he still maintained brutally high interest rates. But when Mexico threatened default, he decided, enough. Default threatened the entire banking system and without lower rates the new loans necessary to bail out the old loans would be untenable.
On August 1, 1982, Mexico declared it could not make its interest payment. On August 2, Volcker cut the federal funds rate. On August 13, the stock market began it 20-year boom. There is an almost inevitable relationship between lower interest rates and higher asset prices. Assets, be they shares, houses, bonds, companies are always worth more when interest rates fall.
Volcker had one more task: to restore bank profitability so that at some point, the bad loans could be written off without shattering the financial system. Three mechanisms were employed during the Latin American debt crisis and the same three mechanisms are being employed today to deal with our current financial crisis:
1. Steep yield curve
2. Public absorption of bad private debt
Lets take a look at each in turn.
First the yield curve. This is a chart, familiar to all bankers. On the y-axis yield, the interest a particular bond or debt will pay. On the x-axis duration, the maturity of the bond or debt. Generally, the longer the maturity, that is to say the period of time when the principal has to be repaid, the higher the yield. This makes sense. If you are lending someone money for thirty years, you are taking a bigger risk than if you are lending it overnight and so you should get a reward for that added risk. That is why the yield curve generally slopes upward.
Here is the important bit. The steeper the slope, the better for the banks. That’s because banks are in the business of borrowing short and lending long. Bank profits are in the spread between the interest rate they pay for their short-term deposits and what they earn for their long-term loans. So the greater the premium for holding debt longer, the more money the banks make.
Three times over the past thirty years the major banks have actually been bankrupt, that is to say, their liabilities owed to depositors exceeded the value of the loans on the asset side of their balance sheets. Each time, the truth had to be masked or else the financial system would fall apart. The first time was during the Latin American debt crisis. The second time was in the late 80s early 90s after the collapse of both the junk bond market and the commercial real estate market. The third is the aftermath of the 2007-2008 financial crisis. Each time, central bankers engineered a steep yield curve, forcing down short-term rates while letting long-term rates soar. This manipulation of the yield curve ends up being a subsidy to the banks, allowing the spread between what they pay depositors and what they charge borrowers to increase. The hope, successful the first two times, was that after a few years of this hidden subsidy banks would make so much money that they would be finally able to write down their bad debts without going bust.
The second tool, used both during the Latin American debt crisis and the travails in the PIIGS nations today, was utilizing public money to buy up private debt. The goal, remember, wasn’t to save Argentina then or Greece now, they can go bust and the world economy can keep ticking over. It is to protect the banks from their dubious loans. So various mechanisms (Brady bonds then, European Central Bank purchases of Greek government debt today) were used to take bad debts off of bank balance sheets and put them onto the taxpayers, who both can afford them and also don’t really understand what is going on. That way, if the peripheral countries finally do go bust, the banks (and so the world financial system) don’t take the hit.
Lastly let us not forget austerity. In any financial crisis, we have borrowers and creditors. Bad loans were made, who shall pay for these mistakes? A debtor, whether a household, a corporation or a country always has some cash flow which it uses to make necessary purchases. Their creditor doesn’t care if Johnny has to drop out of school, or workers get fired, or old people don’t get their pensions. Creditors want to get paid back and austerity is always their preferred choice: cut expenses in order to free up cash to pay the banks. Of course, both in Latin America then and in Greece and Spain now lowering government expenditures, in an already slowing economy, means business contracts and GDP falls.
So it was during the Latin American debt crisis. Citibank and its friends didn’t really lose much money. They profited early on making the loans and when they lost value they were able to sell them off to the US government through the Brady bonds. All in all lending money to countries that could not repay them ended up being a pretty good deal for the big money centre banks.
The people of Latin America, especially the middle class and the poor, didn’t do so well. The 1980s were a lost decade. Argentina didn’t return to its 1980 GDP until 1992. During the 1970s, because of the loans, Argentines and Brazilians were able to live beyond their means. They could import more than they export (thus consume more than they produce) and make up the shortfall in their balance of trade through borrowing. But in the 1980s, the capital flows reversed. Latin America had to cut consumption bellow production, export more than they import, and use their trade surplus to pay off their loans.
So the lessons of the Latin American Debt Crisis:
1. When yields are low for safe loans at home, banks look for more dangerous and more profitable places to lend their money.
2. Short-term profits mean more to bankers than long-term risks. Bankers who realized that Argentina et al would have a hard time paying back their debts got fired or transferred. The banks needed these stupid loans in order to make their quarterly profit goals and anyone sensible who spoke out against them lost his job.
3. As long as banks are willing to roll over debts, silly loans are not dangerous to anyone. The debtors get free money, the banks get paper profits, the bankers get juicy bonuses. Everybody wins!
4. UNTIL something changes. In this case, interest rates went up.
5. When interest rates go up,
a. The economy slows so debtors earn less money with which to repay their debts
b. If the loan is on a variable rate (which these days it almost always is) then the monthly nut goes up as well, sometimes quite dramatically.
c. And with rates higher, banks can earn a healthy yield with safer, domestic loans so the desire to roll over debts dissipates.
6. When banks don’t roll over debts they are very hard to pay back. Our entire financial system is dependant on loans being refinanced when they come due. Imagine if you had to pay back your mortgage two years after you buy your house. In all likelihood, you would have to sell your house. That, on a much larger scale, was Ireland and Greece’s nightmare until the European Central Bank promised to back them up and buy their debt.
7. Since big banks assets and liablities so exceed their equity, a few loans going south can wipe them out. That is to say, their liabilities (money they owe depositors) exceed the value of their assets (loans they have made which generate a cash flow), which means they are bankrupt.
8. If you go bankrupt, or I go bankrupt, or Greece or Iceland goes bankrupt, life goes on. If Citibank or any of the huge money centre banks goes bankrupt, all the other banks that do business with them will also take a huge hit and the entire financial system could collapse. No matter how free market an ideologue a Central Banker is, he will overcome his inhibitions and do whatever it takes to save the big banks. This may be corrupt and is certainly hypocritical, but it is also the right thing to do.
9. The first thing the central bankers need to do when the banking system is effectively bankrupt is hide this truth. This can be done by allowing accounting shenanigans, by renegotiating the loans so that they don’t have to be repaid until some distant date, or by continuing to roll over enough of the debt so that the truth that these loans will not be repaid can be masked until the banks’ balance sheets are healthy enough to take the hit.
10. So what are the tools Central Bankers have used just about once a decade for the last 30 years to save the banks from their dumb loans?
a. Get the taxpayers to buy the dumb loans from the banks. That way, when the loans finally are written off, the taxpayers take the hit and the banks can survive.
b. Cut the short-term rates so that banks can borrow cheaply while letting long term rates remain high. Since banks borrow short and lend long, this means their profits skyrocket. Do this for a few years, and the banks make enough money so they can afford to write down the bad loans.
c. Impose austerity. If the debtor is a company (as in private equity leveraged buyouts) that means firing workers, eliminating research and development programmes, foregoing needed maintenance. If a debtor is a country, it means raising taxes, firing government workers, eliminating pensions. These actions inevitably slow the economy (firing workers lessens demand making other firms less likely to hire and invest) but the banks don’t care, they get paid.
The Latin American Debt Crisis ended with neither a whimper nor a bang, it just faded away. The boom of the 80s, with a very steep yield curve and major profits for financial institutions, refinanced the banks. Brady bonds took much of their bad loans off their books. And Latin America, which in the 1970s imported more than it exported (that is to say consumed more than it produced) suffered through a brutal decade of high taxes, high unemployment, lack of investment and deindustrialization so that it could meet its obligations to its creditors.
One last thing. The banks made out all right, Latin America paid the price. But the story could have been different. The Latin American finance ministers could have told the banks to go fuck themselves The banks didn’t have all the cards. In most respects the banks needed the compliance of the Latin American governments more than the Latin American governments needed fake paper loans with which to remain current on their interest payments. Citibank may be mighty but it didn’t have an army that could invade Buenos Aires and force the Argentine government to shell out its tax revenues.
Within a few years, the Latin American countries moved into a primary surplus. That means, take out interest payments and tax revenues are sufficient to pay all other obligations. At that point defaulting becomes a sensible choice. Argentina hit that point in 1983 but it kept on cutting spending, raising taxes so as to be able to ship its dollars back to Citibank.. I suspect the reason they never did was sociological: the finance ministers, often bankers themselves, sympathised more with their expensively dressed creditors than with their own poorer citizens. Default is a choice. Sometimes it can be the right one.
 The value of an asset is all of its future cash flows, discounted for present value. The lower the interest rate, the less the discount. That is to say, future cash flows are worth more in present value when rates are lower. That is why an interest rate cut (or even the possibility of an interest cut) will inevitably raise stock prices.
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