The Mexican Peso Crisis and The Treasury’s Exchange Stabilization Fund

Creditwritedowns reports that worst damage yet to come from AIG.

(emphasis mine) [my comment]

AIG: worst damage yet to come
Posted by Marshall Auerback on 19 March 2009 at 12:17 pm

Marshall Auerback here. I have a few thoughts about AIG and what it means politically and for American banks.

The episode may have already made it much harder to get any support in Congress for bailing out more banks in the future. The Obama administration, and some outside experts, believe the economy will only get worse if big banks start to fail. Which means the worst damage that AIG's adventures in high finance have caused might be yet to come.

We had a broadly similar type of situation in 1994, and as Lawrence Summers was one of the key actors, it is worth considering the episode in details, as recounted in "The New Republic
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In December of 1994, the Mexican finance ministry alerted Summers's assistant secretary, Jeff Shafer, that the country was nearing a currency crisis. During the early '90s, Mexico had started down two paths that, together, proved unsustainable. First, the country ran large trade deficits. To pay for all the goods it was importing, Mexico needed dollars, which meant it had to sell government bonds. This led to the second problem: To appease all the foreign investors who worried the peso would lose value, Mexico issued certain short-term bonds—called "Tesobonos"—that were linked to the dollar.

This worked fine for a while. Foreign money flooded in as investors snatched up the Tesobonos. But, as the years passed, creditors began doubting that the government would pay off its bonds at the fixed exchange rate. Many began withdrawing their money, forcing the Mexicans to redeem the bonds for dollars. By the time Treasury tuned in, in late 1994, the dollars had almost run out and the government could no longer defend the peso-dollar exchange rate. The imminent decline of the peso would make Mexico's foreign debt more expensive and raise the risk of a default.

Worse,
Treasury itself was in limbo. Then-Secretary Lloyd Bentsen had announced his retirement, but Bob Rubin, his successor, had yet to replace him. It fell to Summers—whose team included Shafer and a young deputy assistant secretary named Tim Geithner—to figure out the consequences of a Mexican collapse. By January 10, 1995, the Summers group had a tentative answer: The fallout could be several hundred thousand U.S. jobs and a 30 percent spike in illegal immigration. If Mexico infected other emerging markets, it could wind up shaving a point off U.S. GDP growth.

That same day, Summers accompanied Rubin to his Oval Office swearing in. Once President Clinton administered the oath, Rubin recalls in his memoir, the new Treasury secretary turned to the president and urged a massive loan package. He then gave the floor to Summers, who briefed the president and concluded that something on the order of $25 billion would be necessary. Surely he meant twenty-five million, George Stephanopoulos interjected. No, Summers said, "billion with a 'B.'" Clinton swallowed hard and, after weighing every angle, signed on.

The initial response from congressional leaders was also favorable. But the rank and file was hostile. Vermont's then-congressman, the socialist Bernie Sanders, told Rubin to "go back to your Wall Street friends [and] tell them to take the risk and not ask the American taxpayers." A freshman Republican named Steve Stockman accused Rubin of arranging a bailout to protect the investments he'd made while a partner at Goldman Sachs
[of course it was]. Soon, even the once-supportive leaders were either quietly backtracking (Senate Majority Leader Bob Dole) or railing against the package outright (Banking Committee Chairman Alfonse D'Amato). It was what High Noon might have looked like if Gary Cooper had played a policy wonk.

As it became obvious that cooperation from Congress wouldn't be forthcoming, Rubin and Summers began to consider plan B. Back in 1934, Congress had given Treasury a pool of money called the "Exchange Stabilization Fund" (or ESF) to help smooth out exchange rates. Sixty years later, the fund stood at about $35 billion, and Treasury lawyers believed they had the authority to draw on it. And so, on January 30, with no congressional help in sight, Summers, Rubin, and Clinton's top White House aides decided to tap the ESF to the tune of $20 billion.

This entry was posted in Bailouts, Currency_Collapse, Market_Skepticism, Treasury. Bookmark the permalink.

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