L. William Seidman, a former FDIC/RTC chairman under Presidents Reagan and Bush, Sr, explains the genesis of the Third World debt problem
(emphasis mine) [my comment]
One of our early problems in international finance was the buildup of billions of dollars by the oil-producing countries after they raised their prices and could not put their huge profits to work quickly. Since these bank deposits accumulated during the deep and sharp recession of 1974—75—indeed they were one of its causes—we felt it was necessary to find a way to put these dollars back in the world economy, or to "recyde" them in the jargon of the time. Saudi Arabia, the Arab Emirates, Kuwait, and others, for example, had accumulated multibillion-dollar surpluses that they had not yet learned how to spend in their own underpopulated countries. Meanwhile, countries without oil, particularly in Latin America, were strangling on the new prices and were unable to buy imported goods. There were numerous proposals to organize the recycling under the aegis of governments, but the Ford administration, led by Treasury Secretary Simon, held out for private sector recycling of these petrodollars through the world's commercial banks at market interest rates. Thus the foundation was laid for the LDC (Less Developed Country) debt problem, especially in Latin America.
Recycling worked like this: Saudi Arabia deposited its oil profits in Citibank or Chase Manhattan at the going rate of interest. The big banks loaned the money to Mexico, Brazil, or Argentina (the MBA countries as The Economist christened them in honor of the eager young bankers who booked the loans and advanced their banking careers). The Latin borrowers then had enough money to buy goods from the United States and other countries. This put the petrodollars back into circulation rather than letting them sit sterile in the Kingdom of Saudi Arabia. Recycling was thought to be economically beneficial, and the government spent a good bit of time cheering on the banks as they lent more and more funds to the developing countries, with less and less concern for exactly how these loans would be repaid. When the loans came due, the bankers argued, they would just be rolled over at the current rate of interest or paid off by the newly revived economies of the borrowers. The most outspoken proponent of this process was Walter Wriston, chairman of Citicorp. who is said to have summed up the conventional wisdom of the day with a wisecrack: "Countries don't die, they just roll over." His argument was that a country's credit stood behind its debt. We have since learned, to our sorrow that this is not always the case. Nor was it a dependable policy even then. A brief survey of the international debts arising out of two world wars, plus an accounting of the countries that defaulted on their international bonds during the Depression, present a deplorable record of the repayment of large foreign debts.
While recycling may have looked good from a macroeconomic view, its purely financial aspect was much more suspect. For example, if the Saudis had loaned their petrodollars directly to Argentina, the U.S. banking system would have been fairly well protected because it was the Saudis who would be taking the risk. But they were smarter than that; they let foreign banks take all the risk. Their deposits were still protected, but the banks' loans were not. The whole thing exploded in 1982. Interest rates had climbed into double digits to help the world sweat out the inflation of the 1970s; the result was recession, and the borrowers simply couldn't pay interest to the banks. By this time, the major U.S. banks had loaned so much to the Third World that the outstanding loans were the equivalent of three times their capital. In other words, if the loans were not paid back, almost all of our major banks would have been broke.
Not everyone had agreed that the recycling of petrodollars was such a great idea. At an Economic Policy Board meeting one morning, President Ford was in attendance, and so was Fed Chairman Arthur Burns. Arthur was known for his deliberative and often deiphic statements delivered through a cloud of smoke from his pipe (which rarely moved from his lips). So when Arthur cleared his throat, removed his pipe from his lips, and began to speak that morning, we all listened.
"These Latin American loans are not recyding," he said. "Recycling, bah, these are just all bad debts." The rest of us at the table looked at Arthur as someone who was getting old and was still thinking in national, rather than international, terms. But we paid him his due by saying, "Of course, Arthur, that is something to be considered." And then we all promptly ignored him.
The entire Ford administration, including me, told the large banks that the process of recycling petrodollars to the less developed countries was beneficial, and perhaps even a patriotic duty [and banks that don't do their "patriotic duty" are likely to face very unfriendly regulators...]. On the other hand, no one ever implied that the U.S. government would stand behind these loans. In fact, we never really considered the possibility that not repaying the loans might jeopardize the financial system. We thought that if Saudi Arabian dollars ended up in Brazil, the money would be spent for roads, machinery, and equipment, or other things to increase productivity. But as it happened, the money was mostly used to close the payments gap caused by higher oil prices, and therefore to maintain living standards and avoid hard choices by local politicians about future investment. Since the money did nothing to increase output and make the countries richer, the loans did not generate the profits from which they could be repaid. In other words, they were used up rather than invested [like the US has been doing for decades]. Thus, when it came time to get the money back, it was not there. This was the genesis of the Third World debt problem, which
almost sank the U.S. banking system.
With the clear vision hindsight provides, it is easy to see that one of the larger problems facing the banking system in the 1980s was the direct result of very large loans to Latin American countries by major U.S. banks. We assumed that a free market would apply appropriate discipline, and in the long run, of course, it always has. But in the short run, many may die in the process of assuring the ultimate rationality and discipline of such a system. Latin America lost a decade of growth under the weight of its debts, and only now are the banks finally winding up the liquidation of their unpaid debts at thirty, forty, or fifty cents on the dollar—one reason they have been so cautious in lending to American business during the recession of the early 1990s. Back in the m id1970s we in the Ford administration had the chance to deal with creation of the LDC debt problem as well as many other problems in the financial system, but we just did not see the magnitude of the trouble ahead. We saw only the short-term benefits of the loans to our industry and finance. But then long-range planning has never been an outstanding attribute of our governmental process. [UNDERSTATEMENT OF THE CENTURY]
As we can see now, the banks' troubles began when they lost their big corporate customers to the investment-banker-operated commercial paper market early in the 1970s. Our banking laws prevented them from entering this market, so recycling petrodollars was their first big replacement activity; and that turned out to be a dud. Then came the financing of the big management buyouts of the 1980s known as leveraged buyouts, many of which also did not end up too well for the banks. When that line of business finally dried up (or worse) after the 1987 stock market crash, the banks in the late 1980s turned to real estate and bankrolled the Donald Trumps of this world. As one of the banks' principal regulators, the FDIC under my chairmanship advocated permitting the banks to break out of their straitjacket and provide a full line of financial services that could have returned them [from insolvency] to lively, competitive health. [ie: earn their way out of insolvency (like thrifts failed to do)]
FDIC explains The LDC Debt Crisis.
As the LDC debt increased after 1979, so did the warnings of possible problems for U.S. banks. Paul Volcker, the chairman of the Federal Reserve Board during this period, suggested that rising oil prices would mean some rescheduling of debts owed by developing countries. Henry Wallich, a Federal Reserve Board governor, criticized the rapid growth in LDC debt and indicated that the money-center banks' exposure to sovereign risk placed their capital in jeopardy. He believed that additional lending should be restrained by regulatory officials. Others also warned about the potential implications of the accumulation of LDC debt for the U.S. and world financial systems. The Wall Street Journal noted in 1981:
It doesn't show on any maps, but there's a new mountain on the planet—towering $500 billion of debt run up by the developing countries, nearly all of it within a decade . . . to some analysts the situation looks starkly ominous, threatening a chain reaction of country defaults, bank failures and general depression matching that of the 1930s.
Eruption, August 1982
The record-high interest rates of the early 1980s (see figure 5.8), caused by the Federal Reserve's efforts to curb the oil-based inflation of the 1970s, brought on a global recession and helped to trigger the overall crisis. Because most Third World credits were priced to LIBOR rates, debt-service costs grew progressively greater as these rates reached record levels. This situation, coupled with the slowdown in world growth and the drop in commodity prices for the second time in eight years (figure 5.2), left exports stagnant and debt-service commitments hard to meet. Many scholars point to another factor that compounded the debt-service problems: most of the new bank loans to the LDCs from 1979 to 1982 went to cover accrued interest on existing debt and/or to maintain levels of consumption, rather than for productive investments.
In August 1982 the Mexican finance minister indicated that his nation could no longer meet interest payments. By year-end 1982, approximately 40 nations were in arrears in their interest payments, and a year later 27 nations—including the four major Latin American countries of Mexico, Brazil, Venezuela, and Argentina—were in negotiations to restructure their existing loans. ...
The seven-year period after the most serious international financial crisis since the 1930s was devoted to restructuring existing loans, setting aside loss reserves, and attempting to protect the solvency of the U.S. financial system. A decade or more would pass after the crisis before the economies of the LDCs would recover and the banks would clear their books of the bad loans. Bank advisory committees were established to represent the banks in bilateral negotiations with the individual debtor countries for debt reschedulings. These talks lasted until the end of the 1980s and were supported by creditor governments and international financial institutions.
Unlike some European regulatory authorities, immediately after the Mexican crisis U.S. banking officials did not require that large reserves be set aside on the restructured LDC loans or on the succeeding arrearages by other LDC nations.44 Such a policy was not feasible at the time and might have caused a financial panic because the total LDC portfolio held by the average money-center bank was more than double its aggregate capital and reserves at the end of 1982 (table 5.1a). Thus, regulatory forbearance was also granted to the large banks with respect to the establishment of reserves against past-due LDC loans. According to Seidman, this forbearance was necessary because seven or eight of the ten largest banks in the U.S. might have been deemed insolvent, a finding that would have precipitated an economic and political crisis. He noted that "U.S. bank regulators, given the choice between creating panic in the banking system or going easy on requiring our banks to set aside reserves for Latin American debt, had chosen the latter course.
It would appear that the regulators made the right choice."
In retrospect, this strategy proved to be successful by avoiding a major domestic or international financial crisis. During this period no large U.S. banks failed because of delinquent or nonperforming LDC loans. The large banks were able to maintain funding and liquidity while being given time to raise capital and increase reserves. The overall debt strategy also forced structural adjustments in the LDCs, such as trade liberalization, privatization, deregulation, and tax reform, that eventually brought both growth and investment to several LDC nations. Seidman contrasted the regulatory forbearance of the debt crisis with that of the savings and loan crisis in the United States during the 1980s:
Sometimes forbearance . . . is the right way to go, and sometimes it is not. In the S&L; industry, all rules and standards were conveniently overlooked to avoid a financial collapse and the intense local political pressure that such a collapse would have generated. But in this case there was not a visible plan for a recovery, so the result of this winking at standards was, as we know, a national financial disaster. On the other hand, in the case of Latin American loans, forbearance gave the lending banks time to make new arrangements with
their debtors and meanwhile acquire enough capital so that losses on Latin American loans would not be fatal. Like medicine and the other healing arts, bank regulation is an art, not a science [the hole in bank balance sheets was never fixed. Central bank gold was used to temporarily prop up the system.].
The average profitability of money-center banks in the earlier periods contrasts sharply with that in the post-1982 years. For the average money-center bank during the 1983-89 period, net income to total capital and net income to total assets averaged only 4.2 percent and 0.23 percent—returns significantly below the industry averages of 9.0 percent and 0.55 percent. Moreover, for the years 1987 and 1989, the average money-center bank experienced negative returns (table 5.1), bringing down total earnings for the U.S. banking industry during the two years (see figure 5.9).
This slowdown in earnings was reflected in the substantial buildup in loan chargeoffs, loan-loss provisions, and the accumulation of total reserves recorded over the 1983-89 period (tables 5.1a and 5.1b). Although between 1982 and 1986 the loan-loss reserves for the average international bank more than doubled, as of year-end 1986 they were still only approximately 13 percent of the total LDC loan exposure. Starting in 1987, however, the money-center banks began to recognize massive losses on LDC loans that in some instances had been carried on the books at par for more than a decade. After extensive bilateral negotiations with the LDCs beginning in 1983, the banks realized that a large portion of the loans would not be repaid. In May 1987 Citicorp was the first major bank to break ranks and recognize a loss, establishing loss provisions for $3.3 billion, or more than 30 percent of its total LDC exposure. Shortly thereafter all of the other major banks followed suit. By year-end 1989, the average money-center bank had total reserves that were almost 50 percent of their total outstanding LDC loans.
The LDC experience, as reflected in the regulators' handling of large banks after the crisis erupted, illustrates the high priority given by banking authorities to maintaining stability in the banking system [after causing the problems that threatened it in the first place]. It also represents a case of regulatory forbearance with respect to certain supervisory rules and standards. The 1979 interpretation of the loans-to-oneborrower rule allowed banks to continue lending, and the delay in recognizing loan losses avoided the repercussions that could have threatened the banks' solvency.
Over time forbearance proved to be successful, however, because loss reserves and charge-offs were greatly increased and no money-center bank failed because of LDC lending. [Citibank, etc never returned to solvency. Forbearance was a failure.]
Businessweek reports about Citibank in the 1990s.
In late 1989, as Reed was stewing over his numbers in Jamaica, the real estate market took another blow. The "Massachusetts miracle'' was going the way of the "Brazilian miracle.'' Regulators stormed into the Bank of New England, which had gone hog wild making real estate loans. Days before Christmas, its aggressive chairman, Walter Connolly, was forced to resign, and the bank later posted a staggering $1.2 billion quarterly loss. Unloading every asset it could, it sold its credit-card operation to Citicorp for $828 million. Under the gun for their belated handling of BNE, regulators came down like gangbusters on institutions throughout the country, virtually cutting off bank credit for real estate transactions. "That just killed the market,'' said Reed. "From then on you couldn't sell buildings for love or money.'' If the credit crunch and the recession that it triggered needed a starting date, the 1989 examination of Bank of New England was it. Reed would later describe the downturn as a "regulatory recession.'' When the government finally seized BNE and two banking affiliates a year later in a $2.3 billion rescue, BNE was so far gone that the "rescue'' was merely an afterthought.
Ironically, in a rambling speech to financial leaders at the New York Economic Club on January 30, 1990, Reed said he believed that one of the roles of banks in society was to absorb shocks. Citibank would now begin to absorb them to the point of fracture. In a matter of weeks, Citicorp's perception of its real estate portfolio swung 180 degrees, according to insiders. In February 1990, one top real estate lender delivered a presentation to the board that pointed up some problems. "It was not as good as we would like it, but not as bad as it could be,'' said a former officer. Ten days later, he said, write-offs of $100 million seemed to show up out of nowhere. The auditors and review process had missed the problem. "John was not thrilled,'' the officer said. The lack of a real-time portfolio information system was now obvious for all to see. Incredibly, said the officer, "nobody was interested in the fact that real estate outstandings were $13 billion.'' The idea, he said, "was to put on everything you can to make good money and it will sort itself out.''
That was just the beginning. In the first quarter of 1990, the U.S. real estate market plunged. Nearly overnight, the impact of the 1986 tax changes and overbuilding, in part triggered by overlending by now-defunct thrift institutions, came home to roost. The Japanese, who had helped hype the market in the first place, now retreated en masse. The Japanese banks, however, would soon have their own problems. They merely disguised their losses with an accounting system that made New York City's lucid in comparison. "After the comptroller said what he said, forget it,'' Reed said in a 1991 interview. "Liquidity evaporated and hasn't come back since.'' For Reed, the early years of the decade of the 1990s were to be a black hole.
Citi's problems were heavily concentrated: domestic real estate, Australia, Brazil, and highly leveraged transactions. The biggest chunk of the leveraged deals--16 percent--were in media and entertainment. By 1991, Citibank had made more than $13 billion in commercial real estate loans, more than a third in the western United States. Nearly 43 percent of them were now nonperforming. Citibank had lent up to 80 percent or more of the value of the properties, putting Citibank's investment underwater when values plunged 40 percent or more. Residential mortgages were turning sour too.
In early 1990, Citicorp debt was downgraded by the major rating agencies, and by 1991 some of it had been reduced to junk bond status. Ratings are not as important in consumer banking as they are in corporate banking. Individual depositors generally don't know a bank's credit rating, and don't care. But the rating downgrades cost Citibank dearly. Not only did they increase the cost of purchased money, but they also hurt its ability to execute certain capital markets transactions, such as swaps.
In the first quarter of 1990, earnings fell 56 percent and the loan loss provision surged 80 percent. At the April 1990 annual meeting, Reed declared the real estate market "frozen,'' noting that "typically the down cycle in real estate lasts three years.'' Things were getting tight all over. Arizona, where Citi had bought a bank in 1986, was a "black hole,'' Reed conceded.
At a later annual meeting, one testy shareholder asked Reed how he had lent so much on real estate. "We made a mistake,'' Reed said. "If you make two mistakes they send you back a grade,'' the shareholder scowled.
As late as 1989, Citibank was still lending heavily to real estate developers. For example, in Atlanta it underwrote One Peachtree Center, developed by builder John Portman. But by midyear 1990, Donald Trump was on the skids. Trump had started out as a good customer. But in the opinion of former Citibank officers, he, like other developers, got carried away. "We did one deal too many with people who were okay,'' shrugged a former officer. With $2 billion in bank debt, Trump's lenders moved to restructure his empire, including his new Taj Mahal casino in Atlantic City, which had opened in April 1990 with great fanfare, but which quickly proved disappointing. Bankers had bought Trump's pitch that the "magic'' of his name would enhance the value of his properties, so that they could dispense with the traditional credit analysis. The Donald, one banker told the Wall Street Journal, "will have to trim the fat: get rid of the boat, the mansions, the helicopter.'' But Trump got over this hump by persuading the banks to extend a new loan to pay interest, enabling him to hold on to all his assets.
Trump's problems paled alongside those of his Canadian counterparts, the Reichmann brothers. Through vast, ambitious projects in the United States and the United Kingdom, their Olympia & York had amassed debts of nearly $20 billion. It was the largest commercial landlord in the United States; the restructuring, akin in complexity to that of a Third World country, was the largest of any private company in history. Citibank alone was owed close to $500 million. By the spring of 1992, the Canadian parent had filed for bankruptcy, and later Canary Wharf entered the more draconian British equivalent.
Australia once again was a disaster, proof positive that Citibank had no institutional memory. Over a two-year period, Citibank racked up about $1.2 billion in loans to high-flying real estate developers and other promoters, most of which would ultimately have to be written off. "In Australia, if there's a fool, it's us,'' said former Citibanker William Heron. Highly leveraged transactions, which included LBOs, also suffered, though at the end of the day they were a pimple compared with the real estate cancer. In January 1990, Campeau's Allied and Federated units, which owed Citibank $288 million, filed for bankruptcy. Incredibly, Citi had backed Campeau up to nine months before everything unraveled.
Even as Citibank's difficulties worsened, Reed was confident that as long as the economy grew at all Citi would be able to earn its way out of them. But if, as some predicted, the recession deepened to a negative 3 percent growth, Citibank would be in dire straits. If that happened, Reed would be forced to consider selling his crown jewels--even the credit-card business.
He was not pleased with the Bush administration's economic policy. The problem was that there was none. At one point, as the recession took a turn for the worse, Reed spent a weekend on the phone talking to Treasury secretary Brady and other Washington officials. "Let me tell you, they heard the riot act,'' he said. "I haven't gone down and yelled and screamed,'' he said at the time. "Maybe I should.''
By 1991, Wriston was also fed up with the Bush administration and its economic non-policy--and not just because Bush didn't play tennis with him anymore. "What is frightening to me is I don't think the current incumbent [Bush] appears to have any fixed values other than loving his grandchildren. I don't see any direction in economic policy,'' he said in 1992.
But Citi and the banks did have a friend at the Fed. As the economy screeched to a halt, interest rates, with a push from the central bank, plummeted to their lowest levels in decades. And because the cost of money plunged faster than loan rates, bank loan spreads grew fatter. [central bank gold was used to drive interest rates down.]
No one in Washington was as disliked at 399 Park as Representative John Dingell, who had flogged Citi over the Edwards affair. In mid-1991, he delivered the unkindest and most dangerous cut of all. He declared at hearings that Citibank was "technically insolvent'' and "struggling to survive.'' When Dingell made his comment, Reed and his colleagues "went bananas,'' said a former senior officer. FDIC chairman L. William Seidman rode to Citi's defense. Of Dingell, Reed said, "I assume he's trying to assert an interest in legislation, and the best way to do it was to make an outrageous statement that can attract attention.''
Yet even as Citibank was suffering from its problems, it did not relinquish its role as a source of liquidity for other troubled firms. One was Salomon Brothers, whose CFO was Donald Howard, late of Citicorp. "Howard,'' said Reed at the time, "must be running around making sure those who lend continue to lend.'' That included his former employer. "We keep everybody afloat. It's part of the process,'' Reed said.
Reed sometimes exacerbated his own problems with his bluntness. In a speech to Chicago business executives that was reported in the Wall Street Journal of September 23, 1991, he declared that real estate write-offs would continue longer than he had expected. He added that values would plummet 30 percent before they stabilized. That statement by the nation's largest real estate lender, experts said later, itself caused values to decline. Reed felt one of his major weaknesses was his inability to present himself to the outside world in a sophisticated way, for which he was widely criticized inside the bank. His speech in Chicago may have been one such example.
When the bad news rained, it poured. In the third quarter of 1991, Citicorp disclosed a loss of $885 million. After having already slashed the dividend--Citicorp's sacred cash cow--Reed was now forced to take the drastic step of eliminating it entirely. Citi could no longer boast that it had paid dividends without interruption since 1813. Reed now owned 500,000 shares himself, and was using the dividends to pay off the loans he took out to buy them. So these measures squeezed Reed personally. "I'm sensitive to that. I'm embarrassed by that,'' he told analysts. Half of the deficit resulted from a write-down of the ill-fated Quotron acquisition. By now, the Wall Street firms were ripping out their Quotron machines and replacing them with the box of choice, the Bloomberg terminal. By 1992, just a handful of firms still used the Quotron.
In November 1991, Reed canned senior executives of a credit-card unit for inflating revenues. And in December, more unfounded rumors about new Citicorp troubles and Reed's impending resignation sent Citi stock plummeting to $8.63 a share, the lowest level since the 1960s. That month, the cover of Institutional Investor depicted Citibank's treasured "Credit Doctrine for Lending Officers'' wrapped around a fish.
Citibank may not have been insolvent, but its condition was clearly a cause for alarm. In August 1992, it was forced to disclose that regulators had demanded that it sign a "memo of understanding''--an "MOU'' in regulators' shorthand--admitting that its difficulties were critical enough to require intensive regulatory supervision. Examiners, one Citibank officer said, regularly took over the boardroom to go through the loan portfolio piece by piece. In fact, Reed admitted later, Citi came "very close'' to the abyss in December 1991, when the comptroller of "the Currency declined to sign off on Citi's reserve levels. But Citi was deemed "too big to fail.'' [which explains gold leasing]
In the thick of the S & L crisis, Wriston was dumbfounded at how Lincoln Savings, one of the costliest thrift failures of them all, was able to corral five U.S. senators to pressure regulators not to take action against it. "I don't think the commercial banking business could marshal one U.S. senator to talk to any one of the regulators.''
Reed seemed to take the heat well, though he complained that "people talk about Citicorp as if we were the only people in America with a troubled real estate portfolio. No one is writing articles that [Tom] Labrecque is going to get fired from Chase, [Walter] Shipley from Chemical, [John] McGillicuddy from Manufacturers, or [Robert] Smith from Security Pacific.'' To be sure, much of the U.S. banking industry was in the same sinking boat.
My reaction: The point here is that the US financial system has been insolvent for a long time. Gold leasing (selling of central bank gold) was used to prop up the system, setting the US up for complete economic collapse two decades later (today). (blue line represents Federal Reserve emergency lending to insolvent institutions and the red line represents the gold lease rate (a proxy for how much central bank gold is being sold))
(blue line represents Federal Reserve emergency lending to insolvent institutions and the red line represents the gold lease rate (a proxy for how much central bank gold is being sold))