The Petrodollar Recyclers
IN 1969, WHEN THE PEARSON Commission warned of the Third World’s looming debt crisis, it feared loose purse strings at government agencies, and paid scant attention to the private commercial banks, who accounted for 15 per cent of the Third World’s borrowing. Within five years the commercial banks had abandoned their back seat role to overtake international development agencies as the Third World’s most important source of credit. By 1980, through what could only be described as feverish lending, the banks were providing nearly two-thirds of the Third World’s foreign financing.
The banks’ lending binge flowed from the OPEC oil crisis of 1973, which saw oil prices double, then double and double again, within a decade selling for 20 times their former price. Arab sheiks and other oil producers, suddenly swamped with billions of dollars in unexpected earnings and unable to otherwise invest them, deposited them in Western banks. The banks, unable to say no to these windfall deposits, eagerly accepted them, then set about lending these billions to any and all borrowers to earn the interest needed to pay the oil sheiks.
Many of those borrowers were in the West — often in the booming energy business, much of it nuclear and tar sand megaprojects that would later go bust. But the West had too many constraints on unbridled expansion. Most of the commercial banks had to go further afield to place their cash.
They came to the Third World, over one thousand of them from Chase Manhattan, Lloyds Bank, and the other big names in international banking circles, to the small banks of rural USA, all desperate to place their cash and gluttonous for profits in an unprecedented banking bonanza.
They weren’t disappointed: million and even billion-dollar bank deals were settled in a matter of days. A Salomon Brothers report showed the thirteen largest U.S. banks had quintupled their earnings from $177 million to $836 million during the first half of the 1970s, with the most spectacular part of the increase coming from the Third World loans. By 1976, Chase Manhattan Bank was earning 78 per cent of its income abroad, Citibank 72 per cent, Bank of America 40 per cent, First Boston 68 per cent, Morgan Guaranty 53 per cent, and Manufacturers Hanover 56 per cent. The Banque Nationale de Paris (BNP), one of the world’s largest banking houses, was thought to be profiting more from its various affiliates in Africa than from its extensive branch network in France. In absolute terms, Nigeria alone came to account for up to 20 per cent of BNP’s after-tax earnings in the late 1970s. A 1982 bank survey reported that international lending had been more profitable than domestic lending for two out of three banks.
As the petrodollar deposits accumulated in Western banks, so did the pressure to lend. The competition between banks for Third World business became intense. With so much money to be lent and so much money to be made, Mexico’s Minister of Finance David Ibarra recalled the days when “I had many bankers chasing me trying to lend me more money.” Ibarra wasn’t complaining: during his tenure Mexico added $30 billion to its debt, almost doubling it.
To lend such vast sums, the banks needed to innovate. International trade finance had always been the meat and potatoes of the banks’ international lending. A bank would finance an exporter until the importer paid for the goods, upon their receipt. These loans were short-term, with the goods themselves serving as collateral in the event of non-payment. But only a limited amount of money could be moved in this way. So the banks entered the uncharted world of balance of payments finance in which there was no collateral, in which loans were long-term, and in which borrowers were governments with persistent balance of payments deficits. The banks’ only security became “sovereign guarantees,” or government promises to pay the money back.
At the same time the Western governments — fearing unemployment at home if the Third World couldn’t afford Western goods — were pressing the banks to lend money to the Third World’s oil importing nations to help them pay their oil bills and to finance their ambitious development programs. By going along with the Western governments’ requests, the commercial banks were making a virtue of recycling the petrodollars, crediting themselves with helping to carry the world economy through the trauma of dramatic oil price increases.
Not only did the Third World come to account for so much of the world’s banking business, but this business seemed to be less risky too. The loss rate on international loan portfolios tended to be low: Citibank’s foreign losses were half that of its domestic losses throughout the 1970s, for example.
Minimizing the risk further, the commercial banks believed, were quiet understandings between them and the governments of the industrialized countries. Since the banks had come to the rescue of the global economy, they expected the governments to return the favor.
The overwhelming majority of loans carried sovereign guarantees. According to Pedro-Pablo Kuczynski, a former World Bank official, Peruvian cabinet minister, and later an investment banker with First Boston Corporation, “banks preferred to lend to the public sector, not for ideological reasons but because government guarantees eliminated commercial risk.” Credit judgments, explained Mr. Kuczynski, “were much simpler to make than for a corporation, which might disappear in a bankruptcy.”
This view was epitomized by the leading international banker of the time, the man described as “the intellectual author of overlending to developing countries,” Walter Wriston, chairman of Citicorp. “The country,” Wriston explained in his now famous statement one month after the Mexican debt collapse in 1982, “does not go bankrupt…. Any country, however badly off, will `own’ more than it `owes.'”
To maintain the illusion of security, banks heaped rationale upon rationale to keep away any sober second thoughts. Rather than evaluating the investment quality of loans, they based their lending decisions on statistical theory and political guarantees.
For example, the banks used what Mr. Kuczynski called the “pseudo-science” of “country risk analysis” to determine how much to lend to each Third World country. This analysis assumed that risk could be measured by probability, the way insurance companies determine the chance of someone dying. But while insurance companies base their probability calculations on historical information from millions of unrelated cases, banks applied these statistical tools to about one hundred countries, all dependent upon the same international financial circumstances. The result was statistical rubbish.
Banks also comforted themselves by “herding” together: as long as all the banks were making loans to the Third World, they thought, any crisis would be system-wide and would force governments to bail out those countries in trouble.
Helping the banks to herd, and to simultaneously recycle huge sums of petrodollars, was the joint loan, or syndicated loan — the vehicle for a massive expansion in world credit that fueled economic growth after the oil shocks of the 1970s. Hundreds of billions of dollars in loans were syndicated between 1970 and 1982. Mexico’s syndicated loans marshaled credit from a record 1,400 banks. At the high point of the recycling phase, when the financial needs of Latin America as a whole seemed insatiable, $1 billion syndicated loans were commonplace.
Syndicated loans work like this: A lead bank negotiates the terms of the loan with a state corporation or other borrowers, invites 50 or more other participating banks to join it, and manages the paper work. One or two dozen banks would normally agree to take part with contributions of $1 million to $10 million each. For the participating banks, it was an efficient way to lend money — they avoided preparing the credit analysis and legal documents while diversifying their loan portfolios, scattering their loans among a wide variety of clients in a large number of countries, instead of putting all their eggs in one basket. And, the argument went, syndications allowed the small banks to take part in the boon, without knowing anything about the Third World, since they could rely on the judgment of the big banks in New York and London.
But the wide variety of clients did nothing to diversify the risk. The diversity of borrowers disguised the fact that there was really only one ultimate borrower — the central government. By 1983 the nine largest U.S. banks were owed nearly $39 billion, by just four borrowers — the governments of Mexico, Brazil, Venezuela, and Argentina.
IN THE EARLY 1980s, when the banks came to realize that their Third World clients were all but bankrupt, they began taking measures to protect themselves. New loans covered shorter periods of time in the belief that, if widespread problems emerged, the banks could reduce their exposure by simply not renewing expired loans. This logic turned out to be hopelessly flawed. A bank could only be repaid if another lender extended a new loan to the troubled country. The commercial banks did not expect all lenders to simultaneously cut off funds to Third World borrowers. They didn’t expect a run on Third World treasuries.
It all ended on Thursday, August 12, 1982, with Mexican Finance Minister Jesus Silva Herzog telephoning U.S. Treasury Secretary Donald Regan, U.S. Federal Reserve Chairman Paul Volcker, and the Managing Director of the International Monetary Fund, Jacques de Larosière, to tell them Mexico was broke. Within 24 hours, as the sums were tallied, the international banking system’s vulnerability became evident.
August 13, the Mexicans were in Washington to begin negotiations. Brazil followed in November. Within twelve months, 27 Third World debtor countries had begun rescheduling their debts; more did so thereafter.
Unable to collect on their outstanding loans, some of the biggest banks faced the unthinkable prospect of default. If the banks couldn’t get their money back from their Third World debtors, they could not repay their own depositors and the other banks from which they had borrowed, who in turn couldn’t pay off their own debts. Nor was there much security behind the banks themselves: they had broken a cardinal rule by lending an inordinate proportion of their capital to such risky borrowers. It soon became apparent that three of the four largest U.S. banks — Chase Manhattan, Citibank and Manufacturers Hanover — were particularly vulnerable. To the richest countries of the world who were home to the world’s big commercial banks, the world banking order suddenly seemed precarious. A string of bank collapses could set off chaos in trading relations and bring on recession, if not an all-out depression.
To stop Mexico from triggering this doomsday chain reaction, the world’s banking officials sprang into action. The safety of the major international banks, especially in the U.S. and Britain where banks were deeply steeped in Mexican debt, depended upon a regular inflow of interest payments. Without the inflow the banks’ billions in Mexican loans would become “non-performing,” leading to huge losses on their earning statements, and plummeting share prices as shareholders dumped bank stocks.
The U.S., major European, and Japanese central banks committed money to a massive emergency loan package. Then the IMF’s de Larosière made the commercial banks an offer they could not refuse: lend Mexico another $5 billion, or there would be no IMF funding. The message was unmistakable: without the IMF funds, the entire rescue operation could fail and Mexico would default, taking some banks down with it. The stunned bankers, coerced into throwing good money after bad, did what they were told. To the commercial banks’ $5 billion, the IMF added $1.3 billion and governments $2 billion.
For the next eight years the same scene would be replayed. Endless negotiations, or “debt workouts,” among Third World governments, the banks and the banks’ home governments, and the World Bank, International Monetary Fund, and other international institutions would take place. Debts would be refinanced and rescheduled, new loans would be extended to make interest payments on old loans, old loans that could not be paid back would be extended into the future. In many cases the money never left New York.
To cut their losses, some banks started to sell off their Third World debts, getting, for example, 58 cents for a dollar’s worth of Mexican debt or 11 cents for a dollar’s worth of Bolivian debt, or swapping their debts for minerals or other assets in the debtor countries. By 1989, after a decade of defaults and much hand wringing, they had written down hundreds of billions in doubtful Third World debts. At the same time, like the person who prepares for disaster, the commercial banks were stashing away cash reserves to cover further losses.
At the 1989 annual meeting of the World Bank and the International Monetary Fund, a gathering considered a rite of passage for budding international bankers, J.P. Morgan Bank stunned the thousands of delegates by announcing that it had set aside enough loan-loss reserves to cover 100 per cent of its troubled medium and long-term Third World debts. By the end of 1989, most big Western banks had moved to put the nagging issue of troubled loans to developing countries behind them.
By 1990, they were safely out of danger of financial collapse, and with this new-found financial security they also bought freedom from the latest debt workout — the Brady Plan, endorsed by the U.S., the World Bank, and the International Monetary Fund. Under the Brady Plan, the banks would write down a portion of their existing loans in exchange for taxpayer guarantees for the remainder. To many bankers, this rang of the IMF’s extortion over Mexico.
The banks’ mistrust of government assurances would persist. Bank of Nova Scotia President Cedric Ritchie, reacting to later government appeals to provide Eastern Europe with huge amounts of investment capital, dismissed the requests, saying they had “a familiar ring. Not so long ago, the analogous responsibility was to recycle petro-dollar surpluses to finance the development of Latin America.” This time around, Ritchie said, his bank would do nothing of the sort “on the faith that public policy might be standing behind us this time. Today, we require assurances that are more tangible than simply a wink and a nod.”
Sources and Further Commentary
Statistics on bank earnings from Third World loans come from The Debt Trap: Rethinking the Logic of Development by Richard W. Lombardi, Praeger, New York, 1985, as does the reference to the Salomon Brothers report, which is called U.S. Multinational Banking: Current and Perspective Strategies, New York, 1976.
Mexico’s Minister of Finance was quoted in a Canadian parliamentary report entitled Canada, the International Financial Institutions and the Debt Problem of Developing Countries, Report of The Standing Senate Committee on Foreign Affairs, April 1987.
For general background on the role of the commercial banks in the Third World’s debt crisis I used several publications in particular, including: Richard Lombardi’s book (as above); The Money Lenders by Anthony Sampson, Coronet Books, Hodder and Stoughton, 1982; Latin American Debt by Pedro-Pablo Kuczynski, The Johns Hopkins University Press, Baltimore and London, 1988; Passing the Buck: Banks, Governments and Third World Debt by Philip A. Wellons, Harvard Business School Press, 1987; The Debt Threat: The Dangers of High Real Interest Rates for the World Economy by Tim Congdon, Basil Blackwell, 1988; The Debt Squads: The U.S., the Banks and Latin America by Sue Branford and Bernardo Kucinski, Zed Books, London and New Jersey, 1988; Disaster Myopia In International Banking by Jack M. Guttentag and Richard J. Herring, Essays in International Finance, no. 164, International Finance section, Department of Economics, Princeton University, New Jersey, September 1986.
The figures on Citibank’s losses on foreign loans come from Guttentag and Herring.
One of the most interesting displays of the banks’ confidence that the public sector would bail them out if things went wrong appeared in a December 1975 Euromoney article by David I. Levine (executive director of Chase Manhattan) entitled “Developing countries and the $150 billion Euromarket financing problem” in which he said: “On the one hand, a purely technical analysis of the [non-oil developing countries’] current financial position would suggest that defaults are inevitable: yet on the other hand, many experts feel this is not likely to happen. The World Bank, IMF and the governments of major industrialized nations, they argue, would step in rather than watch any default seriously disrupt the entire Euromarkets apparatus with possible secondary damage to their own domestic banking systems, which in many cases are already straining under their own credit problems.”
Walter Wriston’s now legendary quotation appeared in an article he authored in The New York Times, called “Banking against disaster,” September 14, 1982.
Information on country risk analysis comes from Pedro-Pablo Kuczynski’s book, while details on syndicated loans and the banks’ dependence on a handful of high-risk countries come from Philip Wellons’ book in particular. Also see “Banks showing more caution regarding Third World loans” by John Kohut in The Globe and Mail, Toronto, August 7, 1987. One particularly good review of what went wrong was written by Donald Fullerton, CEO of the Canadian Imperial Bank of Commerce in “Banks have lessons to learn from debtor nations in financial crisis” in The Globe and Mail, Toronto, November 25, 1989. For good descriptions of the build-up to the Mexican debt crisis, the measures banks took to protect themselves, and the IMF plan, see Pedro-Pablo Kuczynski’s book, Latin American Debt; Philip Wellons’ book; A Fate Worse Than Debt by Susan George, Penguin Books, 1988; and The Economic Effects of an Untying of Canadian Bilateral Aid, Effectiveness Evaluation Division, Planning Branch, Treasury Board Secretariat, Canadian Government, July 1976.
For the early history and prices of various Third World country loans on the secondary market see Pedro-Pablo Kuczynski’s book: also see “Return of the Living Debt” by Lee C. Buchheit in International Financial Law Review, May 1990. Much has been written on the loan-loss provisions that commercial banks have been setting aside, and the sales of Third World loans on the secondary market. Just a few of the many good articles include: in Canada, “Top six Canadian banks plan to double reserves against Third World debt” by Gord McIntosh in The Globe and Mail, Toronto, July 7, 1987; “Bank chairmen tackling issue of global debt” by Virginia Galt in The Globe and Mail, Toronto, January 23, 1988; “Third World loans still haunt banks” by Sonita Horvitch in The Financial Post, Toronto, January 19, 1990; “Banks’ loan-loss woes coming to an end” by Jacquie McNish in The Globe and Mail, Toronto, December 8, 1989; “Canadian banks reducing exposure to Third World” by Satinder Bindra in The Globe and Mail, Toronto, October 30, 1990. For European and Japanese banks see “The Debt Squad Pays the Price” in South, U.K., April 1990; “Third World debt woes likely to lead to weak ’89 results for big U.K. banks” by Craig Forman, in The Wall Street Journal, February 12, 1990; “British banks move on debt by Third World” by Craig Forman in The Wall Street Journal, November 10, 1989; “Third World debt starts to hurt Japan’s banks” by Marcus W. Brauchli in The Wall Street Journal, February 7, 1990. For the U.S. banks see “Banks’ reserve action may make debt crisis even more vexatious” by Peter Truell in The Wall Street Journal, July 2, 1987; “Corporate profits fell 18% in third quarter, for first drop since ’87” by Lindley H. Clark Jr. in The Wall Street Journal, November 6, 1989; “Morgan adds $2 billion to reserve for loans to developing nations” by Robert Guenther in The Wall Street Journal, September 9, 1989.
Just a sample of the bankers’ anger over the Brady Plan can be found in the following: “Debt condition of developing nations seems to further unravel, Moody’s says” by Peter Truell in The Wall Street Journal, August 31, 1989; “Banking On A Better Future” in Euromoney, U.K., September 1989; “Brady plan ill-conceived, banker says” by Paul Melly in The Globe and Mail, Toronto, August 4, 1989; “Whose Pound Of Flesh?” by David Shirreff, in Annual Meeting News, Washington, D.C., September 25, 1989; “Carrot and Stick” by David Shirreff in Risk, vol. 2, no. 8, London, September 1989; “Brady strategy: rest in peace” in The Wall Street Journal, January 22, 1990, “Bankers’ barbs at Brady” by Hobart Rowen in The Washington Post, February 8, 1990; “Third World interest payments arrears have surged since Bush Plan began” by Peter Truell in The Wall Street Journal, October 3, 1990; “The Background to Brady’s Initiative” by Lee C. Buchheit in International Financial Law Review, April 1990.
Bank of Nova Scotia President Cedric Ritchie’s comments about the banks’ role in lending to risky sovereign borrowers are from his address to the 158th Annual General Meeting of Shareholders of the Bank, January 16, 1990, Halifax, Nova Scotia.