It was about a year ago, and by one International Monetary Fund aid’s account, Citibank chairman Walter Wriston was nettled. IMF head Jacques de Larosiere was questioning Western banks’ runaway lending to less-developed countries, including oil exporters like Mexico and Nigeria. “These are solid loans,” Wriston is said to have insisted. “We’ve never lost a dime on lending to sovereign borrowers.” A de Larosiere aide smiled. “You will, Mr. Wriston,” he replied. “You will.” Newsweek March 7, 1983
Today, the bullish consensus would scoff at the notion that there is much to gain from pondering the economic misfortunes of the 1970’s and 80’s. Certainly, few would accept that that period’s inflation and the less-developed country (LDC) debt crisis have even the slightest relevance to the present. Yet, we believe they certainly do. The consensus would argue passionately that today is to the inflationary 1970’s, as black is to white. We, however, don’t see it this way either, as there are strikingly clear and disconcerting similarities. Both are characterized by runaway money and credit inflations that fueled ill-advised lending, rampant malinvestment and acute financial fragility. Today’s inflation manifestations may be much subtler and, indeed, seductively surreptitious, but certainly no less dangerous.
The 1970’s were a decade of conventional, hence obvious, inflation. Lax Federal Reserve policies augmented excessive money and credit expansion fueling a general surge in prices. Of course, oil prices played a powerful role in the escalation. On the back of strong economic growth during the preceding 1960’s, energy consumption surged more than 50%. Over time, previous oil surpluses turned into ballooning oil deficits and the energy crisis was born. Pulling facts from the excellent book by Allen J. Matusow, “Nixon’s Economy – Booms, Busts, Dollars, & Votes”, after previously running oil surpluses, by 1972 “imported oil grew to 29% of US consumption.” “In 1973, 35% of U.S. oil supplies had come from foreign sources, with Middle Eastern oil accounting for 18%.”
On Yom Kippur, October 6, 1973, Egypt’s Anwar el-Sadat ordered troops into the Israeli-occupied Sinai peninsula and another Arab-Israeli war was commenced. “On October 16, the Gulf States raised prices from $3 to $5.11. On October 20th, 1973, the Saudis at last took the fateful step so long feared. They augmented the production cutback with a total embargo on oil exports to the United States…On Christmas Eve, the Persian oil ministers sent seasons greetings by announcing a price increase of Gulf Crude from $5.11 to $11.65, making a total increase of 470% since January…Higher oil prices helped raise the inflation rate from 8.4% during 1973 to 12.1% in 1974.”
“Energy prices in the United States rose at the astronomical annual rate of 72% in the winter quarter of 1974 – the principal reason why the quarterly CPI rose at the rate of 14%, a U.S. peacetime record. As a result of higher oil prices, consumers spent nearly $40 billion more on energy in 1974…”
Literally, dollars flooded into the hands of the oil producers, creating so-called “petrodollars.” At the same time, importantly, the petroleum exporters deposited these petrodollars largely into the US money center banks. This “recycling” of dollar inflation was a momentous development. The aggressive money center banks, including Citibank, Bank of America, Chase Manhattan, Chemical, JP Morgan, Manufacturers Hanover and First Chicago, now flush with new petrodollar deposits, were looking for big returns. They happily extended credit to the oil patch and to residential real estate, stoking inflation, malinvestment and economic distortions. They thought, however, that they had found paradise lending to governments from less-developed countries, particularly in Latin America and Asia. The perception was that these borrowers were about to enter a new era of growth and prosperity, with extraordinary prospects for the future. Over-zealous lenders, unable to resist the captivatingly high interest rates the LDCs were willing to pay, seemingly created analysis that justified the financing of this imagined future prosperity.
In reality, this aggressive credit expansion instead worked largely to exacerbate already escalating inflation and severe distortions throughout these economies. And with loans often channeled to uneconomic investment, the end result was to create severe economic distortions and acutely fragile financial systems - a mountain of debt with grossly inadequate underlying enterprise cash flows to service these loans, let alone ever pay them back. Yet, as long as additional credits were issued to these economies, true economic and financial fragilities could be masked, and the appearance of stability and favorable prospects maintained. There comes a time, however, when that which cannot go on forever, must come to an end. In what should have been clear was anything but; that as soon as the money spigot was shut down, the reality of the underlying cash flow situation would lead to almost immediate collapse – the proverbial “house of cards” for borrower and lender alike.
William Greider in his wonderful 1980’s classic, Secrets of the Temple – How the Federal Reserve Runs the Country, captured the predicament clearly and brilliantly.
“The largest single factor responsible for (the major US banks’) weakened capital condition was their aggressive lending to the less-developed countries of the world, mainly in Latin America and Asia, the so-called LDCs. For the previous decade (the 1970’s), the leading international banks of the U.S. had pushed for a larger and larger share of this global loan market and their capital base had shrunk proportionately. Brazil, Mexico, Argentina, South Korea, the Philippines and Taiwan were the leading borrowers. Collectively, Third World nations had amassed about $400 billion in debts to foreigners, as of 1980, and U.S. banks held about 40% of the banks loans.
But the American loans to the developing nations were highly concentrated among a few big banks. More than four-fifths of the lending was done by only twenty-four banks. Their LDC loans constituted a full tenth of their overall business – and added up to 180 percent of their capital base. The nine largest money-center banks were the most aggressive of all. Their risk exposure in less-developed countries had mushroomed to 204% of their capital by 1980. In other words, if the Third World nations were to default for some reason, that catastrophe would wipe out – twice over – the capital of the biggest names in American banking.
The major bank executives did not seem the least embarrassed by their aggressive position in the less-developed countries. On the whole, they were proud of it. (Citibank Chairman) Walter Wriston, the most forthright among them, openly boasted that these countries were his best customers. The interest-rate returns were higher and loan losses were lower than on domestic lending to American enterprises. In public and in private, Wriston scoffed at critics who perennially warned that America’s largest banks were dangerously overcommitted.
“In my view,” Wriston predicted, “this fear that banks have reached a limit will turn out to be wrong tomorrow, as it always has in the past.” Citibank’s vice chairman, G.A., Constanzo, derided the “doomsday fantasies” of defaulting nations and failing banks. “The concept of banks, flooded with OPEC deposits, chasing loans of deteriorating quality is an Alice in Wonderland fantasy,” he wrote.
The voices of caution included that of Governor Wallich, the Federal Reserve Board’s leading expert on international finance. Wallich had been gently admonishing the major banks in recent months, without apparent effect. In June 1981, he gave a speech entitled “LDC Debt – to Worry or Not to Worry,” and answered his own question in the affirmative.
…today we are in a transitional phase that in the long run is not sustainable [Wallich warned}. In the short run, it is made to appear sustainable in some degree by inflation, which causes a country to amortize its debts via interest rates. Fundamentally, a good number of countries are borrowing amounts that cannot be continued far into the future without leading to burdens that appear unsustainable from historical experience.
Wallich was discreetly suggesting to the banks that they slow down, but the major bankers were heading in the opposite direction. According to the executives from Citibank, the biggest LDC borrowers – Brazil and Mexico – were countries with the brightest prospects for the future. Citibank’s Costanzo declared: “Mexico, after Brazil the second-largest debtor among the LDCs, is in a particularly favorable position as it enters the 1980s…On the basis of present trends, Mexico’s external debt may surpass that of Brazil during the decade, reflecting not an uncontrolled deficit but the recognition of unparalleled investment opportunities.
As a central banker, Wallich felt restrained from challenging these claims more precisely. “You don’t ordinarily publicize the fact that a country’s credit isn’t any good,” he said. “it’s counterproductive and stupid. So it’s not very easy to sound warnings.”
Anthony Solomon, president of the New York Fed and an intimate of Wall Street’s most important bankers, privately lamented their lack of caution:
“What I don’t understand is why the major commercial banks pay so little attention to their own country-risk assessments. My guess is that it isn’t the country-risk experts who are too optimistic. It’s the top lending officers of the banks, the senior officers themselves. They watch what other banks are doing. They rely too much on imagery, not enough on risk analysis. The real cause is the enormous need to be competitive – to show as good a profit sheet as your peers, to show steady growth in the size of the bank. That’s the only way to get the right price-earnings multiples in the stock market. Second, they are consoled by fashion. If everyone else is lending to sovereign LDCs, they feel a little better even if their own country-risk department is suggesting otherwise.”
“On Friday, the thirteenth of August (1982), Jesus Silva Herzog called once again at the Federal Reserve and the Treasury Department, this time to declare that the game was over. Two weeks before, the Fed had lent another $700 million to Mexico and new that money was virtually gone too. The nation’s liquid reserves had dwindled to less than $200 million, but capital was fleeing the country at the rate of at least $100 million a day. On Monday, when the world opened for business, Mexico was broke. The United States government could not allow that to happen. If Mexico defaulted on its $80 billion debt, the largest banks of America and Europe would be swamped in the resulting panic. Other debtor nations, faced with the same financial crisis, would no doubt follow Mexico’s failure. Investors worldwide would rush to find safe ground, dumping bank stocks and pulling deposits out of any banks that had heavy exposure in Third World loans. The bubble of optimism that had led Citibank and the others to lend so heavily to Mexico, Brazil, Argentina and the rest was about to burst.”
In fact, the game was indeed over and the consequences would be financial and economic collapse for many of the borrowers, and near catastrophic losses for the lenders. The LDC crisis, along with domestic losses emanating from reckless credit excess in the oil patch and real estate markets, led to a string of major bank failures and nearly brought the US financial system to its knees.
Now, let’s attempt to garner relevant insight from history to make more sense of today’s extraordinary environment. First, it is important to appreciate how the oil supply shocks during the 1970’s set off processes with profound financial and economic ramifications, inflationary and otherwise, that ended in problematic economic distortions and severe dislocations for the US financial system. In this respect, it is our strong view that supply shocks during the 1990’s, although today remaining virtually unrecognized and unappreciated, have been similarly powerful in inciting profound economic distortions and catastrophic financial fragility. The global crisis that exploded in SE Asia in the summer of 1997 and escalated in 1998 with the collapse in Russia and the near meltdown of the US credit market with the failure of LTCM, was a major supply shock. With the Asian economic crisis, in particular, having major deflationary consequences, this allowed US interest rates to remain considerably below what they would have been otherwise, especially considering truly extraordinary domestic borrowing demands and economic vigor. Momentously, the Federal Reserve responded aggressively by loosening credit conditions, giving priority to financial market tumult above the rapidly escalating US financial and economic bubble. With the double-effect of both collapsing currencies and domestic demand throughout Asia, imports of a vast array of goods and commodities, including technology components, were available to US consumers and manufacturers at sharply lower prices and in seemingly endless quantities. And while the Federal Reserve likely viewed this as a powerful force working against inflation, the truth was that this supply shock originating with the global crisis actually proved the catalyst for one of history’s great money and credit inflations.
As we have chronicled extensively, the GSEs responded aggressively to reliquefy the financial system, expanding their lending by an astonishing $620 billion, or 56%, during 1998 and 1999. In the process, American homeowners were granted an amazing opportunity to refinance their mortgages at significantly reduced interest rates. Over this same period, total US financial sector debt increased a staggering $2.2 trillion, or 40%, and broad money supply expanded by nearly $1 trillion. Such unprecedented money and credit excess fueled historic stock market inflation, with the mania most fervent throughout the Internet and telecommunications sectors, and technology generally. Additionally, endemic residential real estate inflation stoked prices, especially in locations most directly impacted by inflating equity prices and, really, upper-end neighborhoods throughout the country. Encouraged by the perception of surging wealth, the American consumer borrowed and spent like never before. This inflationary shock led to unprecedented trade deficits. Monthly trade imbalances ranging between $5 and $10 billion up through the end of 1997, ballooned to February’s nearly $30 billion. Once again, immense US money and credit inflation has flooded the world with dollars, not just petrodollars, but also a tidal wave of Bubble Dollars.
Importantly, like the 1970’s petrodollars, Bubble Dollars are being deposited and recycled through the major US and international money center banks. Earlier last decade, particularly during 1993-1996, these dollars were significant fuel for the booms and inevitable busts in emerging markets, particularly Mexico, SE Asia and Russia. But since the global crisis and resulting heightened risk aversion to the emerging markets, these Bubble Dollars have chosen to play in the US stock market, as well as fueling the greatest lending boom in history that has financed a literal “communications arms race.” With an endless supply of concepts and an unlimited appetite for borrowing to develop some sound projects and many many dreams, the Internet, broadband, wireless, cable, satellite and other telecom technologies have created unfathomable credit demands that, nonetheless, have been easily met by an equally amazing supply of recycled Bubble Dollars.
This, however, is anything but good news, as, like the petrodollars that fueled the LDC borrowing and spending boom, lending has too often been directed to ventures and enterprises lacking current or even reasonably prospective cash flows to service the heavy debt loads. Lenders, seduced by New Economy “imagery” and seeing everyone else lending aggressively, have ignored sound risk assessment and underlying cash flow analysis. Last week we highlighted the $1 trillion annual creation of new syndicated bank credits, including last year’s stunning nearly $400 billion of credits categorized at “leveraged lending.” We certainly suspect that this market, dominated by the major US and international money center banks, is closely intertwined with the recycling of Bubble Dollars. Clearly, the incredible growth in syndicated bank lending has played a critical role in funding the borrowing and spending boom for the historic Internet and telecommunications build out. And like the LDC lending fiasco, the game can play on only as long as additional credits are forthcoming.
The same holds true for the US real estate bubble. Here the leading instigators of mortgage credit excess, the GSEs, have become at the same time leading recyclers of Bubble Dollars. Through the issuance of tens of billions of “benchmark” Agency securities to the international speculating and investing community, the flood of Bubble Dollars that the GSEs themselves helped create in the first place are channeled right back to finance additional mortgage credit, perpetuating the American housing bubble. This too has led to momentous economic and financial distortions with a massive misallocation of resources and dangerous housing inflation. Additionally, the real estate bubble and the ballooning of GSE balance sheets have dramatically heightened systemic risk. During 1998 and 1999, agency securities outstanding increased by almost $1.1 trillion, while outstanding interest rate derivatives held by the major US commercial banks increased from $17 trillion to more than $28 trillion. Undeniably, such egregious credit and derivative excess have created an acutely fragile financial sector.
Many of us skeptics of the US boom have been puzzled by the continued resilience of the US dollar, especially in the face of ballooning trade deficits. Well, we believe the responsibility lies directly in the extraordinary effectiveness, thus far, of the money center banks and GSE’s in recycling the Bubble Dollars back to perpetuate the great US financial and economic bubble. Clearly, the epicenter of global credit and speculative excess now resides in the unprecedented bubble in US dollar financial assets. But, unfortunately, what cannot go on forever will at some point end. The LDC lending crisis finally erupted with Mr. Herzog saying that Mexico had had enough, and the game could no longer continue. And while such an event is obviously not a logical conclusion for the US bubble, we certainly have the sense that the stock market over the past few weeks has signaled that, finally, enough is enough for the technology mania. And with equity investors fleeing technology stocks, particularly Internet and Telecom issues, it is difficult for us to comprehend that speculators and investors from home and abroad will continue the frenzied acquisition of risky credits from the very same sectors. Indeed, as we have stated recently, it is our view that the US credit bubble has been pierced, with momentous ramifications for the US financial system and economy. If this proves to be the case, we would expect to see faltering liquidity in the market for risky credits, particularly in the bank syndication marketplace. And, importantly, we furthermore anticipate that this situation would effect at least initial stress in the powerful mechanism for recycling Bubble Dollars. Such a development will prove a seminal event for the highly vulnerable US financial system and economy.
