Page 1 of 2 Bankers' greed and supervisors' folly
By Hossein Askari and Noureddine Krichene
We are smack in the middle of a crisis that will only get much worse before
getting better, a crisis that could entail the worst recession since the Great
Depression and one that could reverse much of the gains from globalization.
Policy makers need to react more quickly than they have to contain the crisis
from becoming much worse than currently envisaged. An often-overlooked resource
is the past.
The world was confronted with the Third World debt crisis in the early 1980s,
but the international banking community, especially US banks, and the US
treasury and the US Federal Reserve learned very little from that debacle.
That's a pity as they might have picked up a few tips on how to tackle the
present financial crisis. As in the 1980s, the greed of bankers and the
ineptitude of
supervisors are today exacerbating financial conditions.
In the run-up to the Third World debt crisis, bankers the world over fell over
themselves to make syndicated loans to many developed countries. They did so
with little regard to the borrower's ability to service the loans and the risk
created by their concentrated lending. A number of banks were ecstatic to be
lead managers of syndicated loans for fat upfront fees, and a thousand or more
banks were happy to sign on the dotted line and get a piece of the high-yield
action.
Any reasonable look at most of the countries the banks were lending to would
have revealed the borrowers' increasing inability to service their growing
debt. There was no way that they could both service their debt and finance
their needed imports for their economies to grow.
Yet bankers adopted Walter Wriston's famous slogan that countries don't go
broke! They wanted to believe that because countries did not die or disappear
like people and companies, they would eventually get paid back. But they forget
that while they waited for payment they might disappear from the scene
themselves!
For example, Manufacturers Hanover Trust (a bank that no longer exists on its
own today) had lent five times its capital just to heavily indebted Latin
American countries that could not service their debt; MHT was not just buried
but buried two meters under. The greed of bankers blinded their judgment. And
where were the regulators and supervisors when we needed them? How did they let
this happen?
All the while, regulators had their heads in the sand. They just did not want
to recognize reality even when it hit them in the face. When Mexico started the
crisis, they called it simply the Mexican Crisis, and did not want to see that
other countries were in the same boat. They did not even want to admit that
Mexico could not service its debt and grow, but insisted that it was just a
short-term liquidity crisis. So their plan was a bridge loan.
Then the regulators came up with a series of unrealistic and inefficient
approaches such as the "Baker Plan" and the "Brady Plan" as the Mexican crisis
spread. They never saw the need to study and analyze what was at the core of
the problem before devising the most efficient approach for handling it.
Instead, their process was haphazard and shooting from the hip.
The core problem of the Third World debt crisis was that the countries had
borrowed too much, not to finance income-generating projects in agriculture and
industry but mainly to cover current government expenditures in the form of
higher salaries for their armed forces and civil servants. They could not both
service their debt and finance their economic growth. If the principal of the
debt was reduced somewhat, or the interest rate on the debt or both, then the
loans could be serviced, restoring full value to the loans that had been made.
Bankers were unwilling to do either; instead they raised interest rates and
collected fat rescheduling fees for rescheduled loans! That's greed for you.
They had a bleeding body on their hands and they wanted more out of the
patient. They did not face up to the fact that they had collected big fees and
high rates in the past as compensation for risk. They wanted more fees and the
same returns as before. They were not willing to take a hit. The similarity to
the present crisis is all too obvious. In the run-up to this crisis, bankers
made money making loans that they knew could not be paid back and they are now
not willing to take a hit; they want to be bailed out.
At the same time and more rationally, a bank was unwilling to reduce the
principal on its loan but wanted other lenders to take the hit, improve the
borrower's creditworthiness and restore value to the country's overall debt
portfolio; that is all banks wanted to take a free ride at the expense of other
banks.
Financial supervisors should have quickly realized that all lenders had to take
a simultaneous hit. A plan was needed to help countries do better; a little
debt relief was a waste, and enough had to be done to get countries in a
position to service their debt and grow. There was an opening for financial
supervisors, but they were blind to it and did not take up the challenge.
One of the hallmarks of the Third World debt crisis (and invariably most
crises, including the current one) was that bank assets (loans) were selling at
a significant discount on the secondary market. The discount was the key and
afforded ways to resolve the crisis. It would have allowed all parties to
improve their position from where they were.
Imagine a case where the loan was selling on the secondary market at a 50%
discount. If we were sure that the country would be in a position to fully
service its debt and grow if it received a 25% debt relief (on the face value
of the debt), then here is what could have been engineered. There would have
been a debt forgiveness of 25% by all bank holders of debt. We say all bank
holders of debt because, as we have mentioned above, all banks would rather not
forgive a thing and benefit from other banks forgiving debt (the free-rider
issue).
The result would be that the value of the remaining debt held by the banks
would have gone up in value from 50 cents on the dollar to 100 cents; given
that they have forgiven 25% of the debt, the value of their remaining holdings
would have gone up from $50 to $75. Yes, they are worse off than if they had
not forgiven any debt and the country was able to service the debt, but that
was not the position that they were in (the market value of their holdings had
declined from $100 to $50).
In a sense it is a win deal for all, for banks from where they found themselves
at the time of the crisis and for the debtor countries, as they owed less. Note
that supervisors need not engineer 100% debt forgiveness (or buy 100% of the
debt) but just enough so that the country could service its debt balance and
thus restore par value (reduce the discount sufficiently) to its debt. In
short, banks would remain solvent but take a hit and countries could continue
to grow.
After a number of excruciating years some elements of this approach were
adopted, but not as an integrated plan and not decisively, cleanly and quickly.
What lessons can we take away from this about bankers and supervisors? Bankers
are greedy. They made lots of money but when bad times came they were not
willing to be realists and acknowledge that the value of their portfolio had
declined and take a hit. They did not want to realize any losses but instead
wanted either to be bailed out or for the countries to pay up and if need be
starve their people.
In such crises, supervisors must force banks to face reality. But supervisors
invariably do not stop a problem from becoming a crisis. They want to wish the
problem away. They don't want to confront their banker friends and they are too
slow to react. And when the crisis develops, they don't develop a rational and
comprehensive plan but instead react to put out fires in fits and starts if
they can; they just don't seem to be able to do all that is needed in one move.
How does the ongoing global financial crisis differ from the Third World debt
crisis? What have the supervisors done? What should they have done? What can
they do now?
The current crisis was principally fueled by four factors: overly expansionary
monetary policy in the US, an ill-conceived and haphazard system of financial
regulations, lax supervision and a push by US politicians to expand home
ownership.
At its core was a housing bubble. As the bubble started to burst,
less-creditworthy borrowers were unable to service their debt, resulting in a
decline in the value of the loans (mortgage-backed securities) held by the
financial institutions and leading to the insolvency of a number of financial
institutions. Although the ongoing crisis is much more widespread and entangled
(involving credit default swaps and the like), in both crises the value of the
assets held by financial institutions has declined, threatening their solvency.
But two of the major differences are, first, that in the case of the Third
World crisis, the borrowers (the countries) were relatively few in number,
whereas now the borrowers (homeowners) are in the millions; and second, the
assets have been so re-packaged in the case of mortgages that it is difficult
to know which mortgage-backed security is impaired.
How did US regulators approach the present crisis? US decision makers took the
following course of action. They reduced market interest rates aggressively and
then sat back and did nothing for some time, with no analysis of what had
happened and the best way to address it. They relied on the market to do this,
not realizing that low interest rates had in part caused the bubble and would
not now deflate the bubble in an orderly manner.
After the problems became more dangerous and widespread, they bailed out some
institutions (Bear Stearns and AIG) and not others (Lehman Brothers). Until
today we cannot understand on what basis these decisions were made. Has in fact
the bankruptcy of Lehman frozen the credit markets?
Then when the crisis became more widespread than they had imagined, they put
together just a three-page memo and asked the US Congress for US$700 billion to
buy impaired assets. Their plan made no sense. At what price would they buy the
toxic assets? Which assets would they buy? Would they be able to buy these
assets quickly enough? Then when they saw how impractical their plan was and
that still things did not improve, they decided that they wanted to follow
Europe's lead and inject capital into endangered financial institutions, while
quietly affording a tax break of over $100 billion to banks to encourage
mergers by allowing them to benefit from losses for a number of years.
More recently, they have decided to terminate their purchase of impaired assets
and concentrate on capital injection for ownership. Now and most recently, the
US Treasury wants to help banks and other financial institutions that issue
student, auto and credit card loans.
At the same time, another federal authority, the Federal Deposit Insurance
Corporation (FDIC), wants to keep homeowners in their
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