When will they ever learn?

I was listening to NPR recently and I heard an interview with author S.C. Gwynne. "Could it be the same S.C. Gwynne who wrote "Selling Money," I wondered. So I googled him and it was, indeed the same person.

When I was working for the Manila Chronicle, my editor I plunked a book at my desk and said, "Here, read this and write about it. Fill up a page today." The book was "Selling Money" by S. C. Gwynne. I checked my files and found my article. Rereading it, I was struck by how relevant it seems today - just think credit derivatives instead of Third World country loans. Banks chasing profits without fully understanding what they were dealing with caused a financial crisis.

So here is the article:


The Debt Crisis Through a Banker's Eyes
by Edith Sangalang-Atienza
Manila Chronicle, 1987

SELLING MONEY by S.C. Gwynne, Penguin Books ©1986

An insider guides you through the otherwise intimidating, confusing world of international banking during the lending boom of the 1970s and the debt crisis years in the '80s. S.C. Gwynne, international loan officer of the Cleveland Trust Company at age 25, paints a fantastic picture of banks swept along by a confluence of events to banking imprudence on a global scale.
The tale begins, appropriately, with the event that brought to the world's consciousness the term debt crisis. In August 1982, then current finance minister of Mexico Jesus Silva Herzog told the US Treasury Department that his country was bankrupt and therefore had to default on $80 billion that it owed to one thousand four hundred foreign banks.
"Loans to Third World nations barely even existed prior to 1970. Now a single country had been able to borrow a massive percentage of the capital and reserves of the world's largest banks," Gwynne states.
The more horrifying realization that had been brought home to the bankers by Mexico's announcement, however, was the fact that the creditor banks had been caught unaware by it: they were ignorant of the real state of Mexico's finances.
How could such a thing have happened? Gwynne tells of his own experience with the Cleveland Trust Company to show the reader how. Cleveland Trust Company (renamed Ameritrust in 1979) was, by Gwynne's account, "a conservative Midwestern bank with no international division to speak of," but towards the mid-70s was feverishly staffing up, as other banks were, to cash in on the enormously profitable business of lending to developing countries.
The lending boom, Gwynne says, began with the oil crisis of 1973: "...between enriching itself and impoverishing the third world, Opec created the most dangerous economic disequilibrium in history: the unnaturally large surplus on Opec's books became unnaturally large deficits on the books of poor countries of the world. And that surplus had to move, or else the world financial establishment would come tumbling down with a crash not heard of since 1929."
Whether or not one agrees with Gwynne's analysis of the imperatives created by the situation, the fact remains that there were huge funds deposited in the large (and not so large) banks of the world which, in the logic of banking, had to be invested somewhere (or rather, lent to be invested).
American banks, however, were in a bind. American banking law prohibited international bank branching, thus limiting banks' potentials for growth. But the banks soon discovered that the law did not limit where corporate clients could come from, so the banks turned to corporate financing as they grew. One thing leads to another. The big corporate clients had significant overseas operations, and when the oil crisis hit developing countries, their capacity to pay for imports (whether raw materials or finished products) was severely impaired. Banks were persuaded by their big corporate clients to finance developing country imports. For Cleveland Trust Co., at least, this was the route "into the money vortex."
So who cares about the Cleveland Trust Co.? How many people have even heard of it? Banks whose names people the world over recognize and associate with foreign debt are Citicorp, Bank of America, Chase Manhattan, Manufacturers Hanover, Morgan Guaranty, and Chemical bank, the big banks with branches around the world.
Gwynne points out: "Although they dominate banking in the US, the top ten banks still constitute less than 25 percent of the system's assets. The next fifty banks down the ladder control $557 billion in assets, and viewed in aggregate they constitute a powerful presence in international banking."
Lending to Third World firms and governments need not necessarily have led to a debt crisis. The crux of the matter is, "the banks seemed to have learned nothing from history."
Young bankers with impressive MBAs and even more impressive expense accounts jetted around the world "selling money," looking for firms, whether private or state-owned, to lend money to. The pace of growth of foreign lending was so fast, however, that these loan officers were sent on field with hardly any knowledge of the culture and inner workings of the sociopolitical milieu of the potential borrowers' countries. Some were even sent to countries whose language they hardly understood. Assiduously, they compiled data and filed reports on which banks calculated the risks involved. (Citibank invented country risk analysis in 1974, Gwynne informs us.) But statistics were often dated and sometimes even falsified, and the banks' bright boys were ill-equipped to detect this.
Worse, "what was inexplicably overlooked by Cleveland Trust and by many other US banks was that a foreign borrower was only as solvent as its country of domicile...This is 'convertibility risk': the possibility that a foreign company might not be able to convert local currency to dollars to repay foreign debt."
Despite avowed awareness of convertibility risk, banks went on their lending spree and compounded their error, Gwynne relates, "with a far more serious breach of their traditional credit policies: They placed no upper limit on the amount any country or company could borrow from a banking system... ."
The system itself made this difficult to do. There were thousands of banks competing with each other to lend to the Third World, and many loans were short-term borrowings from the Eurodollar market (which were frequently rolled over and ended up in effect as long-term loans).
The Eurodollar market, the "invisible bank," explains Gwynne, placed much of international lending outside sovereign control. He called the practice of interbank lending in the Euromarket "the most radical and dangerous innovation in banking in the post-war world," because it became possible for banks to operate on very high leverage ratios. It was the Eurodollar market which made it possible for the banks to lend astronomical sums beyond their capitalization.
Using the London Interbank Offered Rate (Libor), the banks found a way for the borrowing countries to assume the risks involved in the loans. Creditor banks arranged long-term loans for Third World firms, borrowed on short-term from the Euromarket, tacked on the Libor plus their own fees/interest, and for as long as the borrowers kept paying, raked in a lot of money.
The banks' confidence in the soundness of this enterprise was bolstered by its discovery in 1978 that "the International Monetary Fund (IMF)...could be used to police the banks' credits, enforce their loan covenants, and-here was the real genius-underwrite foreign risk with taxpayers' money."
One more significant thing that the banks overlooked was the phenomenon of capital flight. As fast as loan dollars were coming into the Third World countries, the affluent classes among them would be acquiring properties abroad instead of putting them into productive enterprises that would have generated the means for their ultimate repayment.
Cleveland Trust's $10 billion loan to the Construction and Development Corporation of the Philippines (CDCP) in 1980 provides the perfect example. Gwynne was involved in the loan as a calling officer (something like a glorified Euroclean man).
The loan was to finance exports of an American firm to CDCP. The firm had an unhealthy debt-equity ratio, but its president, Rodolfo Cuenca, was a close friend of Marcos, and he was "leaned on to persuade the Philippine National Bank to issue a 'standby letter of credit,' a form of conditional guarantee of payment of principal and interest." But Cleveland Trust's ironclad loan quickly turned sour. They were wrong about the company's financial health and they were unaware that the country was surviving on short-term loans.
The debt crisis, then, as Gwynne paints it for us, is a complicated picture. He also cites cases where clearly, loans were given because they were in the political interest of the United States.
Despite his initial indictment of the role of the IMF as the creditors' policeman, Gwynne argues for the need for some sort of disciplinarian/coordinator, but this time to regulate the banks.
In his discussion of the Philippine example, Gwynne observed:
"...the crisis itself could probably have been avoided had the IMF been enlisted earlier, and in a better cause. Sovereigns, like private sector borrowers, should have had strict, IMF-monitored limits on their ability to take on new debt-limits that would have protected the banks from their own aggressive instincts. Such a debt formula would have to be complex-involving debt service ratios, average loan life and maturity analysis, and continuous monitoring of a country's foreign exchange and short-term debt positions-but it would be no more complex than the current austerity programs and reschedulings. It would be built into all foreign loans, both public and private, since from the perspective of sovereign risk the two are ultimately the same. Once a country hits its upper limit, it would trigger what amounted to default clauses and be forced to retrench, to adopt austerity measures such as currency devaluations and foreign exchange controls. Such a formula would have undoubtedly led to a series of minidefaults and minicrises. But the scale would have been much smaller and more manageable.”
In the final chapter he recommends: "There is no easy solution to the debt crisis. Too much money is involved to simply wipe the slate clean, and anything short of that necessarily involves thousands of principals with much at stake. But there is a logical first step, and that is for the banks to give up as quickly as possible the misguided notion that they can earn market interest on this debt. They should be prohibited from lending money to pay themselves interest. Instead, they should be required to use these loans-and the restructuring fees they receive-to amortize the principal... ."
He ends with a warning to the big money center banks like Citibank that the regional banks may yet decide to write off their loans, in which case regional banks can survive but the big banks may not.