IOU: The Debt Threat and Why We Must Defuse It

He must have been good-looking when he was younger, although now with his paunch and perma-tan, it’s hard to imagine. But clearly there was a time when he was a player: the waterbed and hot tub are still there – I know because he pointed them out, as he showed me around his spectacular, though crumbling, apartment. Stained-glass windows shipped in by the Rothschilds, wooden panels, galleried living room and everywhere his own amazing photos of Africa, the continent in which he spent the best days of his life.

In 1969, the year man landed on the moon, Richard Nixon took office as President and Charles Manson murdered Sharon Tate, Karl Ziegler was 26, and just out of business school when he went off to Kenya with First Chicago to head up the bank’s syndicated loans division.

The biggest loan he made was to Nigeria in 1975, a jumbo loan of $1.4 billion. It was the biggest loan, in fact, that had ever been made to that country. $400 million of it went to the Wari Steel rolling mill (that part of the loan supported by Hermes, the German Export Credit Agency) and the rest undesignated, a generalpurpose loan to support Nigeria’s balance of payments. Nigeria, he told me, was a good risk at that time. It was one of the world’s major oil exporters and the oil price was high.

It was a good risk, true, in the sense that it wasn’t likely to default, but it was not exactly the most salubrious of countries to lend to. Especially at the very time that Ziegler was working on the deal. Because right then the country was embroiled in a huge and highly visible scandal. A number of public officials and private contractors had imported over a million tons of cement at hugely inflated prices using central bank funds with the difference between the market price and the price they paid to be shared as a kickback between them. But rather than arriving in instalments, the shipments arrived en masse. With hundreds of cement ships waiting to offload their cargo in a harbour which, at the best of times, could only unload ten ships a week, the shipments began to solidify in the hulls, rendering many ships useless, fit only to be scuttled. 1.5 million tons of cement were left in vessels for 15 months waiting to be unloaded, cement of such a poor quality that years later many of the buildings constructed with it had to be demolished. Building after building made with that material was simply collapsing.

Ziegler may not have known at the time about the inadequacy of the concrete, but he was well aware of the corruption that brought about the cement scandal. But back then cement wasn’t the issue. ‘My job was to sell money,’ he told me. And his $1.4 billion deal was all about that: selling money, and making money, too. As the lead bank in the syndicate, First Chicago would make 0.25 per cent of the $1.4 billion up front – $3.5 million. And if all went to plan, it wouldn’t carry the risk. That would be passed on to other banks in the syndicate. ‘To some schmuck in Des Moines, or some smaller bank in the North’, to quote Ziegler:

Doing the deal was, he explains to me now, what it was all about. ‘First Chicago came along and we won, and I felt eternally grateful for that,’ he told me. I asked him about the corruption. ‘It worried some of us more than others,’ he replied, but ‘it was great kudos…The important thing was to win the mandate…[And when we did]…I was on a high. It was enormously exciting…We were young guys with the world at our feet.’

I pressed him on the corruption issue, and he smiled wryly, perhaps because he now heads a centre whose mission it is to fight corruption and stamp it out. ‘As long as the country’s flag wasn’t black with a skull and crossbones on it or with a yellow banana on it,’ Karl tells me, ‘it was eligible for a loan.’

Ziegler’s experience wasn’t unique. Throughout most of the 1970s, a host of banks – large banks (Chase, Citicorp, First Chicago, JP Morgan, Lloyds, Union Bank of Switzerland, the Banks of Montreal, Tokyo, Japan, and the French Banque National de Paris) and small rural American banks, too – lined up indiscriminately to push their loans to developing countries. It wasn’t only the Cold War players and other developed world governments getting in on the lending game.

With memories stretching back to the widespread defaults on Latin American bonds in the 1930s, commercial banks had, on the whole, stayed away from lending to the developing world since World War II. But, in 1973, the banks returned to those shores with a bang. Eurodollar syndicated loans (#litres_trial_promo) to Latin America jumped from $2 billion in 1972 to over $22 billion in 1982: 1,600 banks were involved in loans to Mexico alone. Commercial lending to Africa (#litres_trial_promo) was significantly more limited, never reaching the poorest sub-Saharan countries, but, by 1982, it accounted for 35 per cent of regional debt (#litres_trial_promo).

Many countries which had already seen their bilateral debts rise earlier in the Cold War now saw their financial obligations really explode. Argentina saw its debt rise by 544 per cent, for example, between 1976 and 1983. And while, in 1970, the combined external public debt of Algeria, Argentina, Bolivia, Brazil, Bulgaria, Congo, the Ivory Coast, Ecuador, Mexico, Morocco, Nicaragua, Peru, Poland, Syria and Venezuela was $18 billion (10 per cent of their GNP), by 1987, once the commercial banks had entered the picture, these countries owed $402 billion (almost 50 per cent of their GNP), with most of the monies being owed to the banks.

What accounted for this sudden desire to lend on the part of commercial banks? As in so many geopolitical cases, you just have to follow the oil. In the wake of the Yom Kippur War of 1973, oil-producing countries perpetrated a massive hike in oil prices, sending them skyrocketing up by 400 per cent, almost overnight. The oil producers were suddenly extremely rich, and the surplus was far too much for them to be able to spend in their own countries. Furthermore, Islamic sharia law forbade the practice of usury and prevented the Arab oil producers from earning interest in their own banks. They needed somewhere else to invest their petrodollars and Western banks seemed the perfect choice.

This meant that overnight a huge new supply of credit emerged – $333.5 billion, to be exact. 40 per cent went to banks in the US and the UK, and the remaining, but still significant, portion to banks in France, Germany and Japan.

The banks were desperate to put this windfall to productive use. The highly competitive banking industry of that time required the recycling of funds; it was absolutely key to staying at the top. Lending the petrodollars out again was a clear money spinner. Banks benefited doubly, from the fees they charged to arrange the loans and also from the interest they would make on the loans themselves.

But simply lending to the developed world wasn’t going to satisfy the bankers given that the demand for loans from borrowers there had failed to keep pace with the expansion of available credit. So the banks actively sought out new lending targets in the developing world, especially in those places where they felt there was an opportunity to establish a close relationship with a burgeoning economy. A market for commercial debt was created where there had not been one for decades. And once the big banks started lending, medium and smaller banks had no option but to follow suit.

It was another round of borrow, borrow, borrow – this time courtesy of the commercial banks. ‘The banks were hot to get in (#litres_trial_promo),’ Jose Angel Gurria, then head of Mexico’s Office of Public Credit recalls. ‘All the banks in the US and Europe and Japan stepped forward. They showed no foresight. They didn’t do any credit analysis. It was wild. In August 1979, for instance, Bank of America planned a loan of $1 billion. They figured they would put up $350 million themselves and sell off the rest. As it turned out, they only had to put up $100 million themselves. They raised $2.5 billion on the loan in total.’ Other loans were similarly over-subscribed, and developing governments often found themselves offered more money than they had requested; that is, if they had even requested the loan in the first place.

The commercial loan pushers soon created commercial debt junkies. Money was lent under terms that were hard to turn down. In the mid-1970s loans actually had a negative real interest rate, which meant that a borrower could pay less than they borrowed, and although the rates were variable, no one expected them to rise significantly. Unlike funds from governments, which often had strings attached such as having to be spent on imports of that country’s goods or having political colours firmly attached, these loans usually came obligation-free.

It was easy for developing countries to rationalize their new addiction. For some, the decision to borrow more was based upon a belief that they needed to incur these commercial debts in order to ensure their country’s future development. During the 19th century, the United States went through a massive period of development, driven by a period of indebtedness to commercial banks, an example held up as a shining path for poorer countries (#litres_trial_promo) to follow, despite the fact that many states never actually paid the loans back.

For others, like oil-importing countries who had suffered under the particularly harsh blow of oil price hikes, it was basically a huge relief to be offered these loans (#litres_trial_promo). What they were being offered by other governments didn’t always suffice. As for the oilexporting countries such as Colombia, Ecuador, Mexico, Nigeria and Venezuela, the loans were a way to capitalize on their much improved financial status, at very reasonable interest rates. Likewise, African commodity exporters, seeing an increase in revenues thanks to the commodity price boom which initially accompanied the oil price increase, and anticipating a continuation of this enhanced income, were delighted to increase their level of borrowing.

For others, the fact that these loans were being sold so hard was just too much of an allure to be able to resist. A Latin American Minister of Finance in the 1970s put it this way: ‘I remember how the bankers (#litres_trial_promo) tried to corner me at conferences to offer me loans. They would not leave me alone. If you’re trying to balance your budget it’s very tempting to borrow money instead of raising taxes to put off the agony.’ The surplus of offers was often overwhelming. And for poor countries in general, borrowing money made sense in theory at least, providing them with the potential to address the economic plight of their citizens.

Moreover the IMF, the World Bank, and the governments of the industrialized countries, actively encouraged the developing world to borrow from these private banks, with the World Bank preaching ‘the doctrine of debt as the path towards accelerated development.’ The IMF, too, staunchly defended the system, claiming that higher foreign indebtedness was sound policy for both lender and borrower because the higher level of investment financed by foreign borrowing would eventually be reflected in additional net export capacity. As a result, commercial loans increased at much higher rates than those from governments or multilateral institutions during this period: while loans from official sources decreased from 54 to 34 per cent between 1979 and 1981, the percentage coming from private banks rose from 25 to 30 per cent.

Down the hatch

And just as when governments lent out monies to serve their geopolitical interests or the interests of their domestic industries, commercial banks also turned a blind eye to how and where their money was spent. As long as the money kept on flowing, the bankers didn’t care.

Most of the Latin American loans were granted ‘for general purposes’, like the bulk of the Ziegler Nigerian loan, rather than for specific projects. In the best cases, governments chose to use this money to invest in the structures needed to support growth. Argentina, Brazil and Mexico, for example, used some of the monies for infrastructure – roads and transportation systems and communications. More usually, the loans were used for debt servicing or supporting domestic financial policy, enabling the borrowing government to retain popular support by avoiding raising taxes, cutting jobs or increasing prices, even though such moves might have been in the long-term interest of the country and its currency. In the worst, but by no means atypical, cases, these loans were simply another type of borrowing being siphoned off by the ruling elites. Between 1974 and 1982, the external debt of Argentina (#litres_trial_promo), Brazil, Chile, Mexico and Venezuela grew by $252 billion (most of which was owed to banks), about a third of that money went to buy real estate abroad and into offshore personal bank accounts.

Similar scenarios played themselves out (#litres_trial_promo) in Africa where much of the debt simply went unaccounted for, usually the victim of false invoicing, capital flight or other techniques to send funds to ‘more secure’ havens outside the country. In an alarming number of cases, the loans went into projects that had no chance of generating the income necessary to pay the loans back. Commercial banks lent monies hand-in-hand with ECAs, for a ghostly parade of white elephants. The Inga-Shaba hydroelectric project and power transmission line in Zaire, for example, originally estimated to cost $450 million – a loan which the US Export-Import Bank guaranteed the initial bill for while commercial banks covered cost overruns – ended up costing over $1 billion, equivalent to 20 per cent of Zaire’s debt. ‘It’s taking so long,’ one US embassy official noted, ‘that a lot of the equipment they’re putting at the two ends is deteriorating.’ In fact, by the time the project was finally completed, the need for power in Zaire’s rich copper mines, the whole reason for the project in the first place, had already been met. The Belgians who were running the mines for the Zaire government had tapped their own sources of external finance, as well as locally available hydroelectric power, to keep themselves afloat.

In Togo (#litres_trial_promo), a combination of export credits and a loan syndicated by German commercial banks was used to build a steel mill. When the Togolese government realized that no iron ore was available to start production, it ordered the German technicians to dismantle an iron pier located at the port – a pier that had been constructed by Germany prior to WWI and which still functioned well. Once the steel mill had exhausted the pier as a feedstock, it closed down.

And, once again, dictators, tyrants and military juntas were bankrolled by Western money. In Argentina, the debt contracted by the military dictatorship between 1976 and 1983 (the vast majority of which was commercial (#litres_trial_promo)) went from $7.9 billion up to $45.1 billion. With half of the money lent by commercial banks between 1976 and 1983 remaining abroad, often with the knowledge of the lending banks themselves. In Brazil, it was also the military that contracted most of the roaring commercial debt – jumping from $3.9 billion in 1968 to $48 billion in 1978. In 1970s Africa, the corrupt Mobutu ran up $579 million of commercial debt.

How did these loans make it through the banks’ due diligence? Investigations the banks carried out before they made their loans ranged from the minimal to the actively negligent. A loan is said to have been granted (#litres_trial_promo) to Costa Rica in 1973 on the basis of a single Time magazine article on the country. Chase Manhattan and many other banks tried to lend to countries which were already in default to them: when Chase offered Bolivia a new loan in 1976, for example, it did so in complete disregard of the fact that it was a creditor on another loan for which Bolivia was already in default. Mexico was offered additional loans even though it had already committed 65.5 per cent of its export revenues to paying debt service charges, which indicated a pre-existing level of commitment that was already very high and extremely difficult to service. And many bankers making the loans just didn’t know what they were doing. As one of the bank executives involved in the negotiations said at the time, ‘I am far from alone (#litres_trial_promo) in my youth and inexperience. The world of international banking is now full of aggressive, bright but hopelessly inexperienced 29-year-old vice presidents with wardrobes from Brooks Brothers [and] MBAs from Wharton or Stanford.’

Inexperienced they might have been, but they were sure making money. A Salomon Brothers’ report (#litres_trial_promo), published in 1976, revealed that the 13 largest US banks had quintupled their earnings (#litres_trial_promo) from $177 million to $836 million during the first half of the 1970s, with a significant share coming from developing country loans. By 1976, Citibank was earning 72 per cent of its income abroad, Bank of America 40 per cent, Chase 78 per cent, First Boston 68 per cent, Morgan Guaranty 53 per cent and Manufacturers Hanover 56 per cent. In the 1970s, Banque National de Paris, one of the world’s largest banking houses, profited more from its various African affiliates than from its extensive branch network in France. Nigeria alone came to account for up to 20 per cent of the bank’s after-tax earnings in the late 1970s.

All this lending appeared to have no potential downside at all. Walter Wriston, former president of Citibank and perhaps the greatest recycler of them all, famously said during the wild lending period, that there was no danger in foreign lending because ‘sovereign nations do not go bankrupt.’ This was a maxim which essentially became the rallying cry for a whole generation of bankers. Lending, lending and more lending was held up as a huge achievement: ‘It was the greatest transfer of wealth (#litres_trial_promo),’ Wriston said, ‘in the shortest time and with the least casualties in the history of the world…[it is] something to be proud of. It was a terrifically difficult thing to do. We did it. It was also hard to-put the guy on the moon. We did that.’

And this was the accepted position. ‘We reject the view (#litres_trial_promo) that international lending activities of American banks are posing grave risks to the American economy or the banking system,’ said C Fred Bergsten, Assistant Secretary of the Treasury for International Affairs, when he testified in 1977 before the House Banking Committee. ‘We believe to the contrary, that they have been remarkably successful in playing a vital role in helping to finance an unprecedented level of international trade, capital flows and payments imbalances – and that they continue to enjoy such success.’

To some extent, this exuberance was understandable. Countries such as Argentina, Brazil, Nigeria and Mexico had natural resources and enough trade to cope, at least initially, with a certain degree of indebtedness. Interest rates were low, which meant that servicing the debts should have been manageable in theory. Countries which could not pay back their debts were just given even more new loans to pay off the old ones. And even if countries couldn’t service these loans, bankers believed that when push came to shove they would be bailed out, that geopolitical interests would as ever hold sway.

‘Banks who lend too much (#litres_trial_promo) too fast know there will be a bailout, no question about it,’ the officer of a large New York City bank said at the time. ‘They scoff at bankers who create large loan loss reserves and those who in general are more conservative. They know that come the revolution in Mexico, or wherever, their banks will have the highest earnings and pay the highest dividends, and that they personally will receive the highest bonuses.’

Those who did recognize the precariousness of the situation and advised caution were viewed as doomsayers. The late Senators Frank Church of Idaho, Clifford Case of New Jersey and Jacob Javits of New York criticized the Ford and Carter administrations’ ‘laissez-faire approach to petrodollar recycling’ and warned that the American taxpayer would ultimately have to pay the price for the banks’ lax lending. They were ignored. ‘As a loan officer,’ an ex-banker who did his share of lending at the time said, ‘you are principally in the business of making loans. It is not your job to worry about large and unwieldy abstractions, such as whether what you are doing is threatening the stability of the world economy.’

But the bankers should have worried.

If they had studied their history books, they would have realized that the path they were taking was neither new nor safe. Since its independence from Spain and Portugal in the 1820s, Latin America, for example, had gone through several cycles (#litres_trial_promo) in which it had borrowed extensively, seen long periods of economic expansion, and then in the inevitable post-boom stagnation, found itself unable to service its debt obligations. In 1827, almost every Latin American government had defaulted on its debt. And this had happened again in 1873. The defaults of 1930 had been no anomaly.

And at the end of the 70s the merry-go-round which enabled banks to keep on lending to Latin America and elsewhere, once again came to a screeching halt.

The morning after

In 1979, the Shah of Iran was deposed, an event shortly followed by the Iran-Iraq war. A second oil price hike occurred, with the price of oil more than doubling within two years. This put pressure on the economies of oil importing countries and created further demand for credit which, in turn, created a new boost of lending. On the other side of the ledger, the added costs stretched the ability of borrowing countries to service the debt they had already contracted. In developed countries, the hikes caused prices of many consumer goods to rise, which triggered inflation.

To curb inflation, industrial countries, led by the US, raised interest rates. There was an enormous global recession. The markets for developing countries’ products shrank, which meant that these countries’ capacity to pay back debts drastically diminished. Developing countries that had taken out loans with commercial banks had done so under variable interest rates. These now jumped up markedly – interest rates rose from an average of 0.5 per cent on commercial bank loans to an average of 13.1 per cent. Developing countries’ debt payments skyrocketed. Argentina, to provide just one example, saw its interest payments rise from $1.3 billion in 1980 to $3.3 billion in 1984 and $4.4 billion in 1985. Projects that had originally made good economic sense now saw their costs go through the roof – the Brazilian-Paraguayan Itaipu Dam Project (#litres_trial_promo)