Living on the Default Line

Until september tenth of 1970, I was a banker, head of a group of banks in Basel, Zurich, Geneva, Lugano and Luxembourg, with joint ventures brewing in Scandinavia and the Far East, all affiliated with the eighth-largest banking entity in the U.S. Heady stuff for a 38-year-old fellow. By noon of that day, it was all over. The Swiss police had arrested me. The charge—at least the eventual charge: My bank had lost $50 million in unauthorized speculation in precious metals and commodities. Since I had both founded the bank and run it as C.E.O., the theory was that I had engineered that financial misadventure. So I spent the next ten months in a medieval dungeon while they tried to prove it. After they let me out, I left Switzerland hurriedly and banking permanently and embarked upon a new life as a novelist, first in England, then in California.

Almost every day now, somebody comes up to me and says, "Erdman, that was the best thing that ever happened to you." That's probably right. Banking has become a highly dangerous profession. I was warned early on that being a Swiss banker meant that you always had one foot in jail. If I were to issue a warning to bankers today, it would be that being a banker anywhere means that you have one foot in the bankruptcy court. Someone wittier than I has suggested that today's global banking situation is one in which the world's great financial institutions have come to the edge of a great abyss—and are about to take a giant step forward. The ugly word that haunts every banker on every continent these days is default.

The size of potential defaults facing the men running Chase Manhattan Bank of New York or Continental Illinois Bank of Chicago or the Royal Bank of Canada in Montreal or the Dresdner Bank in Frankfurt are of such staggering proportions that it makes the little accident I had with my bank in Switzerland look literally like peanuts. Yet in 1970, mine was the biggest banking scandal in the entire world.

To put the current situation into perspective: If just one more major country—Brazil, a borderline case—were to join three other countries already in de facto default—namely, Mexico, Argentina and Poland—the endangered loans by the Western financial system to that foursome alone would total $231 billion. If you added up the amounts that all of the Third World and Eastern Europe owe to us (both of those regions being regarded almost in their entirety as potential financial basket cases), you would end up with a grand total of $735 billion.

American banks are probably on the line for a third of that. And it is the ten largest banks in the United States, the so-called money-center banks, that have lent the lion's share. To get an idea of how exposed they are, consider this: The total combined capital, or shareholders' equity, of those ten banks as of the end of 1981 was $22.6 billion. If you lose your capital, you must close your doors as a bank. One country alone—Mexico—owes those ten banks $12.9 billion, or exactly 57 percent of the buffer that stands between them and bankruptcy. Mexico is broke. Which is why a lot of bankers today wish they were novelists.

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How did the world's banks get into this state of global crisis? As with so many of our current woes, it started in 1973 with oil. When the price went from two dollars to ten dollars a barrel, a lot of countries got very rich overnight—countries such as Saudi Arabia and Kuwait and Venezuela and Nigeria; i.e., the less-developed countries (L.D.C.s) with oil. A lot of other nations—such as Zaire and Argentina and Pakistan; i.e., the L.D.C.s without oil—got poor or poorer. The countries of the former group were piling up oil income much faster than they could spend it, while the countries of the latter group were suddenly paying energy-import bills five times the size they had been used to, draining even further their limited foreign-exchange resources.

The obvious solution would have been for the rich L.D.C.s with oil to lend some of their surplus dollars to the poor L.D.C.s. But that would have been too logical. Plus the fact that the Arabs aren't dumb. Why take the risk of lending money to basket cases?

Enter creative financing, masterminded by the hot-shots from Chase and Citibank and Manufacturers Hanover. Lend the money to us, they told the fellows in Riyadh, and we will lend it to the basket cases. Sovereign loans are what they called them. And their reasoning was this: People go broke, companies go broke—even banks, God help us, sometimes go broke—but countries never do. Right? How safe can you get? And to whom else can you lend billions at one crack and thus save an enormous amount of paperwork? Only countries, that's who.

So the immense supply of surplus petrodollars created its own demand in the form of sovereign loans. The money poured into the banks from OPEC countries, and the men in their pinstripe suits got onto Pan Am and headed for darkest Africa, remotest Latin America, searching for sovereign nations that would take some of those billions off their hands—at at least a percentage point over the rate they were paying the Arabs, plus enormous front-end fees. They found them quickly enough. Peru took a couple of billion. Brazil took tens of billions. Zaire, Argentina, Costa Rica, Pakistan—the list never ended. Then, the bankers of Germany, fearing that their greedy American competitors were in the process of wrapping up the whole world, discovered Eastern Europe. Hell, if Brazil were good for $40 billion, Poland had to be good for at least $20 billion. And if Poland were good for $20 billion, then Romania and Hungary had to be good for half of that.

So it went between 1973 and 1977. By the end of that period, Western bank loans to L.D.C.s and Eastern Europe had gone from almost scratch to more than $250 billion. Then came the second oil "shock." The price of crude, which had seemingly stabilized in the ten-dollar range, suddenly zoomed to $20 a barrel, then $30, then $40. The OPEC surpluses quadrupled. And there was not an energy expert on earth who was not firmly, indisputably, irrevocably forecasting that $60 and then $80 and then $100 a barrel were inevitable, probably by as early as the mid-Eighties. Which meant that there would be money gushing out of the Arabian peninsula into the hands of the world's bankers ad infinitum. So they scrambled around the world ever faster, lining up takers willing to pledge their country—maybe for the tenth time—as collateral for yet another sovereign loan. Result: Between 1977 and 1980, the banks doubled their borrowings from the Arabs and also doubled their lendings to the L.D.C.s and Communist Europe—bringing the grand total to well over one half trillion dollars.

Then came a new wrinkle. Theretofore, the oil-producing L.D.C.s had been the suppliers of funds to the banks, and the non-oil-producing L.D.C.s had been the borrowers of the same funds from the same banks. Beginning in 1979, that changed. Nigeria, Mexico, Venezuela—oil-rich nations if there ever were such—suddenly decided that if the price of oil were inevitably headed toward $100 a barrel, then they might as well lie back and enjoy it. Emulate the Yankees' formula for success: Buy now, pay later.

So they embarked upon massive development programs financed 50-50 cash/debt—one half from their current oil income, the other half borrowing dollars from the banks of the developed world. Mexico borrowed $81 billion; Venezuela took $35.5 billion; Indonesia, $21.9 billion; the Philippines, $18 billion; Nigeria, $10 billion.

As a result, Mexico became the fastest-growing nation on earth. Venezuela was second. Everybody was happy, especially the bankers. What better borrowers could be found than sovereign states with the highest economic growth rates on earth and hundreds of billions of dollars' worth of oil in the ground?

And then came the oil glut.

Instead of soaring from $40 a barrel to $60 a barrel as everybody had said it would, the oil price went down to $35 and then $32. The projected oil income of the oil-producing L.D.C.s collapsed along with the price. The resulting problem was compounded by the fact that those countries had borrowed short term even though the development projects they were financing were, by definition, long term. Thus, in 1982, Mexico was committed to repay the banks of the developed world $29.2 billion in the form of either interest or short-term debt that had already come due. As a result of capital flight from the country, Mexico had lost all its gold and dollar reserves, and its oil income in 1982 was only $14 billion. So Mexico had no choice but to join the list of nations that had already gone into default in that critical year 1982, when the global financial house started to fall apart.

In the order of the magnitude of their de facto default, the countries in Chapter 11 were Mexico, Argentina, Poland, Romania, Peru, Vietnam, Costa Rica, Sudan, Zaire, Bolivia, Pakistan, Togo, Senegal, Honduras, Madagascar, Guyana, Malawi, Sierra Leone, Uganda, Liberia and the Central African Republic.

To give you an idea of how rapidly such a crisis developed, I should point out that as late as 1978, only two countries on earth—Peru and Turkey—were in default, and the grand amount involved was a paltry $2.3 billion. (continued on page 251)Living on the default line(continued from page 96)

The reasons each country has had to renege on its financial commitments are all somewhat different: Argentina because of a war, Poland because of its vast misguided overinvestment in heavy industry, Honduras because the coffee price went sour, Zaire because nobody in the government there has a clue as to how to run a country. But the result is the same in all cases: They no longer have sufficient dollar income and/or reserves to service their dollar debts.

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Are they ever going to be able to repay? If not, who or what is going to bail them out? If there is no bail-out, which banks in which countries are going to be in danger of going belly up?

Let's answer the last question first. The American banks that have lent the mostest to the weakest are the biggest: Citibank, Chase Manhattan, Continental Illinois, Bank of America, J. P. Morgan, Manufacturers Hanover, Chemical Bank, First Interstate, Security Pacific, Bankers Trust. Why? First, simply because they are the ten biggest banks in the United States. And because of their size, they were automatically on the list of the 50 largest banks in the world, those banks the Arabs considered eligible to receive almost unlimited amounts of petrodollar deposits. The vast supply of money put at those banks' disposal created its own pressure to create demand for equal amounts. That's why we saw the proliferation of sovereign loans on such an immense scale by so few banks. The other reason: greed. Every one of those banks today makes roughly half of its profits abroad. Ten years ago, not one did.

Now to the bail-out issue. What if things suddenly get worse? For instance, what if everybody in the developing world, plus most of Eastern Europe, decides to get on the default band wagon simultaneously, openly and defiantly; or, on a much less flamboyant level, what if some bank examiner somewhere, overcome by conscience, decides to declare those bad loans what they are—bad loans—thus forcing one of the big banks in New York or London or Frankfurt to the wall? Will Uncle Sam simply stand aside and let Citibank or Chase or Continental Illinois go broke? Will the Bank of England deliberately allow a Barclays or a National Westminster or a Lloyds to go belly up? Will the Bundesbank let the Deutsche Bank and the Dresdner Bank and the West-deutsche Landesbank Girozentrale go down the drain? Because all of those big international banks are also in the global top 50, all (except for the Japanese banks, naturally) have been doing the same things as Chase or Citibank, and so they are all similarly exposed.

The answer is: Of course not. The reason can be found in one shared memory, that of the Creditanstalt, the huge Austrian bank that was allowed to go broke in 1931, leading to a domino toppling of financial institutions around the world—including the closing in this country of 10,000 banks that would never reopen their doors. That event—not the famous New York stock-market crash of 1929—was the single financial happening that turned a recession that had begun in the fall of 1929 into the Great Depression that lasted until 1940. No government is going to allow that to happen again. In fact, no American Government is going to allow any other government to let it happen again.

How?

Well, first of all, by looking the other way as the commercial banks of the world throw good money after bad in order to preclude the de facto defaults on sovereign loans' turning into de jure defaults. If Poland can't pay interest on its old loans, the banks simply process a new loan so that it can. Ditto when the principal comes due. A lot of people, in describing this process, use the old joke about rearranging the deck chairs on the Titanic.

As a result, increasing numbers of investors in the U.S. have joined the "flight to quality" by moving their funds out of certificates of deposit with the large U.S. banks into treasury bills, notes and bonds of the U.S. Government. Abroad, this capital flight has taken the form of a renewed move into gold. The banks and the bankers pretend not to be worried. Walter Wriston, chairman of Citicorp, has suggested that the debts of the L.D.C.s and Eastern Europe should be considered more or less like the trillion-dollar national debt here in the U.S.—one that must be constantly "rolled over," since it will never be paid back. "There are few recorded instances in history," he wrote in the op-ed page of The New York Times, "of government—any government—actually getting out of debt." What Wriston did not point out was that while our Government can print any number of dollars it needs to service the national debt, since "we owe it to ourselves," the governments of Mexico or Argentina cannot. Unfortunately for them and for their international bankers, they owe dollars but can print only pesos.

So where will the dollars have to come from when the rescheduling process breaks down—as it inevitably must? We already know the answer: from the World Bank and the International Monetary Fund. The U.S. Government and the governments of Western Europe and Japan will have to increase the capital of those international lending institutions by tens of billions of dollars (the funds ultimately coming from the pockets of the developed world's taxpayers). Those institutions themselves will then be able to borrow additional tens of billions in the world's capital markets (contributing to high interest rates for the rest of us). And, as the various sovereign-loan-default crises arise, the huge sums thus accumulated will be lent to the treasuries and the central banks of the basket-case nations so that they can, in turn, pay back the money they owe Chase and Bank of America and Lloyds and the Dresdner Bank. By maintaining the solvency of the basket-case nations, we preclude a rerun of the Creditanstalt collapse and its aftermath.

The U.S. Government has already proposed a variation on that theme: the establishment of a special stand-by facility, a safety net with potential funding of somewhere between $10 billion and $25 billion that could be activated literally overnight if a real biggie—like Brazil, say—went to the wall. The probable outcome will be a mixture of both. But even that process has its limits. At some point, the parliaments and taxpayers of the world will finally refuse to continue footing the bill for the bail-out of the world's private banks.

The ominous default situation is by no means restricted to sovereign loans in the process of going from bad to worse. The same banks whose necks are stuck out a mile vis-à-vis countries around the world often have very serious problems at home as well. In the U.S., that point was underscored last summer by the collapse of Drysdale Securities, an obscure dealer in Government securities. When Drysdale suddenly went under, Chase Manhattan—which had been involved in the financing of Drysdale's inventory of securities—was just as suddenly out $117 million. Then came the collapse of an equally obscure financial institution in Oklahoma City, the Penn Square Bank. Not only did large depositors in that bank lose a couple of hundred million dollars but it turned out that Penn Square had "sold"—to such northern banks as Continental Illinois of Chicago and Seafirst Bank of Seattle—about two billion dollars in loans to oil-exploration companies, loans that, for the most part, will never be repaid. Lurking in the wings is International Harvester, a company that must repay the big banks $1.6 billion on December 15, 1983. At present, it's difficult to see how Harvester can possibly meet that payment. Its net worth is already down to $500 million and the company is still losing money like crazy every month. Or did you ever hear of a company called GHR? It's in the oil and gas business, and because of what's happened to the oil business as a result of the oil glut, it's also experiencing serious financial difficulties. This Good Hope, Louisiana, company owes Continental Illinois $165 million; it owes Chase $125 million; it even owes a French bank, the Banque du Paris et Pays-Bas, $245 million. How much of that those banks will get back remains to be seen.

Not that the U.S. situation is unique. Take Canada—staid, steady Canada. Its banks are in even greater trouble. The reason is that each of its top four banks has lent more than half of its capital and reserves to just one company—Dome Petroleum (something no U.S. bank could do, by the way, since by law, no amount greater than ten percent of its capital can be lent to one borrower. In Canada, there is no limit). Following the Canadianization policy of Prime Minister Pierre Trudeau where his country's energy industry was concerned, Dome Petroleum was encouraged to borrow billions in order to buy out foreign interests in a number of Canadian oil companies, especially Hudson's Bay Oil and Gas. It seemed like a sure thing because, after all, the oil price was going from $40 a barrel to $60 to $100. Remember? Well, wrong again. As a result of the oil glut, Dome Petroleum's income (like Mexico's) is way below what it expected; its debts (like Mexico's) are enormous, more than seven billion dollars. Consequently, Dome (like Mexico) has already been forced to renege on a payment of $1.35 billion (Canadian) due the banks at the end of last September, and it is a foregone conclusion in financial circles that the company will also fail to meet the repayment of another $2.41 billion due in June. The government and the four banks recently reached a rescue agreement that will give them 51 percent of Dome's common stock, but if this default becomes total, who will bail out the Canadian banks?

Had enough? Well, just one more country: Germany, supposedly the model for the rest of us because of its fiscal and monetary conservatism, its hard currency and its solid banks. No more. Teetering on the edge of bankruptcy is one of Germany's largest corporations, AEG-Telefunken, equivalent of our General Electric. It owes the big German banks 2.2 billion marks. The Wienerwald restaurant empire, Deutschland's closest counterpart to McDonald's (in terms of importance in the restaurant business of the country, not of the cuisine), is in equally bad shape—about a half billion. One of the country's biggest construction firms, Neue Heimat, is apparently also broke: It is into the banks for 1.2 billion marks. All that comes on top of Poland, where the German banks are far more exposed to potential massive defaults than any other group of banks. The result is that American banks are now yanking their money out of the German banks because they consider them unsafe!

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How will all this end?

There really is just one, and only one, "ultimate" solution: that which would be provided by a broadly based and sustained economic recovery throughout the Western world, starting in 1983. If the three locomotives of global economic growth—the U.S., West Germany and Japan—really get going again, they'll lift the whole world up with them in the future, just as they've done repeatedly in the past. Demand for, and the prices of, everything from copper to cocoa to sugar to oil will recover. So will demand for International Harvester's trucks and AEG-Telefunken's washing machines, perhaps bailing them out if it doesn't come too late. But most important of all, in the pull of such a recovery, the foreign-trade income of all the debtor nations will revive, and they will once again have sufficient dollars to service their external debts. At least for a while.

If, however, the 1983 economic recovery fizzles—especially if it fizzles soon—those teetering corporations and those destitute debtor nations will have no chance. The banks will have to foreclose at home. And abroad, the World Bank and the I.M.F. will soon run out of financial Band-Aids. The temporary cash-flow problems of the Third World and Eastern Europe will then be recognized for what they really are: deep-seated structural problems so great they are unsolvable in our generation.

The world would then face a default situation dwarfing that which began in 1931. If that realization should suddenly spread, the world's banks—literally all of them—could become suspect overnight. Everybody would try to get his money out at the same time. It could all happen so fast that before the governments of the world could respond by "reliquefying" the banks with "new" money, the worst would have already occurred. My guess is that we'll know the answer to all that no later than 1985.

To be sure, there's no doubt a great temptation to view this situation with a good amount of gloating. After all, when were money-changers ever the most beloved among us? My suggestion, however, is that you be nice to your banker. Sympathize with him. Buy him a drink now and then. Be supportive. Because—let's face it—if he goes, we all go.