Not Even Our Worst Banking Crisis Of The Last 30 Years (The effect of mark-to-market)

Lost in the shuffle of the current banking mess was an easy comparison for our politicians to refer to, the wholesale defaults in the 1980’s of the emerging market bank debt, held by America’s largest banks, by many of the Latin American countries. For those that remember that period it was every bit as serious as today, if not more so.

What separated that time frame from today is that these loans were not held to the same standard of mark-to-market as we have today. But rest assured, the size of the crisis was just as large back then as it is today.

For those that have not read about that period, I suggest Adam Smith’s book about the time, entitled ‘Paper Money’ (not the Adam Smith of Wealth of Nations fame, but the Adam Smith who used to host the PBS show ‘Adam Smith’s Money Show).

After the second oil embargo started around 1979, OPEC nations started piling up enormous amounts of windfall profits, well beyond what they could use internally to grow their economies. On the other hand, you had many smaller and larger countries that had to import that oil, but lacked the resources to be able to pay cash. Among those countries, as amazing as it seems in today’s markets, included Mexico, Argentina and Brazil. Neither Mexico nor Brazil had found and developed their oil reserves to any great level at that time, so they were net importers, not exporters.

In order to help the world get over this oil shock, the major US banks at the time, which included names such as Citibank, Chase Bank, JP Morgan, Chemical Bank, Manufacturers Hanover, etc., decided to act as intermediary between the OPEC countries (the original Sovereign Wealth funds) and the emerging countries. They took in the ‘petro dollars’, as they were called then, and lent them out to the emerging countries. This worked fine as long as the countries could grow their economies faster than the debt servicing costs grew. However, as with all similar approaches, economic reality hit and the banks were stuck with non-performing loans that had no secondary market to them (just like today with the inability to properly dispose of toxic debt.

I was reminded about this by an article on Free Republic yesterday, written by an economist who served under the Reagan Administration when this occurred. He pointed out that if the mark-to-market rules that were in effect then had been OUR CURRENT RULES today, EACH of the TOP TEN BANKS in America WOULD BE BROKE. At least today, we have some banks that were healthy enough to absorb some of the risk of today’s holdings.

What also was different back then is that the media and the administration didn’t run around yelling the ‘sky is falling’. They went about coming up with a similar bailout of the financial institutions, but they did it with a free-market solution that the federal government provided the guarantee as a backstop. This approach was called the Brady Plan:

From EMTA.Org: The Brady Plan, the principles of which were first articulated by U.S. Treasury Secretary Nicholas F. Brady in March 1989, was designed to address the so-called LDC debt crisis of the 1980's. The debt crisis began in 1982, when a number of countries, primarily in Latin America, confronted by high interest rates and low commodities prices, admitted their inability to service hundreds of billions of dollars of their commercial bank loans. Because many of these countries' economies were then dependent on commercial bank financing, continued debt reschedulings and the resulting perception of uncreditworthiness led to a "lost decade" of economic stagnation, during which voluntary international credit and capital flows to these nations and their private sectors were severely interrupted. From 1982 through 1988, debtor nations and their commercial bank creditors engaged in repeated rounds of rescheduling and restructuring sovereign and private sector debt, in the belief that the difficulty these nations experienced in meeting their debt obligations was a temporary liquidity problem that would end as the debtor nations' economies rebounded. However, by the time the Brady Plan was announced, it was widely believed that most debtor nations were no closer to financial health than they had been in 1982, that many loans would never be entirely repaid, and that some form of substantial debt relief was necessary for these nations and their fragile economies to resume growth and to regain access to the global capital markets. The basic tenets of the Brady Plan were relatively simple and were derived from common practices in domestic U.S. corporate work-out transactions: (1) bank creditors would grant debt relief in exchange for greater assurance of collectability in the form of principal and interest collateral; (2) debt relief needed to be linked to some assurance of economic reform and (3) the resulting debt should be more highly tradable, to allow creditors to diversify risk more widely throughout the financial and investment community. Because the rescheduling process evolved on a case-by-case basis, each Brady issue was unique, but most Brady restructurings included at least two basic options for debt holders: the exchange of loans for either Par Bonds or Discount Bonds. Par Bonds resulted from an exchange of loans for bonds of equal face amount, with a fixed, below-market rate of interest, allowing for long-term debt service reduction by means of concessionary interest terms. Discount Bonds resulted from an exchange of loans for a lesser amount of face value in bonds (generally a 30-50% discount), allowing for immediate debt reduction, with a market-based floating rate of interest. The principal of both Par and Discount Bonds was secured at final maturity by a pledge of zero-coupon instruments which, in the case of Par and Discount Bonds denominated in U.S. dollars, were U.S. Treasury securities. A portion of the interest payable on Par and Discount Bonds (generally from 12 to 24 months coverage) was also secured by the pledge of high-grade investment securities. While both Par and Discount Bonds were 30-year collateralized bonds, a number of nations also issued uncollateralized bonds with shorter tenors (e.g., "Floating Rate Bonds" and "Front Loaded Interest Reduction Bonds"). Some nations also issued bonds in exchange for unpaid interest on defaulted loans (e.g., "Past Due Interest Bonds" or "Interest Arrears Bonds"). Each Brady country negotiated the specific terms and details of its Brady restructuring during discussions with its commercial bank creditors, who were offered a resulting 'Menu of Options' for their exchange of eligible debt. Mexico, the first nation to begin negotiating with its commercial bank creditors (August 1982), was also the first nation to restructure under the Brady Plan (1989-90). In addition to Mexico, Brady bonds were issued (in an aggregate face amount of over US$ 160 billion) by Argentina, Brazil, Bulgaria, Costa Rica, the Dominican Republic, Ecuador, Ivory Coast (Cote d'Ivoire), Jordan, Nigeria, Panama, Peru, the Philippines, Poland, Russia, Uruguay, Venezuela and Vietnam. The large issue size of many Brady bond issuances helped to provide the Brady bond market with substantially greater liquidity than is found in many other financial marketplaces. The Brady Plan was very successful in several important respects. First, it allowed the participating countries to negotiate substantial reductions in their overall levels of debt and debt service. Second, it succeeded in diversifying sovereign risk away from commercial bank portfolios more widely throughout the financial and investment communities. Third, it encouraged many Emerging Markets countries to adopt and pursue ambitious economic reform programs. Finally, the Brady Plan has enabled many Emerging Market countries to regain access to the international capital markets for their financing needs. This is not to say, of course, that the Brady Plan succeeded in solving all economic problems throughout the Emerging Markets. The road to greater economic development and democratization has been a bumpy one for some countries. But the Brady Plan did facilitate a return from the rescheduling mode of the LDC debt crisis to a more normalized, market-oriented relationship between Emerging Markets countries and their creditors. With these successes and the subsequent re-access to international capital markets by Emerging Markets countries, the dominance of Brady bonds in the Emerging Markets debt markets was gradually eroded, as they were essentially replaced by a wide variety of even more market-friendly instruments. By mid-2006, most Brady debt had been exchanged or bought back by debtor nations in public or private secondary market transactions. While Brady bond trading accounted for 61% of total Emerging Markets debt trading in 1994 (U.S. $1.68 trillion), EMTA's Debt Trading Volume Survey showed that Brady bond market share had declined to approximately 2% of total trading by 2005.

The effect of mark-to-market, if put in place back then, would have been just as devastating back then as it is now.

What was interesting about the comparison is that it too was based on an attempt to socially engineer a public good, although on a global scale, not a US-based one. The bankers kept re-negotiating terms until they could no longer avoid reality.

There are lessons in the Brady Plan that can be applied today. One is that, as painful as the bailout is to our sense of free markets, sometimes as Americans we know that pragmatism needs to win out over ideology. Another is that private market solutions to work these problems out can work, but most likely need the ‘imprimatur’ of a government guarantee behind them for markets to give the workout a chance to work (which is why some form of the Republican alternative is worth exploring). It is too bad that Hank Paulson didn’t bother to have read the details of the Brady Plan before he came up with his first proposal. By trying to put together a Bi-partisan political coalition before he had spent a few days researching this relatively recent solution, he put the ‘solution train’ on the wrong track, by allowing the same people who oversaw the disintegration of Fannie and Freddie to be given far more input at the beginning than they warranted.

If the leadership of this country resides in the hands of Nancy Pelosi, Harry Reid and Barack Obama in the future, then we might look back at this time as the period Hank Paulson panicked the country into voting that way.

The thesis of this article is that we have a perfectly reasonable model to work with to get ourselves out of this mess.

The Brady Plan did work.

The debt ratio to assets of this country are much healthier than almost all the other countries of the world.

I am astonished you could make such a statement. A Balance Sheet has three components, not one. To reference debt in a vacuum without showing assets and net worth is ignorance.

We also have over $200 Trillion in Capitalized Assets - ($50 Trillion in homes alone). That gives us shareholder's equity of over $140 Trillion or almost $500k per capita.

The main issue here has been the mark to market nonsense. If there is no current market for an asset due to any number of reasons in including fear, panic, lack of information, seasonality etc, it is ridiculous to force any institution to value that asset on the current days bid. This rule needs to be revisited and altered significantly. This seems to be getting the least amount of attention of all the issues we are facing.

You are a clueless idiot.

First the most important things on a balance sheet are income and outgo. Whimpy cannot trade his suit to repay his hamburger debt.

Second, the problem with estimating our assets is that you cannot liquidate the assets of the US to pay $62T. Third, the $62T needs to be compared to GDP which is about $13T. Reasonable principal and interest on $62 T would be about $6.2 T per annum (sort of like a mortgage). That is almost half of GDP. Fortunately a lot of that is just transfer payments from working people through WS and back to themselves in their 401K, pension funds, etc. But a significant fraction of that $6.2T is one group living off of the work done by the rest of us.

You are a clueless idiot.

First the most important things on a balance sheet are income and outgo.

That is an Income Statement, not a Balance Sheet. Who’s the clueless idiot now?

I don’t know much about economics but for many years I have thought that many people living well beyond their means would be the downfall of our great country. We will not be able to spend our way out of this one and I fear this bailout is throwing good money after bad. Somehow though we must not let our banks fail. How to do it? Or do we simply have to go bust, pick up the pieces and start over. As much as I hate to say it
I believe this is what is going to happen. It could get ugly. Especially with obama and a democratic congress.

You are a clueless idiot.

First the most important things on a balance sheet are income and outgo.

Pot, meet kettle.

There is no Income account on a balance sheet, nor is there an "outgo" account on a balance sheet. A balance sheet only reflects the current BALANCE (hence the name) of the various accounts on it as of a given point in time. Furthermore, the two sides of the balance sheet must be in BALANCE (again hence the name). The two sides of the balance sheet are the Assets on one side and Liabilities and Equity on the other side.

The financial statement(s) that have items most closely resembling the "most important things on a balance sheet" that you cited are the Income statement (revenue and expenses) or the Statement of Cash Flows (Sources of cash and Uses of cash), but even those statements do not have an account called "income" or "outgo".

You are an idiot if you want to run a semantic argument with any one of the 75% of Americans oposing this bailout about what you call what normal folks have to do every day. Whatever you accountants want to call it, every responsible household ensures that its income exceeds its out go, biweekly, monthly, quarterly and annual income exceeds expenses, cash on hand is trending up rather than down. Every healthy operating organization does the same. Sure, you can take a time out when you are building a new capability that is not yet operating, but once it is up and operating, the VP incharge gets fired pretty quickly if cash coming in does not start exceeding cash going out (including principal and interest payments pretty quickly).

You see, where you are wrongheaded is that you are just like the political idiots who got us into this mess, and a lot of other overleveraged idiots who collectively got the country into this mess. You are trying to justify borrowing against assets, not for capital investments, but to pay current acounts.

History shows it is a disaster every time. Adam Smith already covered the issue in great detail

Yes, you may be an accounting sophisticate, but you are an economic idiot.

We also have over $200 Trillion in Capitalized Assets - ($50 Trillion in homes alone). That gives us shareholder's equity of over $140 Trillion or almost $500k per capita.

All based upon self-referential pricing inflated by the leverage used to run up the valuation of these assets.

For instance, I a house, which today is valued at 3 times what I paid for it in 1999. But that is as a result of Greenspan/Bernankes post 2001 housing bubble. That bubble is bursting. My house is not actually worth 3 times what I paid for it based either upon normal cost of labor and materials to replace it, or based upon what mortgage can be supported by average incomes in my neighborhood.

Or, look at it from the standpoint of cost of maintenance. Say you allowed 5% cost of maintenance / operations on the so-called $200T of assets, which is a pretty low annual cost, actually. that would be $10T per year which is 80% of GDP. Now, we may think we have $200T in assets on the books. The notiong that we have $200T in productive assets is absurd.

The reason why you and this VRW idiot smug hypersophistated permatouts were so wrong about this mess a year ago is that you guys completely overlooked very basic economics fundamentals. VRW idiot claims to be an economics professor, so I am sure he is completely familiar with the writings of Adam Smith, who has a wonderful section in his book, 200 years ago on the dangers of financing current expenditures by borrowing against assets. Of course Adam Smith didn’t know about default swaps.

You are an idiot if you want to run a semantic argument with any one of the 75% of Americans oposing this bailout

And you are even more ignorant than I thought if you think that I, or the author of the article, or the FReeper who posted it want to argue with the 75% of Americans opposing this bailout. The point of the article and the point raised by the other poster is that there is a workable plan that was used 30 years ago that was not even considered instead of this bailout plan. I might have been giving you too much credit when I mistook you for Senator Biden.

From the article:

There are lessons in the Brady Plan that can be applied today. One is that, as painful as the bailout is to our sense of free markets, sometimes as Americans we know that pragmatism needs to win out over ideology. Another is that private market solutions to work these problems out can work, but most likely need the ‘imprimatur’ of a government guarantee behind them for markets to give the workout a chance to work (which is why some form of the Republican alternative is worth exploring). It is too bad that Hank Paulson didn’t bother to have read the details of the Brady Plan before he came up with his first proposal. By trying to put together a Bi-partisan political coalition before he had spent a few days researching this relatively recent solution, he put the ‘solution train’ on the wrong track, by allowing the same people who oversaw the disintegration of Fannie and Freddie to be given far more input at the beginning than they warranted.
If the leadership of this country resides in the hands of Nancy Pelosi, Harry Reid and Barack Obama in the future, then we might look back at this time as the period Hank Paulson panicked the country into voting that way.

Now granted, this was at the end of a pretty long article, and there weren't any pictures so you might not have read this far, but it should be pretty clear that the point of the article is that this crisis is NOT as bad as is being hyped by political leaders and the media, and if a government intervention is needed it would be best if it were at least based on a model that has worked before.

I will agree that the solution then is one that should be looked at here, instead of just borrowing $700B to get us out of the debt problems we already have. I think, however, that that the problem we have is of a proportion not see recently.

The kind of debt / income ratio we are sustaining now is similar to that post WWII. But then, we were coming off of a war, and bringing idled or misallocated capital, raw material and labor resources (because they were making things that were meant to be blown up had no long term value to the economy) back to the a productive economy. This time, however, we have run up this debt in a civilian post Cold War context, and don't have new additonal resources that will come on line to pay down the debt.

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