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The first two case studies (Conglomerate and REITs bubbles) are examples of the use of equity leverage – see last week’s newsletters). The international banking crisis, on the other hand, was caused by debt leverage. This case study is particularly useful today because we currently have the sight of massive fiscal and monetary stimuli creating an atmosphere of economic confidence. This will lead to increasing confidence among bankers to lend, egged on my central bankers and governments. This bank lending is likely to affect the fundamentals (business and household collateral, economic growth, etc.) in a reflexive (two-way feedback) manner (mostly domestically rather than across borders this time). We need to recognise the point in the bubble/deflation sequence we are at any one time and take either advantage or evasive action.
The story starts with the oil shock of 1973, following which the main international banks experienced large inflows of deposits from oil producing countries. They lent this money to oil-importing countries – petrodollar recycling. In judging the size of loan to grant (and interest rate to charge) lenders estimate the borrower’s ability to pay.
Many people view the valuation of collateral as independent of the act of lending. This may be a false assumption in many cases – it is possible that the act of lending increases the collateral value.
The sovereign borrowers did not always pledge collateral in the normal sense, e.g. a charge over property, so the international banks had to take a broader view of ‘collateral’. They relied on debt ratios to judge creditworthiness. Typical ratios included:
- external debt as a percentage of exports
- debt service as a percentage of exports
- current deficits as a percentage of exports
The act of lending permitted these countries to maintain these ratios at high levels because widespread low interest rates and voluminous lending stimulated the world economy and the developing countries enjoyed strong demand for the commodities they exported.
Thus the collateral ratios and the lending were reflexive. This reflexive interaction led Soros to postulate that there would be a slowly accelerating credit expansion followed by credit contraction.
East European countries borrowed, expecting to repay from the products produced by the factories built with the money, South American countries expected to repay their loans from the export of commodities.
For the first few years international lending was very profitable and banks took an eager and accommodating attitude, asking few questions of borrowers. Often the banks did not know how much a borrowing country had borrowed from other banks before they lent to it (modern examples of this lax attitude: Credit Suisse lending to Greensill entities and Archegos which borrowed from many banks).
Soros noted that there are large personal incentives for bankers to participate in bubbles even if they suspected that a bubble was being blown up. If the banker refuses to lend in what seems like profitable business (at
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