The American banking system might not last until Monday

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  • The American banking system might not last until Monday

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  • In time, a financial crisis does pass. Life goes on. Memories fade. The next crisis arrives as a surprise.

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  • How good is the human group mind at financial memory? Pretty bad.

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Learning from the crises you’ve forgotten.

How good is the human group mind at financial memory? Pretty bad.

For example, consider this really striking bit of history: “The then Federal Reserve Chairman made a phone call to the Bank of Japan Governor on that critical Friday night (Saturday in Japan) in August of that year.” The chairman’s “first words were that the American banking system might not last until Monday. The crisis was that serious.”

Financial history quiz: Which year was that? What was the crisis? Who was the Federal Reserve chairman making such an extreme statement?

Hint: our most recent financial crisis, which started in August 2007 (already seven years ago this month) is not the crisis in question.

The right answers are: 1982. The global sovereign debt crisis, also known as the “LDC (less-developed country) debt crisis.” The Fed chairman was Paul Volcker. How did you do?

The Volcker quotation is from Richard Koo’s interesting 2003 book, Balance Sheet Recession (I left the names out of the quote so as not to give away the answer). Koo, who was the head of the International Financial Market Section of the New York Federal Reserve Bank at the time, recalls how “hundreds of American banks, including all the big banks,” along with banks in Japan, Canada, and Europe, had been on a lending spree to the governments of less developed, or as we would now say, emerging, countries. The Fed at the time estimated that as many as a thousand U.S. banks had loans to Mexico alone.

This disastrous lending spree had been widely and highly praised as "recycling petro dollars," displaying the typical inability to see the financial future. By May 1982, the Fed was already making special inter-central bank loans to Mexico on financial reporting dates.  This “gave the appearance of adequate currency reserves at the Bank of Mexico,” according to Allan Meltzer in his definitive A History of the Federal Reserve. But, in August 1982, with the default of Mexico, it became obvious that the indebted governments could not pay their debts, and therefore, Koo writes, the “big U.S. banks were all virtually bankrupt.”

At the very same time, the until then dominant home mortgage source, the savings and loan industry, was in the aggregate also bankrupt. Quite a combination!

But there was more: also at that time, two big bubbles were deflating: the oil bubble and the farmland bubble. So not only were the S&Ls on their way to their ultimate $150 billion taxpayer bailout, but nine out of the nine biggest banks in Texas failed in the 1980s, along with a great many others, and so did the Federal Farm Credit System, a government-sponsored enterprise, which ended up with its own congressional bailout. As Chairman Volcker made his call to the Bank of Japan, a most painful decade for the banking system was under way.

Here is another financial history quiz: How many U.S. commercial banks, not counting savings and loans and other thrift institutions, failed or had to get government assistance in that eventful decade of financial unraveling from 1982 to 1992? Before you read the answer, what’s your number?

The right answer is: 1,476 commercial banks failed. That is an average of over 130 per year, continued over 11 years. That is in addition to 1,332 thrifts, for a total of 2,808 American busted depository institutions in the decade. If you guessed wrong, you are in the majority: only two decades later, hardly anyone knows this.

With this time of immense and intense troubles looming, what did Chairman Volcker do to confront the massive amount of bad loans the banks had made to the governments of LDCs and the corresponding, by then unavoidable, losses? Face the facts and take the write-downs? Mark the loans to market? Try to reduce the credit exposure to these insolvent borrowers? Have a stress test?

What do you think he did?

The correct answer is: None of the above. Indeed, he did just the opposite. As Koo relates, “On the day the crisis erupted, we received a personal instruction from Paul Volcker. His instruction stunned us. It basically said, ‘Whatever it takes, make sure that U.S. banks stay on in Latin America and keep lending. Don’t give the banks excuses to flee.’” In other words, let’s send some good money after the bad.

With this surprising instruction, Koo continues, “We had to call on each of hundreds of banks in the United States, asking them not only not to recover funds from Latin America but also to continue lending.” His job at the time, he relates, “was to produce a list of all the U.S. banks with an exposure of more than $1 million to Mexico. That list was then given to the district Federal Reserve Banks so that the officers could contact these banks and try to persuade them to keep lending.” He was “privately outraged,” says Koo, but he was not the boss of the Fed or of the “convoy of hundreds of banks” being commanded by Fleet Admiral Volcker.

How about telling the truth of what was happening with accounting and financial reporting? Well: “Volcker had ordered the three bank supervising authorities in the United States not to treat those loans as non-performing loans” — in spite of the obvious fact that they were non-performing loans. “If they had declared them to be non-performing loans” — if they had stated the truth, in other words — “the banks would have had an excuse to flee.” Recognition of the billions in credit losses was pushed off for several years.

In 1989, the “Brady Bonds,” creatively designed under the direction of then secretary of the Treasury Nicholas Brady, were introduced to refinance the old bad loans: in accepting the new bonds in exchange for the old loans, banks typically recognized losses of 30 cents to 50 cents on the dollar. Writing in the same year, economist John Makin estimated the average market value of LDC loans as 35 cents on the dollar. This is a number not very different from the recovery on defaulted subprime loans a generation later.

But before that, “the financial authorities in the United States streamrollered through, declaring that loans to Latin American were not non-performing loans and forcing the banks to continue to lend.” This history, so interestingly related from personal experience by Koo, displays a distinctly bold strategy and a very high-stakes gamble by the forceful Chairman Volcker. He got away with it, while the hapless regulator of the savings and loans, the Federal Home Loan Bank Board, also made big gambles, but lost them, and finally was abolished by Congress in 1989. (Do you remember that there was a Federal Home Loan Bank Board?)

By the late 1980s, when the LDC losses were finally being recognized (on a mark-to-market basis, which was pointedly not used, they had existed for years), it appeared that the commercial banks were once again profitable and could absorb the losses.

One more financial history quiz: what was the big new banking growth business of the 1980s, which was generating a lot of apparent renewed banking profitability?

The correct answer is: commercial real estate loans. This market in turn went bust in 1990-91, causing huge losses and a renewed bout of bank failures. Real estate loans had succeeded LDC loans as the biggest banking problem. Only a couple of years after that, and only 12 years after 1982, Mexico was in trouble again, with the Mexican Debt Crisis of 1994.

What can we learn from these largely forgotten but very instructive events, as we give a vote of thanks to Richard Koo for his vivid reminder of them? When faced by a banking system that might not last until Monday, powerful central bankers and governments will do whatever they think they need to. This can include cooking the books, ordering around private parties as governments turn to coercion, and sending good money after bad, all in the hope of bridging the crisis. In time, the crisis does pass and losses are taken. Life goes on. Memories fade.

The next crisis arrives as a surprise.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

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