Thursday, January 8, 2009

Lending to the borrower from hell

As usual, there were quite a few good papers (and some bad ones) at the ASSA meetings in San Francisco. Over the next days, I will write about some of them. Note that if you presented a paper and do not have some version up on the web, I will not write about it.

People puzzle these days why banks could have been so stupid to lend so much to risky borrowers. This is not the first time this happens, witness how Argentina could quickly borrow again after each of its numerous defaults. But the risk taking by banks seems much larger than previous seen. Not so. Mauricio Drelichman and Hans-Joachim Voth report on the proverbial borrower from hell, Phillip II of Spain, who accumulated debt up to 50% of his country's GDP and defaulted several times. Why was he still getting loans?

The obvious answer is that he is the king and can offer non-monetary rewards to lenders, such as not getting killed. Or that bankers were irrational, or that the king effectively used his monopoly situation to play the bankers against each other. Not so claim Drelichman and Voth after looking carefully at a large number of lending contracts. In particular, the bankers appear to have formed a very effective coalition through joint lending, cross-posting of collateral and inter-marriage. Whenever the king stopped to pay, he was unable to get any additional funds, as no bank was willing to break ranks. And this had a severe impact on the king as he typically faced large revenue and expense shocks. So he eventually had to settle with the banks, the latter essentially dictating the conditions.

Does this relate to the current situation? Not really, as the Spanish case illustrates a bilateral monopoly game with a weak player (the king). Today, we have a very competitive environment, where banks have been trying to undercut each other and may have overstretched themselves. But one lesson I learned from this paper is that aggregate data may be quite misleading, there is virtue in looking at the detail, the lending contracts in this case.


Vilfredo said...

Welcome back EL, I was afraid you had abandoned the blog.

JV said...

One should perhaps note that Mark Wright, UCLA, makes quite a few good points about how market structure - and the power or otherwise of lenders - relates to sovereign debt today....