Bureaucratic Folly Costs Dearly

The ongoing bank rescue in Mexico has exposed both the economic and political ills of the country. Much more important, it has shown the extremely burdensome and costly nature of the nation’s legal system and extensive government powers.

The banking scandal turns around a trust fund called Fobaproa, set up by the banks in order to cover potential losses by any one of them, much like the Federal Deposit Insurance Corp. operates in the U.S. Those funds are typically intended to cover an exceptional banking failure, like an insurance policy. Unfortunately, the devaluation of the peso in 1994 precipitated the failure of virtually all of the banks, involving tens of billions of dollars of losses, a circumstance for which Fobaproa was never intended. Altogether, the Mexican government has asked the Congress to approve legislation authorizing an increase of U.S. $65 billion in the country’s public debt, about 14% of Mexico’s gross domestic product.

The failure of a bank is not a frequent circumstance, but it is not an exceptional one either. What makes the current Mexican drama a particularly complex one is the mix of politicians and parties smelling blood on the one hand, and the poor management of the banks’ rescue on the other. Politics and confusion make explosive bedmates.

The banking drama started two decades ago. During the 1970s, President Luis Echeverria increased public spending to such an extent that he not only destroyed the fiscal balance that had characterized the government’s accounts since the late 1940s, but also drained the banks’ lending funds. Banks were compelled to lend most of their resources to the government. Economic policy was politicized beyond recognition. Inflation soared as did the country’s domestic and foreign debt. By 1982, President Jose Lopez Portillo decided to expropriate the banks in a final attempt to blame someone else for his administration’s failures.

For two decades, the banks lived under government control, first as subordinate institutions, later as direct property. Good and experienced bankers quit their previous jobs; bank supervisors did not grow and develop. By the time the banks were privatized again in the early 1990s, there were virtually no bank supervisors and regulators or experienced bankers. Even the smartest privatization would have been difficult.

But the Mexican government did not have a straightforward agenda when it decided to privatize the banks. Rather than merely auctioning the banks, the bureaucracy sought to maximize their price by altering regulations, preventing competition by foreign banks and accepting leveraged acquisitions. Against standard banking practice, the government not only accepted buyers using borrowed funds rather than cash but went as far as to have its own state banks provide those credits to their preferred customers. In short, the price of the banks was inflated as the financial system as a whole was drained of capital.

The situation of most banks was shaky from the outset. The new bankers had paid such ridiculously high amounts of money for their new entities (an average of more than four times book value) that they needed to increase lending right away. Bad loans increased dramatically. The whole thing exploded with the devaluation of the peso at the end of 1994, which increased interest rates tenfold overnight (from about 18% to more than 170%). Monthly payments on the average loan increased by more than 500%. Very few people or companies remained solvent at those rates.

Rather than rapidly capitalizing the banks and subsidizing the debtors in order to keep the banking system afloat, the government underestimated the problem and had no stomach to dilute holdings of the banks’ shareholders, to which government officials felt committed. The regulators ended up buying the bad loans from the banks. In most cases, once a loan was transferred to Fobaproa, it ceased to be managed by the bank, so nobody had an interest in recovering the loan. On top of that, most loans were now worth much more than the houses or businesses for which they had been contracted. Needless to say, most people ceased to pay their mortgages and loans. The judiciary proved ineffective to prosecute even outright fraud. So far, there has been no penalty for not paying. In fact, the only people who have paid any penalty have been those who were never late in any of their monthly payments. It is difficult to imagine a worse set of incentives.

Though there was some corruption along the way, the bulk of the Fobaproa problem is one of an accumulation of mistakes, cover-ups of those mistakes and endless opportunities to avoid responsibility by the bankers; the regulators, who were charged with the impossible task of having to save the banks and supervising them at the same time; and above all by greedy business people who had their loans transferred to Fobaproa--that is, to the taxpayers.

The two large political opposition parties, the National Action Party (PAN) and the Democratic Revolution Party (PRD), have been exploiting the government’s failures to the utmost. PAN recognizes the need to approve the government’s debt-increase bill but does not want to pay a hefty political price for so doing. PRD has stolen the legislative agenda from the other parties and is doing everything it can to enhance the political cost of the whole deal. At this point it appears that the bill will eventually be approved, but only after the government and some big fish among the bankers and large debtors have been found guilty in the court of public opinion.

Extensive--and excessive--discretionary powers in the hands of bureaucrats with their own agendas and a totally ineffective judiciary made this big failure possible. Interestingly enough, even today, after this costly fiasco, nobody in the government is thinking about developing a modern, competitive and, above all, sound banking system.