Thursday, September 25, 2008

What can we learn from the Mexican debt crisis?

We can use the Mexican debt crisis as an example of what can go wrong with a bank bail-out. The Mexican economy needed to be bailed-out by the US Treasury in December 1994 after the serious devaluation and run on international reserves. The fall-out from the currency crisis was significant. The economy plunged into recession. Banks needed to be recapitalized by the the government.

The Mexican government set-up a special agency to buy loans at book value from the banks to save them form going under. The impact was severe. The banking sector consolidated. and taken over in many cases by foreign institutions. The loans from the banks held by the government were only paid out eventually as cents on the dollar. There still are bonds outstanding from this bank bail-out.

The law of unintended consequences made matters worse. Banks did not need to lend given they could hold safe Mexican treasury bonds. There was a strong crowding out effect, and more importantly there began a cultural epidemic of not paying your debt by consumers. The government when holding the paper was the lender to consumers. The consumer was not afraid of the government foreclosing on their loans. Why pay?

This bail-out is not going to last one year or two years but be measured in something like 5 to 10-years like the RTC. These mortgages especially if payments are adjusted down will have weighted average lives closer to 10-years. Get ready for a long process.


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