David Mulford, chairman of CSFB International; Jacob Frenkel, chairman of Merrill Lynch International; E Gerald Corrigan, managing director of Goldman Sachs; Ernest Stern, managing director of JPMorgan Chase; Bill Rhodes, vice-chairman of Citigroup – put together they have around 125 years’ experience in emerging markets.
They have been close to power – rarely quite in it – for 25 years each, as central bankers, World Bank or IMF economists, under-secretaries of the US Treasury and heads of Federal Reserve banks. And now they are putting their experience to use in the private sector as roving ambassadors for the world’s biggest investment banks.
If a developing country’s economy looks as if it is coming unstuck, there is a very good chance the country’s finance minister will soon be sitting in a room with these people, trying to work out a deal. If you see one of this exclusive club talking to a finance minister at a World Economic Forum meeting in Davos, an IMF session or the Trilateral Commission, it’s a good bet that the minister is considering doing a debt swap or launching a new wave of privatizations or a new currency regime. And when they do, one of the club will be by their side, just out of the frame in the photos in the papers, advising the government and winning the fees for his bank.
Bankers such as Rhodes or Mulford grew up with emerging markets. It is not an exaggeration to say that they helped to define them as an asset class. They epitomize the skill of networking, of moving effortlessly from one high-powered meeting to another – from Davos to the IMF to the IIF emerging-market committee to the Council for Foreign Relations to finance ministries the world over. As Stern says: “We know a lot of people, we travel a good deal, we exchange views on current issues on an informal basis with government officials and private individuals in the course of our visits.”
One of the first people to recognize the existence of this club was Jagdish Bhagwati, professor of economics at Columbia University and a senior fellow at the Council for Foreign Relations. Bhagwati spoke in 1998 of the existence of a “power elite” in international finance. He said: “There is a definite network of like-minded luminaries among the powerful institutions – Wall Street, the Treasury Department, the State Department, the IMF and the World Bank.” Bhagwati called this phenomenon, which probably reached its height during the days when Larry Summers was US Treasury secretary, the “Wall Street-Treasury complex”. He cited Ernest Stern as an example of a club member. Equally applicable for membership are Stanley Fischer of Citigroup, Sir David Walker of Morgan Stanley, and even – at a stretch – former US secretary of state Henry Kissinger, adviser to Goldman Sachs.
Members of this elite club are well positioned to sort out emerging-market crises because they know all the important figures in governments and banks and can get them into a room and try to engineer some kind of consensus. It is a world of contact capitalism, where power is exercised informally, and often effectively.
The perfect example of the effectiveness of contact capitalism was the resolution of South Korea’s December 1997 loan crisis. South Korea was close to default and immediate action was needed. Representatives of most of the major investment banks were called into meetings with government officials and, thanks to the contacts and negotiation skills of such people as Bill Rhodes, a deal was hammered out and disaster was averted. As one banker said at the time: “Getting an agreement in that short space of time was a miracle. And Bill Rhodes is the chief reason it happened.”
So why didn’t the same thing happen in Argentina?
In part, it didn’t work because emerging-market finance had fundamentally changed. At the beginning of the 1990s, most sovereign finance in emerging markets was in the form of loans. Loans lend themselves to an informal, slightly opaque method of working. They require tactful negotiators such as Rhodes. But the Brady debt plan of George Bush senior’s government, which David Mulford helped to propagate when he was Bush’s under-secretary of the Treasury, converted many of these loans into bonds. By the end of the 1990s, most emerging-market finance was in bonds. Bond crises, because of the large number and diversity of investors, cannot so easily be sorted out in a few private meetings. The bond market is far less relationship-driven than the loan market.
A deal too far
Argentina’s finance minister, Domingo Cavallo, nonetheless tried the old method of hammering out a deal with a roomful of top bankers. Cavallo, a jet-setting graduate of Harvard Business School, relied heavily on the advice of a few banker confidants, particularly Mulford, but also Stern, Frenkel, Rhodes and others.
Within half an hour of returning to office as economy minister in April 2001, Cavallo and his friend Mulford had sketched out the preliminary details of what turned out to be the biggest debt swap ever. Half an hour later, the lead managers for the deal were informed.
The speed with which the deal was drawn up was stunning evidence of the power of contact capitalism to get things done. In June, a month after Cavallo had returned to office, six investment banks launched the mega-swap of $29.5 billion in bonds, securing a few months’ grace for Argentina and enormous fees for themselves.
Seven months later and Argentina had defaulted, its banks had closed and both Cavallo and president Fernando De la Rua had resigned. The swap was heavily criticized as soon as it was launched. Mohammad El-Erian, managing director of investment management company Pimco, said at the time that it made no sense for an over-indebted country to increase its indebtedness. He says: “The mega-swap was unfortunate because it didn’t take into account the longer-term interests of the country.”
Bank: CSFB (chairman CSFB International) Experience: senior investment adviser to SAMA; under-secretary of US Treasury (1984-92) Committees MDB Committee at the Carnegie Endowment for International Peace; Council for Foreign Relations; emerging market committee at Institute of International Finance (IIF) Best quote: “If you’re talking about an operation that is four or five times bigger than anything that’s been done before, then the absolute level of commission can seem high” (On the Argentine debt swap, as quoted in La Nación, May 17 2001)
The fees of the banks were also criticized as exorbitant. They were paid $125 million in total.
And the way the deal was carried out was criticized by local press and politicians – it seemed to be done over the heads of the Argentine people – as a private deal between Cavallo and his Wall Street chums.
Stern has defended the role of bank advisers in Argentina. He says a government decides what to do – a bank can never make them do a debt swap or a privatization. He denies that such people as himself, Rhodes or Mulford are advisers. He says: “Such conversations [as they have with government officials] are intermittent and informal, and neither fee-based nor transaction-driven.”
Others are not convinced. “The investment banks’ advice is driven by transactions,” says El-Erian. “There is no guarantee these banks will be mandated for the next transaction. The incentive is always to maximize the size of the deal. There’s a tendency to be too aggressive.” Behind Stern and Rhodes is a whole team of debt capital markets people waiting to see if they have won a mandate or not. Such people are intensely deal-focused.
As one banker says: “Their objective in life is to issue an instrument and earn the fees from that instrument.” Hans-Joerg Rudloff, chairman of Barclays Capital, questions how independent the advice from banks to governments is. Sovereign advisers, he says, are transaction-driven. “In presenting their ideas for the transaction, what can be done, what should be done, they state things which very often an independent adviser would disagree with.”
A source at CSFB who worked on the deal says that, in Argentina’s case, it made sense to do a big transaction. He says that while the new bonds had a higher interest rate than the old bonds, the new bonds could have been swapped for bonds with a lower interest rate once the Argentine economy had grown. The source says CSFB never suggested to Cavallo that he should declare a moratorium: “The Argentines were anxious not to break their bond contracts, not just to foreign investors, but also to domestic banks and pension funds,” says the source, who blames the eventual default not on the swap but on various factors, including the political rift between the central government and the provinces, and the lack of political will from president De La Rua to push through austerity measures.
Rudloff argues that Argentina should have declared a payment moratorium far earlier. He says of a meeting he had with Cavallo’s staff last year: “When I told them they should declare a moratorium, they said ‘How can we do this? We have been told that if we do this, never can we come back to the capital markets.’ I said I knew of many moratoriums, and in every case the countries which declared them have been able to come back to the market in two or three years, once they have put their house in order.”
But not doing a transaction would have meant no fees for the banks. Expecting a bank adviser paid with fees from transactions to advise a country not to do a deal is like expecting a sell-side analyst to put out a sell recommendation. It would appear that there might have been a conflict of interest.
The danger of the club atmosphere of contact capitalism is that such conflicts of interest, if they arise, can be overlooked. If the same handful of economists – Fischer, for example – are endlessly circulated from the World Bank to the IMF to investment banks such as Citigroup, then it may be easy to forget that these sectors have widely differing motives. If they are to act as checks and balances on each other, if multilaterals are to act as a check on reckless government borrowing, rather than a guarantee of it, then it may help if the public and private sectors are not such close bed-fellows.
The appointment of Anne Krueger, who is not a Wall Street insider, as first deputy managing director of the IMF may be a step in the right direction. Krueger has already made several banks furious by her refusal to back Argentina further in December. A source at one investment bank says the IMF’s policy was crazy and showed a failure of leadership.
Columbia University’s Bhagwati saw the danger inherent in the global finance club early on. He said in 1998: “The Wall Street-Treasury Complex … is unable to look much beyond the interest of Wall Street, which it equates with the good of the world.”
And if the elite club has drawn polite criticism from foreign bankers and economists, it has prompted anger and even violence in Argentina. It is not just the corralito – the freeze on bank transactions – that has annoyed Argentines and driven them to the streets banging their pots and pans. The mega-debt swap is probably more widely disliked than any bond deal in the history of the capital markets. Accusations were made in court that the terms of the swap were further altered in a secret meeting between Cavallo and the lead-managers so as to give them below market-rate prices. Cavallo and CSFB say the swap was very transparent.
The arrest of Carlos Rohm in January may be the decisive blow to a whole way of doing business in Latin America. Rohm, vice-chairman of Banco General de Negocios, friend of Domingo Cavallo and fellow BGN board member with David Mulford, is accused of a fraud in which $250 million of small investors’ money was allegedly transferred to a Panamanian subsidiary in which Credit Suisse, JP Morgan Chase and Dresdner Bank are also stock holders, in order to pay off BGN debts.
The scandal has already touched Lukas Mühlemann, CEO of Credit Suisse, who met Carlos Rohm’s brother, Jose Rohm, in Switzerland in January, when Jose brought forward the allegation against his brother. Although foreign banks have been quick to assist the Argentine authorities with their inquiries, the scandal is a further dent to the reputation of the coterie of local and foreign bankers who have run Argentina’s finances for the past decade of “Menemism” – as the era of president Carlos Menem is known. One Argentine legislator, Elisa Carrio, has called the scandal typical of the “tragic history of Argentina in the last 10 years”.
And the Argentine press and people are all too aware of the close links between the Rohms and Mulford – when Mulford visited Argentina Jose Rohm would occasionally act as an interpreter in media interviews.
A source familiar with the situation says none of the foreign directors of BGN (including Mulford, Mühlemann, and William Harrison, CEO of JPMorgan Chase) had any knowledge of the fraud or of any offshore dealings by BGN. The source says: “All the banks are shocked by what has happened.” But the explosion of such a high-level fraud has dragged the role of sovereign advisers into the limelight, and the relationships that enabled them to do good business in Argentina in the past are now a serious reputational risk.
Bank: Merrill Lynch (chairman Merrill Lynch Intl) Experience: Studied under Milton Friedman at University of Chicago; director of research at IMF (1987-91); chairman of Inter-American Development Bank; vice-chairman at EBRD; governor of Bank of Israel (1991-2000) Committees: Trilateral Commission; Council for Foreign Relations; Group of 30; IIF emerging market committee Best quote: “[Globalization is] a golden straightjacket in which we are all in the same pond, but not all of us fit the same rules of the game.” (Kansas Federal Reserve, 2000)
One example of the power of contact capitalism is a dinner that took place in 1999 at the Rohms’ house in Argentina. At the dinner were both Rohm brothers, Carlos Menem (in the last days of his presidency), Ferdinand De la Rua (soon to be president of Argentina), the outgoing president of Uruguay, the incoming president of Uruguay, David Mulford, and George Bush senior, ex-president of the US, ex-director of the CIA, and ex-boss of Mulford. What was the purpose of this meeting? What was discussed?
“Fishing,” says Bush’s spokesperson.
A source says US-Latin American relations were also discussed but that business was not. The Argentine press, meanwhile, has speculated whether one topic of conversation could have been the fate of Raul Moneta, a business associate of the Rohms and a business partner of Tom Hicks, a Texan private-equity investor and one of George Bush junior’s biggest campaign donors. Republica Bank, headed by Moneta, was accused of money laundering by a US senate investigation, but he never stood trial in Argentina.
Even if this wasn’t discussed, such a high-level meeting arranged and conducted at the home of private bankers is bound to arouse suspicions of politics mixed dangerously close with private business.
The global finance club’s method of working – confidential, informal, relying on close relationships with those in power – has rebounded against it, and advisers such as Mulford have been heavily criticized – rightly or wrongly – by the press right across Latin America.
The lack of transparency inherent in the old modus operandi of private meetings, informal discussions, and personal favours has come back to haunt the bankers. One Argentine legislator, Mario Cafiero, sums up the mood among ordinary Argentines: “Argentina was a chicken that laid golden eggs for the foreign banks. But the reality is that Argentina has defaulted and is in serious trouble. The chicken has finally died.”
Behind the animosity of ordinary Argentines towards foreign bank advisers is the suspicion that their country may be a US colony in all but name. The feeling is that economic ministers report to foreign bankers before they report to their own parliament, and that allegedly corrupt local bankers or politicians who are supported by the US are above the law.
Now, the arrest of Carlos Rohm shows that this is changing.
The popular feeling is that US foreign policy towards the continent, as a part of Bush senior and David Mulford’s Enterprise for Americas initiative of the 1990s, exercises itself informally, through US capital, multilateral aid (effectively US capital), trade pacts, and business associations such as the Americas Society and the Argentine-American Chamber of Commerce.
In many obvious senses, private or public capital from the US is a boon for the recipient country and US influence over the country’s government may not be a high price to pay for it. Sovereign advisers could be said to be playing an important role in directing the private portion of that capital, while bringing the US and emerging markets closer together, through trade and a sort of privatized diplomacy, in a symbiotic relationship that is good for all parties.
They also offer a potentially useful unofficial channel for information from one government to another, as the Menem-Bush meeting attended by Mulford shows.
But this is not the whole story. Just as during the Cold War, local politicians or generals who were friendly to the US were supported, no matter how corrupt or brutal they were, so too, after the Cold War, domestic politicians and businessmen who are friendly to US business interests are supported by the US government and US capital, even if they face allegations or rumours of corruption. This is damaging both to the country concerned, to the reputation of the US government and foreign banks, and to the free market system.
Bank: JPMorgan Chase (managing director) Experience: senior VP and chief economist of World Bank; market development in Indonesia, South Korea, eastern Europe, Argentina, etc Committees: Council for Foreign Relations; Centre for Global Development; IIF emerging market committee, Trilateral Commission Best quote: “Individual market participants have a limited appetite to act for the common good … Persuasion by the official sector would certainly improve prospects.” (On introducing restructuring clauses into emerging market sovereign bonds, IFC, April 27 1999)
Carlos Rohm, for example, whose brother Jose is a board member of the Americas Society and on the advisory board of Barrick Gold with George Bush senior and whose son Carlito Rohm is on the board of the Argentine-America chamber of commerce, continued to enjoy the support of senior management at major investment banks, and of US government or ex-government officials, despite BGN’s apparent history of dubious business practices, until allegations of those practices came to light this year – when Jose shocked Mühlemann with allegations against his own brother – and threatened to besmirch the reputation of his foreign supporters.
It is a similar story with former president Menem, who was the architect, along with Cavallo, of Argentina’s rapid economic liberalization. Menem’s foreign minister once famously described Argentine relations with the US as “carnal”.
Because Menem’s policies were good for foreign business, which brought up the majority of Argentina’s privatized industries, and because he was extremely friendly to US governments – particularly that of Bush senior – the charges of corruption, money laundering and arms dealing which he is now facing were for many years quietly ignored.
Instead, Menem was supported and praised as a “visionary”. George Bush senior was even the one who presented him with his honorary degree from the University of Houston.
The Wall Street-Treasury complex’s support for dubious local businessmen and politicians has sometimes lead to fantastic arrogance on the part of these politicians and businessmen, who seem to be encouraged to excesses of public spending and almost criminal incompetence in the belief that they will be bailed out by their powerful US friends.
That has been the real moral hazard. Carlos Rohm’s indictment is a sign that powerful foreign contacts may no longer be sufficient protection.
A new way of dealing with emerging-market crises has been suggested by both the IMF’s Krueger and US Treasury secretary Paul O’Neill. Both, in the past few weeks, have brought up the idea of an international bankruptcy court for sovereign borrowers. This is unlikely to be a quick fix for the enduring problem of either corruption or emerging-market crises, but has merits as a step in the right direction.
O’Neill, in a speech at the World Economic Forum in New York in February, used the example of Argentina to illustrate “the need to create a process for controlled restructuring when a country falls on hard times”. He continued: “I believe we should press ahead on this issue as quickly as possible.” Assuming he keeps his job, this means the bankruptcy court has a good chance of getting established.
Krueger and O’Neill’s plans could do away with the old informal way of handling emerging-market crises. Argentina should not have gone on so long trying to service its $130 billion of debt when it clearly could not pay it all. Cavallo was putting off the inevitable, and the widely accepted view is that the banks should not have advised him to do so, while getting big fees for themselves.
Krueger and O’Neill have made the point that if a bankruptcy court had been in place, Argentina might have been more willing to declare a moratorium and undergo a formal process of restructuring, instead of putting off the inevitable.
Bank: Citigroup (vice-chairman) Previous experience: key player in 1980s’ debt negotiations in Latin America; crisis prevention in South Korea, Argentina and Turkey Committees: co-chairman of IIF’s emerging markets committee; co-chairman of Americas Society; Trilateral Commission; Council for Foreign Relations; Group of 30; US-Russia Business Council; past chairman US Advisory Committee of the Export-Import Bank of the US Best quote: “They are like a foreign service.” (on Citigroup staff, Euromoney, September 2001)
The old guard are not impressed by such ideas. Stern, one of Cavallo’s advisers, firmly disagrees. He says: “The analogy to a bankruptcy court for this purpose is flawed. The remedies cannot be the same. The management cannot be replaced and there is no equity to serve as a buffer for creditors. And there are many issues of jurisdiction and legal principles to be resolved. I doubt that this could be completed any time soon.”
Bank of England governor Sir Edward George recently backed proposals for a slightly different approach: non-statutory guidelines for sovereign debt moratoriums. These could serve as “surrogate bankruptcy laws”, in the words of a Bank of England report, while avoiding the massive jurisdictional effort of establishing international bankruptcy laws.
A leading sovereign debt banker says: “I think these ideas are too complex and elaborate. The effect of bankruptcy procedures would be to narrow the amount of capital emerging markets receive.” But others, such as David Clementi, the Bank’s deputy governor, have suggested such a narrowing might mean “a beneficial switch from short-run to long-run investors”.
And as NGOs such as Jubilee Plus have pointed out, a bankruptcy court or moratorium guidelines might prevent local populations from feeling they are being swindled and would protect countries from rogue creditors out to make a fast buck from a country’s assets.
If a court is introduced, then will the old type of emerging-market banker – the handshaking, silver-haired master of the hotel lounge – disappear? Maybe the style of business they championed will go. In its place will be something more formal, more codified, and more transparent.
The nature of sovereign advice will also change, from being informal (and possibly transaction-driven) to being paid for with a flat fee. Up until last year, the only bank that had a dedicated sovereign advisory business paid for with a fee was UBS Warburg. It was set up at SG Warburg by Lord Roll in the 1970s. Under Darryl Allott, it has advised governments including Russia, Pakistan and Yugoslavia, on bond and Paris Club restructurings and other issues.
Allot says: “Our team is exceptional in providing a stand-alone advisory service for which we are remunerated.” Other banks are following UBS Warburg’s lead. Merrill Lynch’s Frenkel, for example, has established his own sovereign advisory business. Frenkel also emphasizes that his advice is based on a formal fee contract, regardless of transactions. This may not make much of a difference – Cavallo had just mandated another debt swap with Merrill before he was forced to resign – but is a way of providing another check to some of the banks’ more aggressive deal pitches.
If free advice is worth what you pay for it, then bankers’ advice may be more dependable if they are paid for it rather than for the transactions they propose.
