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Lending Lunacy: An American Tradition

MONEY OF THE MIND: BORROWING AND LENDING IN AMERICA FROM THE CIVIL WAR TO MICHAEL MILKEN

By James Grant

Farrar Straus Giroux -- 513pp -- $27.50

Just weeks ago, tottering Olympia & York Developments Ltd. was dickering with its lenders for more lenient terms on the $12 billion or so it owed. The bankers--from Citicorp and many other top commercial banks--balked, in large part because the real estate giant refused to fully open its books. At the same time, the lenders feared the bankruptcy filing that happened on May 14, as they were unsure of what collateral they could claim for their existing loans.

Think about it. Here's a borrower that probably owes more than the gross national product of many small countries, and the lenders don't know what the borrower's balance sheet looks like? How could it happen? The quick but rather unsatisfying answer is that bankers are fools. The more complete explanation can be found in James Grant's Money of the Mind: Borrowing and Lending in America From the Civil War to Michael Milken.

This isn't just another in the long line of books bemoaning the indulgences of the 1980s. Grant, editor of Grant's Interest Rate Observer, believes that the recklessness of that decade was not aberrant behavior but part of a tradition hailing back a century or more. In historical context, the foibles of O&Y's lenders are understandable and predictable.

Grant explains overlending as a manifestation of periodic bull markets in credit, which seem to get a little more manic with every cycle. Credit, he notes, is "money of the mind"--just a promise to pay. And during a bull market in credit (the recent "credit crunch" is a bear market), loans become ever easier to get, and borrowers take them for ever more speculative purposes. "Expecting to get a loan on easy terms, people may change their behavior," Grant writes. "They may spend more, or pay a higher price, than they would otherwise do."

Grant documents how each generation of lenders trips itself up. In the 1970s, for instance, Citicorp Chairman Walter B. Wriston, asserting that countries don't go bankrupt, proceeded to lend billions to deadbeat borrowers in the Third World. So did other big banks. Never mind that Brazil and Peru had each defaulted three times before.

In a discussion of the 1970 collapse of Penn Central Transportation Co., Grant observes that "progress in financial affairs is cyclical, not cumulative. Putting a man on the moon, scientists had stood on the shoulders of giants. Overlending to Penn Central, bankers had recreated the errors of their fathers."

But it's not just bankers who have short memories. Investors burned by junk bonds learned no lessons from the historical debacles involving other so-called high-yield bonds. In the late 1800s, investors bought 100-year bonds of railroads that went bust long before they matured. A period remembered for stock market excesses, the 1920s were also a high time of high-yield foreign-government and real estate bonds. Then came the Depression, many foreign borrowers could not pay their debts, and the real estate market collapsed, too.

Of course, lenders and borrowers don't make billion-dollar blunders all by themselves. Indeed, the government initially urged banks to get into consumer lending to fight loan sharks, for many years the worker's only source of credit. But the "democratization of credit" has gone too far, Grant argues, when anyone can get a credit card, vanquish debts in a bankruptcy proceeding, and, without any social stigma, run up debts anew.

Grant also believes that the "socialization of risk" by government has led lenders to lunacy. He makes the argument, often heard in recent years, that federal deposit insurance was a grievous mistake that made depositors indifferent to banks' financial health. If bankers made bad loans, so what? The government would pay off the depositors.

As readers of his fortnightly newsletter know, Grant has been pounding these themes for years. Unlike many lenders and bond buyers, he spent the 1980s poring through financial statements and crunching numbers and wrote incisive analyses of credit issues in his newsletter and occasional op-ed pieces. Although junk-bond devotees paid little heed, the financial press--and some of the more sober sorts on Wall Street--took note of his work, which was not only readable but amusing.

Money of the Mind, however, is not entertaining. It's so painstakingly researched and meticulously documented that the reader can almost smell the musty archives Grant scoured. With that much detail, it's often difficult to read. Only in the chapters covering recent times does the pace pick up. Readers might do best to absorb each chapter like the newsletter--one every couple of weeks--rather than tackle the book cover to cover.

What's more bothersome is that Grant takes Shakespeare's admonition, "Neither a borrower, nor a lender be," too much to heart. His heroes are bankers who were loath to lend. And he finds little about consumer credit he likes. But how much would the economy have grown without access to home mortgages, auto loans, even credit cards? There's nothing wrong with credit--as long as it's granted with a clear head and sober expectations.

That quibble aside, the book is worthy and should be required reading for bankers and bond investors. Who knows? Had Money of the Mind been available to O&Y's lenders a few years ago, they might have demanded to see a financial statement before they lent out billions.

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