Chile’s Caja de Crédito Hipotecario (Part II)

This is the second in a two-part post. The first covered the origins of Chile’s Caja de Crédito Hipotecario, a state-owned mortgage bank that was one of a handful of financial institutions originating in a wave of bank formation in 1850s and 1860s Chile. This post covers the recovery from a mortgage crisis in the 1860s, the tremendous growth in the country’s financial system in the mid-to-late 19th century, and two financial crises that damaged the economy along the way. Most of the world’s economies grew quickly in the late 19th century but Chile’s story is made more remarkable when you consider how credit-deprived the economy was as recently as 1850.

Recovery

The Caja de Crédito Hipotecario was nearly the entire extent of Chile’s formal mortgage market in the 1860s and both were in a clear retrenchment for the majority of the decade. By 1869 though, conditions were fairly normal once more. Following a mortgage loan crisis that saw 10% of the bank’s portfolio foreclosed on, the Caja was able to halt legal proceedings against borrowers which had generally seen their financial positions improve. Interest rates also returned to healthy levels; the going rate of interest on demand deposits at Chilean banks fell from 6% in 1865 to 3% in 1868. In keeping with this, the market price of Caja de Crédito Hipotecario 8% letras de crédito (the bank’s bonds) rose back to a premium to face value. As yields on debt fall, the price of existing bonds rises.

Starting in 1869-70, growth in the bank’s mortgage loans returned as originations exceeded repayments. In 1870, Chile’s economy was lifted by the discovery of new silver deposits at Caracoles near the border with Bolivia. Domestic prices for agricultural goods rose around the same time, supporting the agrarian sector. As the years went on, the Caja de Crédito Hipotecario was originating new loans at as rapid a pace as ever. The outstanding balance of letras de crédito grew from 5.3 million pesos in 1873 to 15.4 million pesos just five years later as new loan originations were around four times higher than the pace of repayments.

During the 1870s, new banks were formed and existing banks expanded their operations. The deposits of the banking system grew from 21.5 million pesos in 1869 to 41.2 million in 1877 and loans grew from 28.2 million pesos to 59.1 million over those same years. The banking system returned to profitability and the reserve account of the Caja de Crédito Hipotecario, designed to absorb potential loan losses, was replenished and grew to around 4% of its bonds outstanding by the mid-1870s.

Crisis of 1878

Despite the head-spinning growth, not all was good with the banks. The Chilean banking system was operating in an environment of scarce reserves of precious metal specie. This limited the reserves available to the banking system, making it weaker in the face of shocks. Indeed, in these years of remarkable growth in deposits and loans, precious metal reserves increased by a lesser amount.

The first signs of impending trouble came in 1876 and 1877 which were years of poor harvests. By 1878, years of rising interest rates and falling silver prices had strained the economy. Deposits and the reserves of the banking system had fallen. Money was scarce; the going rate on demand deposits in the banking system rose from a low of 3% in 1868 back to 6% in 1876. Prices of securities were correspondingly depressed; the price of 8% letras de crédito fell to below 85% of face value in 1878. So, during the 1870s, mortgage payments to the Caja de Crédito Hipotecario were made in the form of letras de crédito rather than cash, a possibility enabled by the loans’ terms, because these bonds could be bought cheaply in the secondary market, a product of the high interest rates of the time.

Amidst this period of strain, rumors circulated about the health of banks and bank runs commenced. In July 1878, the Banco Nacional de Chile experienced a bank run. This prompted the government to allow banks to suspend the convertibility of their banknotes into precious metal to stop that crisis.

In some ways, the mortgage crisis underway amidst this financial panic was worse than that of the 1860s but the system withstood it better. If borrowers struggled to make payments during these tough years, the Caja de Crédito Hipotecario granted relief to borrowers for periods of one or two years, a more tolerant stance than was exhibited by the bank in the earlier crisis. Despite the delinquencies, the bank made payments out of the reserve account funded with its profits during the good years. Unlike in the early 1860s, the reserve was never exhausted though loan delinquencies actually rose to higher levels than during the earlier mortgage crisis. Sales of liquidated borrower property by the Caja de Crédito Hipotecario were less common than in the 1860s crisis.

Paper Money

A lasting legacy of the crisis of 1878 was the suspension of banknote convertibility. Chile’s monetary system would essentially operate without a precious metal monetary standard until 1894. During this period, private banknotes were required to be backed in part with mortgage bonds, government bonds, or gold placed with the country’s Treasury. The government itself was issuing paper banknotes in 1879-1880 to fund a war against Bolivia and Peru. This all took place in a country that thirty years earlier had a rather strong phobia for paper money.

Nonetheless, paper money proved at least a mixed blessing. For one, it was not overissued despite the wartime circumstances. True, the Chilean peso did depreciate but to a manageable extent considering the context of a financial crisis in a frontier market; the exchange rate fell to about 7.5 pesos to the pound sterling in the early 1880s as compared to about 6 pesos to the pound in 1878.

Unfortunately, domestic prices rose, but not to any hyperinflationary degree. Prices rose about 85% over the fourteen years between 1880 and 1894, equating to an annual rate of inflation of 4.5% per year. No doubt some of this inflation would have resulted from the war and economic recovery anyway.

Fortuitously for the banking system, the issuances of paper money lowered interest rates, from over 10% in 1878 to approximately 6.2% in 1882. The spread between local and global interest rates also contracted sharply. As interest rates fell, the price of 8% letras de crédito returned to a premium to face value by the early 1880s. In 1880, there was a spate of mortgage refinancings at lower interest rates; when counting refinancing activity, the year was by far the busiest to date for the Caja de Crédito Hipotecario. The depreciation of the peso and price inflation helped debtors repay their loans so that it is hard to imagine the financial system recovering quicker than it had in the absence of the new paper money issuances.

The above certificate confirms the payoff in full of a loan in 1880 in a lump sum (perhaps it was one such 1880 refinancing); retrieved via Ministerio de las Culturas, las Artes y el Patrimonio, Chile

Return of Growth

The 1880s saw a run of very good years for Chile’s financial system. Victory in a war against Bolivia and Peru, rising prices, and falling interest rates improved the financial condition of landowners and the Chilean banks. The Caja’s 8% mortgages had mostly been replaced in this period with 5% and 6% loans. The proportion of its loans in arrears fell to 7%. These good conditions describe virtually the entire decade; the mortgage market was remarkably stable compared to the two prior decades. The reserve account of the Caja de Crédito Hipotecario peaked in 1887 at about 7.5% of its bonds outstanding.

As for the wider financial system, between 1882 and 1894, the paid-in equity capital of Chilean banks tripled from 14.1 million pesos to 43.5 million. Deposits grew by 145% from 50.8 million pesos to 124.5 million and loans by a similar proportion from 60.0 million to 147.9 million. Other than the Caja de Crédito Hipotecario, the number of banks making mortgages grew to thirteen. This came despite a civil war in 1891 that saw more paper money issuance and accelerating inflation, among other disorders.

Gold Standard and Panics of the 1890s

The good years came to an end in the 1890s. The post-civil war government sought to restore convertibility of banknotes after the long interlude. The timing was pretty poor. A financial crisis came about in the 1890s along with a global slump. It was preceded by the ‘Barings Crisis’ of 1890 when Argentina defaulted on its external debt, bringing the British bank Barings to the brink of collapse. British capital flows to Latin America collapsed from £49 million in 1889 to just £6 million in 1893. In Chile, imports of British capital fell from £7 million to nearly zero, before a slight recovery back to £1 million over those same years.

Chile’s crisis was prolonged by poor harvests in 1894, 1895, and 1897 and a bungled implementation of a gold standard. There was simply far too little gold in the possession of Chilean banks to back all their notes and deposits so they were forced to contract the money supply. This led to surging interest rates, sharp falls in the value of securities and land and an economic recession. Once again, mortgage payments to the Caja de Crédito Hipotecario were made in the form of depreciated letras de crédito rather than in cash. The bank was still able to offer payment modifications while making up interest to bondholders from its reserves. It refrained from legal action against borrowers unless they were two years or more in arrears.

Santiago, Chile in 1891 (retrieved via Wikimedia Commons)

The price of 5% and 6% mortgage bonds fell sharply, reaching a low of about 75% of face value in 1896; as a result of the dried-up funding at low rates, 8% mortgages returned as interest rates rose. Still, even the 8% letras de crédito traded at just about 90% of face value in late 1890s. Nonetheless, mortgage credit remained available. The Caja’s volume of mortgage bonds outstanding rose from 36.9 million pesos in 1892 to 82.8 million pesos in 1897. Foreclosures were few and the reserve fund remained intact, indeed facing little risk of depletion in this crisis, however severe it was.

That said, the financial system hobbled from one crisis to the next in the 1890s. Runs on Valparaíso and Santiago banks occurred in 1898. The gold standard project was abandoned and paper banknotes became inconvertible once more. The Caja de Crédito Hipotecario kept growing despite this. It was perhaps the bright spot in the entire system. The decade brought consolidation to mortgage banking as many banks suspended mortgage lending; four of the seven incorporated banks in Chile closed. The mortgage industry was left with just four banks including the Caja which was by far the largest. Today, the Caja de Crédito Hipotecario’s descendant is the BancoEstado, the only public bank in Chile and still a large mortgage lender.

Lesson

Chile in the 19th century is interesting as an example of a country with a myriad of note issuing banks in a volatile economy. The credit cycles here are uncontrolled and are exaggerated. The years of plenty are remarkable for the growth in credit, doubling or tripling in the upswing. The years of panic see bank runs and bank closures but there was a difference here between the 1870s and the 1890s. The crisis of the 1870s was arrested fairly quickly with the suspension of banknote convertibility. The equivalent suspension in the 1890s crisis came only in 1898, after years of trouble. While these suspensions can often appear as capitulations, they have often been effective brakes on financial panics, particularly in settings without institutions like central banks or a history of bank bailouts.

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