Men and Markets Observed: Collateralized debt obligation in 16th century

Today's selection -- from Spain by Robert Goodwin. Though he had seemingly unlimited revenue in the form of gold and silver from the New World, Phillip II of Spain (1527-1598) squandered it all, and more, on war and became the first sovereign in history to declare bankruptcy. Spain lost the Netherlands as a result:

"The Spanish Crown borrowed in two basic ways. The foundation stone of sovereign debt was juros, a range of government bonds securitized in one way or another with a guaranteed rate of interest over the life of the loan. The interest was increasingly linked to some specific source of income, perhaps a lien against the alcabala, a sales tax raised in Castile on salt, wine and other commodities, or against the rents payable on certain Crown estates, and recovery of the payment was often the responsibility of the bankers themselves. Then there were the asientos, a bewildering kaleidoscope of floating debt usually agreed on an ad hoc basis in order to fund some particular project or campaign on which the Crown paid a very high rate of interest for a relatively short period, after which the creditors usually agreed to consolidate asientos into juros.

"Until the 1560s, the bankers who lent money to the Crown largely did so out of their own pockets. But in a world awash with money the Genoese were determined to borrow as much as possible from the tradesmen, merchants, noblemen, farmers and even peasants from across Europe who wanted to lend it to them. They then found all sorts of ways of putting that money to work, but the Spanish Crown was always the major client which drove the whole debt market. In fact, Philip's government was so hungry to fund his huge expenditure that it regularly outbid more useful creditors such as farmers and industrialists, driving up interest rates and contributing to the rampant inflation that devalued the principal of Crown debt but was very damaging to the economy.

A shipyard on the river Guadalquivir in 16th century Seville

"The crucial innovation of the Genoese bankers was to create' a secondary market in Spanish sovereign debt by selling shares in the juros they held to a range of investors, but especially to Spanish ecclesiastical foundations, to the growing middle class, such as lawyers and doctors, and to some noble families. They spread the risk associated with a range of juros across a large number of investors, establishing a sort of primitive collateralized debt obligation. The Genoese achieved especially lucrative premiums because the size of their operation allowed them to negotiate on favourable terms with the Crown. As Sarabia de la Calle explained, 'because they are considered so creditworthy, they pay much less interest than the princes who pay at an expensive rate'. But, almost more importantly, they were exceptionally talented at extracting income from the often unreliable sources of revenue put up as security.

"The ingenuity of the Genoese in expanding the market for Spanish sovereign debt allowed Philip II to keep his armies in the field and prosecute his wars against the French, the Dutch and the Turks. But the cost of his military operations far exceeded what he could afford: between 1571 and 1575, expenditure in Europe was over eighteen million ducats, while total Crown income in Castile, including bullion and tax receipts from the Americas, amounted to between five and six million. It may be obvious with hindsight that such a deficit must end sooner rather than later in some sort of default. But the bankers and the government were pioneers experimenting on a grand scale with the first ever recognizably modern economy. Even the extent of Crown revenue was so poorly understood that in 1572. Juan de Ovando, the new President of the Council of Finance and an experienced member of the Council of the Indies, described 'the government and administration of the treasury as divided into too many tribunals' and complained that 'in all of them there is much confusion and little, or no, implementation of the work of each office'. Ovando was a very able bureaucrat, but when he tried to assess the Crown's gross income and debt he was unable to come up with consistent, let alone reliable, figures, offering one set of figures in April 1574 and a significantly different set in August.

"While Ovando and his officials were failing to understand the detail, matters were coming to a head. Crucially, in the late 1550s almost all Spanish sovereign debt had been converted intojuros that were to be funded directly by royal receipts from the Americas. The attraction to the creditors is clear: every year they could actually watch their interest being unloaded in glittering piles of gold and silver ingots on to ox-carts at the port in Seville. Year on year, with almost no exceptions, the Crown had banked more and more money from the New World. There seemed no safer bet. But then in the early 1570s American revenues fell significantly and the supposedly safe juros lost half their value on the secondary market. Public opinion turned ugly, and there were demands that the Crown should default. The bankers became nervous.

"With almost his entire income now tied to the payment of interest, Philip was forced to suspend those payments in order to maintain the Crown's liquidity. At the same time, he had no choice but to default on thirty-six million ducats' worth of loans that had become due for settlement. On 1 September 1575, he effectively declared himself bankrupt, the first sovereign default in history.

"The Genoese retaliated by withdrawing his banking facilities in the Netherlands, and Philip's new military commander there complained that he could 'not find a single penny, nor can I see how the king could send money here, even if he had it in abundance. Short of a miracle, the whole military machine will fall in ruins.' It proved to be a perspicacious prophecy. The light cavalry, for example, were owed six years' pay, and in 1576 the soldiers mutinied. After committing a series of terrible atrocities, including the especially brutal sack of friendly Antwerp remembered as 'the Spanish Fury', the Army of the Netherlands mutinied and abandoned the coastal Counties of Holland and Zeeland. The States General worked quickly to unite all Seventeen Provinces of the Netherlands in an act known as the Pacification of Ghent, which established a humiliating general peace that required the removal of all Spanish troops and officials from both the Spanish and Dutch Low Countries. Dutch obstinacy had bankrupted mighty Philip by forcing him to keep such a large army in the field for so long. ...