Lending to the Borrower from Hell: Debt, Taxes, and Default in the Age of Philip II (The Princeton Economic History of the Western World)

by Mauricio Drelichman

  Table 20. Agreed-on cash flows from the asiento of February 24, 1596

  The second asiento was signed on July 26, 1596. This was a much larger contract. Spinola and De Negro agreed to deliver 1 million ecus of 57 plaques in Flanders in fourteen payments. The first thirteen payments were to amount to 65,000 ecus each, and the fourteenth would have consisted of the remaining 155,000 ecus. The disbursements were to start on September 1, 1596, and continue at a monthly frequency. For accounting purposes, the Flemish ecus were being valued at 1.088 ducats each, although their theoretical gold content only amounted to 0.977 ducats. The contract thus provided for a potential profit of 10.5 percent in the exchange operation alone, although the actual profit would have depended on the market value of the Flemish ecus.

  The king agreed to repay a total of 1,088,267 ducats of principal, which represented 1,000,245 ecus at the agreed-on conversion rate.34 As with the February contract, interest would be added to each installment at the time of repayment. Because of the size of the loan, the king had to use several revenue sources to repay it. He promised the bankers:

  • 75,133 ducats from the royal direct and indirect taxes corresponding to the year 1595, and payable by the end of 1596

  • 75,133 ducats in the taxes owed by the city of Seville and charged on the goods brought by the fleet, also payable by the end of 1596

  • 75,000 ducats from the proceeds of the goods of Cardinal Don Gaspar de Quiroga.35

  • 466,667 ducats from the fleet expected between September and November 1596

  • 263,000 ducats from the proceeds of the three graces and servicios, in three installments beginning in July 1598 and continuing every four months

  • 133,333 ducats payable in the same fashion as the previous clause, but in 1599

  The yearly interest rate applied to each payment was 12 percent (simple, not compounding), calculated from July 1596. Payments from the three graces received an extra month of interest, while payments from the servicios received an extra two months of interest and an additional two months for not otherwise-specified “costs.” The bankers were given broad authority to collect their payments from alternative revenue streams, but they could only convert up to 100,000 ducats of repayments into juros, and another 100,000 ducats from the 1596 payments into silver from the Indies. The king also provided galleys for the transportation of the bullion. Table 21 shows the agreed cash flows from the asiento of July 26.

  The second asiento is different from the one signed on February 24. A large proportion of the repayments are stipulated early in the life of the contract—in November and December 1596. In fact, if those two repayments had actually taken place, the bankers would have had a cash surplus until September 1597. There are only two time periods during which the bankers would have found themselves in the red: September–October 1596, and between October 1597 and March 1599. In effect, this contract can be thought of as having three components:

  1. A relatively small loan of 127,000 ducats disbursed in September–October 1596, and repaid in November 1596

  2. A large transfer to Flanders, for which the king prepays in November and December 1596 (with an additional disbursement in July 1597), and which the bankers actually carry out between November 1596 and August 159736

  3. A loan of some 215,000 ducats in September–October 1597

  Table 21. Agreed-on cash flows from the asiento of July 26, 1596

  It is not possible to separate the compensation for each of the three components, as they are not identified in the contract itself. The profit nonetheless was all back loaded, as the bankers swung decisively into surplus with the last six repayments. The options built into the contract only allowed the bankers to switch the source of the repayments; since they did not affect their timing or amount, they would not have affected the rate of return. Had the contract been honored as agreed on, the annualized rate of return would have been 17.6 percent.

  This contract mirrored a number of other loans, which called for large repayments in November–December 1596. Indeed, it is quite likely that the time of the payment stop was dictated by this fact.37 The bankers actually managed to collect part of the first payment prior to the November 1596 suspension, and recovered 80 percent of the remaining amount in 1597. When evaluated at the terminal date of March 1599, the operation resulted in an annualized loss of 4.82 percent.

  Families like the Spinola regularly entered into asientos worth hundreds of thousands of ducats. Even if they had had the financial wherewithal to remain liquid whenever the king declared a payment stop, lending such enormous amounts to a single borrower may not have been a good business strategy. During the first and second of Philip’s bankruptcies, for example, the Fugger had been caught between largely illiquid claims on the Spanish Crown, on the one hand, and their own creditors, on the other. Only massive injections of private funds saved their banking business (Ehrenberg 1896). In the previous section, we calculated the excess return from asiento lending overall. After the opportunity cost of funds and losses from the bankruptcies, it amounted to 3.16 percent. While such a return compared favorably to other available financial instruments and even to some commercial ventures, it came with the considerable risk of extended periods during which loans were not serviced. The solution adopted by international bankers was to sell shares in asientos in exchange for a fee. This allowed them to spread the risk among several investors while fine-tuning their own exposure. Parceling out the risk was central to the asiento system. Most large contracts gave bankers lead time of a few months before the main disbursement. This allowed them to tap the European payment fairs for the needed funds. In some cases, the king even advanced “working capital” to the bankers, providing them with a sum of money that could be used to round up prospective investors.38

  While the original asiento contracts preserved at the Archive of Simancas only identify the main underwriters, it is possible to find shares of Spanish asientos in the account books of merchant families based in Genoa. One such source is the libro mastro of the partnership formed by the brothers Lazzaro and Benedetto Pichenotti along with Gio Girolamo Di Negro, who we encountered at the beginning of the book.39 The Pichenotti belonged to a well-known merchant family that never lent directly to the king of Spain. Gio Girolamo was a member of the De Negro family that participated in the asientos, although his name is never found in the contracts themselves.40

  The Pichenotti–Di Negro society purchased shares in both the asientos described above. It contributed 5,265 ducats and 4,500 ecus to the one concluded on February 24, and 30,000 ecus to the one signed on July 26. The Pichenotti brothers supplied half the capital, and Di Negro contributed the other half. The society would make the disbursements and collect repayments under the same conditions that the Spanish bankers had stipulated with the king. The intermediation fee payable to the Spanish bankers was 1 percent.

  The suspension decree was published on November 29, 1596. At that point, Spinola and De Negro had not yet collected any repayments from the February 24 asiento. They nevertheless forwarded 12,200 ducats to the Genoese society on account of a partial repayment of their share in the July 26 contract. This indicates that the king had already made a partial repayment himself, even though none was expected before the end of November. The most likely reason for this is that the fleet must have arrived a month earlier than expected, thereby allowing the bankers to collect the 466,667 ducats that had been promised from that source before the payment stop.41

  The default froze all further cash flows on the Pichenotti–Di Negro participation. The situation began to be resolved with the settlement of November 1597, in which the bank debt was converted into juros. Two-thirds of the debt was repaid in 7.14 percent bonds, which largely traded at par. The remaining third was repaid through a bond swap, reducing the interest rate on juros acquired or already held by the bankers, and entailing a net loss of 20 percent of the original capital of the outstanding asientos. The Spanish bankers collected the bonds corresponding to the
settlement, calculated the share of principal and interest corresponding to the Genoese society, deducted their fees, collection, and conveyance expenses, and forwarded the remainder to Genoa using the same mix of assets they had received from the king. This was the provision of la misma moneda, which we mentioned earlier. Since bankers received bonds in the settlements, requiring them to pay their creditors back in cash would have created serious liquidity problems. The arrangement of la misma moneda allowed international lenders to forward the bonds to the smaller investors who had supplied capital. This applied regardless of whether investors had purchased specific shares in an asiento or just made a demand deposit with the banking house (Neri 1989).

  The accounts of the Pichenotti–Di Negro society were finalized and closed in 1600. By that time, with no more credits outstanding, the society had received a total of 38,741 ducats net of costs in cash and bonds of different characteristics. This represented a loss of 8.4 percent of the original capital.42 Because the loss was spread over several years, however, the annualized rate of loss was substantially smaller. While we do not observe the actual dates of every cash flow for the Genoese venture, we can exploit the fact that its investment was structured to mimic the Spanish asientos, whose cash flows we have reconstructed before. After adding the 1 percent intermediation fee, Pichenotti and Di Negro obtained an annualized return of −1.32 percent for their share in the February 24 contract, and −5.19 percent for their participation in the July 26 one.43 Their overall (weighted) annualized return was thus −4.27 percent.

  The true test of any risk-sharing system comes in bad times. The rhetoric during the bankruptcies was harsh enough. Bankers complained loudly to the king about how poorly he rewarded their loyalty. On December 22, 1575, for example, Lorenzo Spinola wrote to the king to maintain that he had been enormously harmed by the suspension decree, and to remind him of the many services and favors he had provided over the years. He then asked the king to make good on his promises because “the word of a king is a law.”44 Contemporary business commentators bemoaned the plight of the widows and orphans of Genoa. For instance, Venetian merchant Giovanni Domenico Peri (1672), describing the effects of the 1627 bankruptcy, wrote: “In addition to the ruin of the bankers, several other financiers who provided them with funds exited the business. Between ones and the others, many rich families were exterminated, and many widows and orphans were at the same time reduced to miserable poverty.”45 Later scholars such as Braudel concluded that the suspension decrees were catastrophic events, periodically ruining the cream of Europe’s financial elite. This is not what the contract with Spinola and De Negro suggests. While the bankruptcies caused short-term losses on specific contracts, these were more than offset by high profits during normal times. This result applies to prominent banking families that kept representatives in Madrid and dealt directly with the king. It is entirely possible that the bankruptcies had a stronger impact on smaller financiers. This is where a second archival document can shed more light.

  Gio Girolamo Di Negro also kept his own master account books, as was customary. These libri mastri detailed all the assets, liabilities, and profits or losses for the relevant period. The book covering the period between April 1596 and October 1598 is preserved in the Doria Archive, giving us a glimpse of the 1596 default’s impact.46 At the end of the period, in October 1598, Di Negro had not yet received the settlement payments corresponding to his participation in the asientos.47 He recorded his participation in the society with the Pichenotti brothers as an asset worth 7,500 Genoese lire and also had another 1,116 lire invested in a different asiento.48 The final balance sheet shows that Di Negro had total assets worth 96,252 Genoese lire. He turned a profit of 6,025. Since these funds had been earned over a period of thirty months, the annual profit was 2.4 percent. Di Negro was not doing particularly well by the standards of the day. Investing in long-term bonds would have netted him 7 percent or more, with little risk (but also less of a chance to receive the principal back anytime soon or without a discount). While Gio Girolamo Di Negro did not report any juros among his assets, most businessmen kept a diversified portfolio that included Spanish bonds backed by various income streams. For example, his relative Ambrogio Di Negro in 1560 had juros backed by the taxes on silk in Granada, internal customs of Seville, sales taxes of Carmona, royal taxes on wool, and yearly payments that the king received from the shepherds’ guild.49

  Overall, Di Negro’s relatively mediocre performance must have been caused by commercial ventures, to which he committed over 90 percent of his capital. More important, he was in no danger of financial ruin as a result of Spain’s default. Had Philip II completely repudiated his debts, Di Negro would have lost less than 9 percent of his assets. Over the period covered in the account book, this would have translated into annualized excess losses of 3.5 percent. This result is consistent with our findings for the top-level bankers and yields a powerful insight into the strength of the overall system. While the defaults of Philip II caused substantial losses, no link in the chain of financial intermediation was exposed to catastrophic risk when they occurred.

  CONCLUSIONS

  Lending to the king of Spain made good business sense; it was hugely profitable on average, despite periodic defaults and restructurings. According to our estimates, the typical contract during the second half of Philip’s reign cost 20.3 percent annually—or 13.1 percent over and above the return on long-term debt. About 9 percentage points of the return was absorbed by write-offs, interest not received, and the delay in settling old debts. This left a net return of 11.6 percent for Philip II’s bankers—or 4.4 percent above the return on long-dated juro debt.

  FIGURE 20. Interest rates on sixteenth-century loans and returns on asientos

  The same conclusion emerges from analyzing the profitability of loans by the banking dynasty. Of the sixty families that lent to Philip, only five failed to earn their likely opportunity cost of capital—and these bankers provided only a negligible proportion of the short-term loans taken out by the king. It therefore is no surprise that so few bankers stopped lending to the king of Spain. While our figures cannot take into account the profitability of lending before 1566—a period hit by two bankruptcies—it is unlikely that additional information would overturn our results. Even the Fugger family, whose laments have been echoed by Ehrenberg (1896), was not so disappointed with the returns that it stopped lending altogether.

  How do these returns compare to those available to lenders at other times, or elsewhere? Genoese and German lenders could have easily extended credit to other borrowers. While few had funding needs on the scale of Philip II, the general demand for credit was not low. In figure 20, we compare the average lending rate to Philip II with other sixteenth-century interest rates (Homer and Sylla 2005, 119). The range of contracts includes government borrowing (by France, England, and Portugal), borrowing by bankers such as the Fugger, and census contracts on land as well as annuities. We cannot pretend that these are comparable in terms of riskiness, maturity, or liquidity to loans to Philip II. What is clear from our analysis is that both the gross and net rates of return overall compare favorably with what was on offer elsewhere.50

  Sovereign lending over the last two hundred years has been profitable on average, but punctuated by periods with severe losses (Eichengreen and Portes 1989b). Our results demonstrate that this was already true during the sixteenth century. The loss rate (a 65 percent reduction relative to the ex ante excess return) is higher than the one for the dollar and sterling bonds examined by Eichengreen and Portes (ibid.), who found a reduction of 34 percent.51 At the same time, the absolute excess return was higher for the lenders to Philip II—460 basis points, compared to the 44 basis points found by Lindert and Morton (1989). As a matter of fact, between the group of borrowers analyzed by Lindert and Morton and those studied in more recent work by Federico Sturzenegger and Jeromin Zettelmeyer (2006, 27), there was only one country with a higher rate of excess return, achieved for a short per
iod of time: Brazil paid a premium of 1,623 basis points between 1992 and 2001. The fact that excess returns were high ex post, over a long time, suggests the high ex ante rates were not simply a compensation for risk. Market power—the ability of the Genoese network to extract favorable terms and conditions from a borrower heavily dependent on credit—must be an important part of our story.

  What underpinned the power of Genoese lenders was a remarkably effective way of raising funds. Lending took place with loans that the leading bankers syndicated, selling on participations to smaller investors. We used two investments during Philip II’s fourth and final default, in 1596, to gain insight into actual gains and losses for the final investors. The Pichenotti–Di Negro partnership bought participations in two short-term loans to the king, underwritten by Agustín Spinola and Nicolás De Negro. They were affected by the payment stop. We carefully reconstruct the profitability of these two investments and interpret them in the context of the investors’ portfolio overall.

  FIGURE 21. Excess returns to sovereign lending, 1850–2001

  The original underwriters achieved a full risk transfer. They only owed the partnership the respective proportion of the money that they received from the king. Losses were modest overall; investments in these loans did not constitute a large fraction of the partners’ wealth. While a sudden payment stop was not a small matter for investors, there was no domino effect—a wave of defaults as one creditor after another sees a large share of their assets disappear or turn illiquid.

  Remarkably, the Genoese system of repackaging and reshuffling risk worked better than securitization did after 2000. As the financial crisis since 2008 has made clear, new securities consisting of repackaged mortgages actually failed to provide risk diversification. Losses in a small corner of the financial system soon threatened to overwhelm it in its entirety (Gorton and Metrick 2012). The sixteenth century instead produced a successful example of how financial intermediation can “work” by offering a combination of attractive returns and relatively modest, well-diversified risk. In part, it did so by passing on some of the exposure from bankers to final investors.