From the flames, a new market
Are we about to witness the creation of a great Third World debt market? Will LDC loans be transformed into junk bonds and equities on a grand scale? Idle talk, some will say, but, in this special report, Euromoney argues the case for believing that a new market will soon rise like a phoenix from the flames.
Heavily provisioned and armed with large portfolios of LDC debt, the US commercial banks are determined to cast off the years of drift and disillusion and begin an era of portfolio management. There are obstacles: conservative regulators, restrictive laws, and a bitter controversy between accountants. But the enthusiasm of the Treasury, the Fed and the bankers themselves should sweep aside any hurdles. Euromoney looks at the strategies that the banks favour and the tools of debt management that are available to them.
Securitization? Debt-for-equity swaps? Cash deals? Euromoney senior staff writer Richard Evans coordinated this section – including special reports from Japan, Washington (where Congress is considering plans to establish a third international institution), and Latin America itself – and wrote its major article, reproduced here:
New debts for old – and the swapper is king
They know the snags; they have been offered bankrupt factories and studied barter plans from Peru. But bankers believe that debt-for-equity swaps can work. They have to.
By Richard Evans
The excitement in the air is unmistakable. "I think we're definitely going to see the birth of a vast new market," said John Ingraham, a senior vice president and member of Citibank's credit policy committee. "The potential is enormous," said Tom Hanley a director of Salomon Brothers in New York.
Ingraham meant a vast new market for Third World debt, doctored into attractive new forms, a $300 billion new playground in which bankers can seek profit. The man responsible for conjuring up this enticing prospect is Ingraham's boss, Citibank chairman John Reed, with his announcement last May of $3 billion of provisions.
It won't be easy. A thousand regulatory, accounting and practical difficulties block the way to the promised land. But there are also firm grounds for hoping that these impediments can be dissolved. The most obvious is the growing pile of provisions banks have set aside against Third World loans.
European banks, including those in Switzerland and West Germany, have around $15 billion in LDC loans. They are already highly provisioned. Deutsche Bank and Union Bank of Switzerland have set aside reserves of about 50% against their Third World loans. The Swiss and West German banks have been players in the secondary LDC debt market for many years.
The big UK clearing banks, with a further $23 billion of LDC debt, quickly followed the lead of the US banks and announced massive provisions. Total commercial bank debt to the 15 most indebted countries is $430 billion. The 15 leading US banks have around $70 billion of this.
"The new provisions created a huge new pool," said Jay Newman, a senior vice president at Shearson Lehman. "Perhaps 70% to 80% of the LDC debt outstanding is, or soon will be, marked pretty close to current market prices."
Among US commercial bankers the phrase of the moment is "active debt management".
There has been a host of re-organizations. Chase Manhattan announced it was setting up a new group under Thomas Gaffney, the president of its UK investment bank, to manage its Third World debt. (Gaffney maintained that he could do the job from London and just commute to New York when necessary. "It should give me a better view of the broad picture," he said.)
Chemical Bank has formed a special committee, chaired by Richard Simmons, the bank's vice-chairman, to coordinate its LDC debt activities. Other banks have, in the meantime, been starting up LDC debt trading teams from scratch.
Many new recruits have been lured from the New York investment banks which have long been active in the secondary LDC debt market. Antonio Angotti was enticed away from Bear Stearns by Security Pacific, to organize its asset trading team. Kathy O'Brien was poached by First Chicago from Merrill Lynch. There have been several team moves. Groups of dealers moved from Libra Bank to Standard Chartered and from Mellon Bank to American Express.
A flurry of hopeful statements of intent followed John Reed's announcement on May 19 that he hoped to write off around $5 billion of Citicorp's debt over the next two to three years by using various asset trading techniques.
After the past five years of disillusion and despair, the optimism is understandable. Some bankers, such as Citicorp's Ingraham, predict a tripling of trading volumes in the secondary LDC debt market by 1990. But no market is created overnight. There are problems.
Some of the difficulties are caused by the size of the provisions that many of the banks chose to make, and the limits this puts on their freedom to act. The table [above] analyses the LDC debt exposure of the 15 leading US banks. The first column shows their LDC debt exposure. The second column gives the value of the loans at market. The third column shows the loss at market. The fourth column shows the reserves, and the fifth column lists the excess of losses over these provisions.
It is clear from the table that banks such as Security Pacific and First Interstate have provisions of over 30% against their LDC loans. But other banks, notably Citicorp, Manufacturers Hanover, Bank of America, Chemical and Chase Manhattan are still heavily exposed. It was easy to discover the exact prices of the debt of Argentina, Brazil, Mexico, Chile and Venezuela in the secondary market. Other LDC loans were not differentiated and were marked down by 50%, in accordance with a consensus of views from New York brokers.
"Active debt management" boils down to four choices. The banks can sell the debt for cash. They can do debt-for-debt swaps if they feel they are too heavily exposed to one country and regard another country as a better credit risk. They can try to securitize all or part of their debt. Or they can convert the debt into equity.
The secondary market prices of the LDC debtor countries vary tremendously. Bolivian and Peruvian paper trades at 10% to 12% of its face value, Argentinian loans at 45% to 46%, Mexican sovereign loans at around 50%, Brazilian loans at about 47%. Much of this paper is either sovereign debt or loans available for debt-for-equity swaps. Prices of private sector or LDC loans which are ineligible for swapping are even lower.
Chilean loans have been trading at around 63% of their face value, because of the country's advanced debt-for-equity programme. Yet the average level of provisions of Citicorp, Chase, Chemical, Manufacturers Hanover and Bank of America stays around 20% to 25%.
Simple arithmetic shows that these banks, with their present level of provisions, will be very unwilling to sell for cash. "I can't see any of the large commercial banks being big cash sellers," said Peter Geraghty, head of capital markets at the New York branch of the Nederlandsche Middenstandsbank (NMB), one of the most active brokers in the market. "It will be the smaller regional banks, with portfolios of around $250 million, which will be selling out. Even those banks with only around $750 million will probably prefer to try doing debt-for-equity swaps."
Besides, bankers have not completely lost faith in their Third World debtors. "It's not just because they're not adequately provisioned that some banks aren't selling," said William Klein, senior fellow at the Institute of International Economics in Washington. "The fact is, many bankers still believe in the long-term potential of their sovereign paper."
The present level of provisioning restricts the use of debt-for-debt swaps. For bankers there are unresolved accounting questions. Some accountants argue that if, for instance, a bank swaps 20% of its Argentine debt for Brazilian debt, the remaining 80% of its Argentine debt portfolio must also be marked down to current market prices.
The reaction from the secondary LDC debt market to the hefty provisioning by the banks has been far from favourable. The market has always been very thin. "I remember one instance when within a matter of hours we had enquiries from banks as to whether we were interested in a certain package of debt which we had offered to another client, but had not yet sold," said Carlos Gonzalez, the general manager of Libra Bank in London. Bid and offer prices have never meant very much. "It's a negotiated market, not a trading market," said Alan Pope, head of Lazard's LDC debt trading in New York. Gonzalez estimated that only around $10 billion of LDC debt had been traded in the market since its inception.
Over the past couple of months trading volumes have dropped sharply. "The secondary market has been dead since the Citicorp announcement," said Geraghty. "There have been a lot of non-deliveries. The market just seemed to disappear overnight." The fall in the price of Mexican debt is typical. As demand has fallen away, the downward price spiral has continued. "Everyone's a seller now. There are no buyers," said Scott Perry, director of the Middle East Financial Group in London, and an active player in the swap market in Chile.
Victor Segal, a director of Singer and Friedlander, a London-based merchant bank, which is in partnership with European InterAmerican, accurately explained what happened. "Following Citicorp's announcement the market was swamped by an enormous quantity of new paper. Now the deals do not fall easily into brokers' laps."
The immediate prospects for the secondary LDC debt market seem gloomy. With the banks' present level of provisions, and without any rise in the market price of the debt, trading is going to be limited. Many bankers have predicted that the banks will make further provisions. But the decision does not rest with them alone.
"It's a political question," said Klein. "To protect shareholders the SEC may not allow US banks to increase their provisions. l doubt if it would have allowed the banks to take the action they have done, without Brazil's refusal to pay interest. There would have to be a serious deterioration in the situation before any more increases were allowed."