Banks Wise to Bite Bullet on Loans

The decision by the major commercial banks to increase their reserves for possible losses on loans to developing countries was based on a number of very sound reasons. It has become painfully clear that the money borrowed by developing nations in the 1970s, when the prices of their commodity exports were soaring and inflation-adjusted interest rates were very low, was not put to productive use.

Much of it has been squandered on useless or unprofitable projects or smuggled into Swiss bank accounts. In the 1980s, most commodity prices have collapsed, and real interest rates have risen to very high levels, so the chance of those loans being serviced--much less repaid in full--are small.

By increasing reserves, the banks simply were admitting a painful reality that the markets in which those loans trade realized long ago--developing country loans sell at discounts of about 40%. Stock investors, too, see developing country loans as dead weight on the banks’ books. This explains why stocks of regional banks generally outperform those of the big money center banks with heavy Third World exposure. By reserving, executives of the banks simply caught up with their shareholders.

Except for a handful of financially weak banks, the stock market welcomed the banks’ decision, and their shares rose. Indeed, additional reserves will strengthen the banks’ hand in dealing with debtors. Before, debtors could blackmail banks by threatening to suspend payments and devastate their earnings. It’s been said often enough that if you owe the bank $1,000 and can’t pay, it’s your problem, but if you owe $10 million and can’t pay, it’s the bank’s problem. Now, the banks’ vulnerability to such tactics is greatly reduced.

The implications of the banks’ action are profound:

- The Federal Reserve under its chairman, Paul Volcker, has long been aware that many of those loans are uncollectible. The Fed has done everything to extend the business expansion to give banks breathing space in which to build up their capital and cushion themselves against developing country loans. Taking additional reserves abruptly ends the period in which the bankers kept rolling over loans to avoid facing reality. As they say in the financial community, “A rolling loan gathers no loss.”

- Regional banks have long been unhappy with developing country lending. Last year, they balked at providing their share of new money to bail out Mexico after the oil price collapse. Now, they may decide to write off all developing country loans and exit the scene. The debtors would then face only a handful of money center banks, whose negotiating stance would be toughened following the boost to their reserves. Debtors could conclude that they have little to gain from being cooperative.

- Increased reserves and writeoffs will reveal more clearly the quality differences among banks. Winners will include a number of regional banks that have boosted their reserves not only against international loans but against questionable domestic loans as well. Foreign banks also would benefit. They didn’t plunge head-on into developing country lending in the 1970s and have long reserved fully against the loans they made. Moreover, European and Japanese banks can afford to worry less about the possibility of writing off developing country loans now that the dollar has weakened against their currencies. Most of those loans are in dollars, and are worth less in terms of deutsche marks, yen and other strong currencies. Losers will include money center banks with weakened capital positions and enormous foreign debt exposure.

- Even after the latest boost, the banks’ reserves probably are inadequate. Developing country loans trade at 60% of their face value, but even those prices may be inflated. Most transactions are conducted among the banks themselves, with few outside buyers and little new money coming in.

At the same time, debt-for-equity swaps, which have lately been touted as a potential solution to the debt crisis, assume that there is enough equity in developing countries worthy of serious investment. Once the banks start swapping their loans for equity on a larger scale, they may find that there isn’t, and there will suddenly be too many dollars chasing too few sound investment opportunities. Already, discounts in debt-for-equity swaps are widening.

- The banks’ decision probably will drive the last nail into the coffin of Treasury Secretary James Baker’s plan to provide new private funds to major debtor nations in exchange for promises to restructure their economies and develop their export industries. Most of those nations lack the zeal or the ability to revamp their inefficient economies, and the banks’ action is, in effect, a resounding vote of no confidence in debtors’ economic programs. It seems that only heavy pressure from the federal government could induce private banks to provide additional funds. It is, apparently, precisely this kind of U.S. government pressure that made a success of Argentina’s recent debt refinancing campaign.

In short, the likelihood of more developing countries following Peru, Ecuador and Brazil into default has increased, while at the same time reserves taken by the banks are insufficient to shield them against the consequences. The U.S. government may in the end be forced to bail the banks out by taking over the loans directly. Yet, the effect of this action on the budget deficit may be unacceptable--as would be the political reaction.

Is there a realistic solution to the debt problem? A panacea may never be found, but, in combination, several measures may defuse the time bomb. Debt-for-equity swaps are reducing the debt burden somewhat, and additional measures may include changing import quotas in favor of goods from the big debtor nations, reducing interest rates on selected loans and changing accounting rules to allow orderly writeoffs of uncollectible loans over a long period, perhaps 40 or 50 years.

In the meantime, the road is likely to be rocky. In particular, since so many debtor nations rely on U.S. markets to earn the hard currency they need to service their debts, the next U.S. recession, whenever it comes--and the concomitant reduction in U.S. appetite for imports--will test debtors’ ability to stay solvent.