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September 6, 1982
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Approved For Release 2009/04/01 : CIA-RDP84B00049RO01102640014-1 Qf%,YNEY & BANKING The world's financial system is facing its greatest test of strength in decades. And even though the plunge in interest h rates will bring relief to some borrow- ;' era, scores of others, from corporations to governments, are becoming delin- quent debtors overnight, threatening the profitability of individual banks and the liquidity of the entire financial system. Y 'Already battered by problems ranging from Penn Square to Poland, creditors are rushing to save Mexico by reschedul- ing debt and extending fresh credit on a scale never before attempted. "The one thing we know is that things are going to get worse before they get bete - ter," says Alexandre Lamfalussy, chief economist and assistant man- sger for the Bank of International Settlements in Basel, Switzerland. Bankers are bracing themselves for a rescheduling of Argentina's $24.8 billion bank debt, and Peru is likely to go to international bankers for a second rescheduling of $4.4 billion in bank debt. - Mexico--of strategic importance Horne, European economist for Smith Barney Harris Upham Inc. The greatest threat to the financial system, bankers concede, is from depositors and institu- tional investors who might suddenly de- cide that yanking money out of a num- ber of banks would be prudent-and for them, it might be, but it could precipitate a widespread liquidity crisis. "The worst thing that could happen is for major in- stitutions to find their funding opportu- nities severely constrained by a market so obsessed by a flight to quality that it refuses to lend to these institutions," warns one U. S. bank economist. "We're but several banks have been stung. Con- tinental Illinois National Bank & Trust Co., caught in the Penn Square tangle with $1 billion in energy loans it had bought from the failed Oklahoma City- bank, is paying a premium for pur- chased funds. And markets were shocked by the losses Chase Manhattan Bank had to swallow in the wake of Drysdale Government Securities Inc.'s failure to pay its debts. The aftertax cost to Chase of covering Drysdale's ob- ligations to securities firms was $117 million, and it posted a $16.1 million loss as a result during the second quarter. German banks, already badly ex- posed to problems in the East bloc Problem loans pile up Growth instead of judgment. OPEC's surpluses disappear to the U. S. and because its oil ranks it _ as a major economic power despite its recent fall from financial grace-will be permitted to delay principal payments on a portion of its debt. And a financial .package combining bridge loans and new money will be offered by central banks, the International Monetary Fund, the U. S. government, and commercial -..;banks. The total value of the package -could reach $10 billion. "Mexico is not Poland," stresses one U. S. Treasury Dept. official. "They face an illiquidity problem, but they will be able to resume payment on their debt." - Some 115 senior executives from inter- national banks heard out the country's Finance Secretary Jesus Silva Herzog, at a hastily called meeting in New York on Aug. 20, and a 14-bank steering com- mittee was quickly formed to set the -.terms of a new bank loan. But however swift the accommodation of that trou- bled economy's needs, it will not mark the end of bankers' woes. Bankers are worried not only about the actual loan losses banks will suffer, but also about market perceptions of bank problems. The problems are "con- sidered by most market participants as systemic or endemic," says J. Paul not in that case yet, but there's a poten- tial confidence problem. There'll be no systemic problem as long as the flight to quality doesn't get out of hand." So far, institutional runs have oc- curred only on a limited basis. A small Texas bank, Abilene National Bank, be- set by rumors that its energy portfolio was troubled, suffered such a run fol- lowing the failure of Penn Square Bank. The Federal Reserve, acting as lender of last resort, advanced money to the bank, but the institution was finally merged into a larger bank holding company in Texas. In Europe, where the collapse of Italy's Banco Ambrosiano sent shock waves through the financial system, creditors of the bank's Luxembourg sub- sidiary suddenly found themselves un- protected by central bank guarantees they had assumed were there all along. Tiering the banks These incidents have turned markets skittish, and a handful of corporations with spare cash are reportedly shunning bank certificates of deposit and commer- cial paper as investments. A genuine li- quidity crisis necessitating speedy reac- tion by central bankers has not occurred, and faltering domestic corporations such as AEG-Telefunken, recently found their Luxembourg subsidiar- ies straining to raise funds after the Ambrosiano failure. Worldwide, a "tiering" of bank names is taking hold,_ with some banks paying more for borrowed money than others. And in an inter- bank market where 1,000 partici- pants-up from nearly 200 a decade ago-borrow and lend funds on a shorty' term basis, even the rumor of trouble can shut a bank borrower out. Bankers concede they cannot be sure of their ex- posure in the. interbank market because a single loan, to one bank ,j*nay go, through a series of borrowers and for- eign exchange conversions. '9hen Mexico's financial troubles ex- ploded in mid-August, the markets were prepared to believe that major U. S. banks would lose millions on loans made south of the border. In this panicky at- mosphere, rumors outran facts.' At one point; the spread between three-month U. S. Treasury bills-deemed a safe in- vestment-and commercial bank CDg widened to 300 basis points, or three percentage points, double what it had been days earlier. 't'he markets aren't necessarily adjusting appropriately or logically," says one bank economist: The dramatic reversal in Mexico's for- tunes strikingly demonstrates the chain of events that has transformed once- worthy borrowers into sickly debtors. Driven by the inflationary fervor of the late 1970s and brimming with deposits from OPEC, banks extended everincreas- ing amounts to hungry corporate and Approved For Release 2009/04/01: CIA-RDP84B00049RO01102640014-1 Approved For Release 2009/04/01 : CIA-RDP84B00049RO01102640014-1 sovereign borrowers. Commodity prices the debt pie declined. By 1982 commer- spiraled, oil seemed as good as gold, real borrowing costs were negligible, and the dollar was weak. Borrowers were con- vinced they could pay loans back in cheaper dollars. "The banking system can't be divorced from the world eco- nomic system," says David F. Lomax, group economic advisor at National Westminster Bank in London. "The OPEC situation led to an aberration, a permissive attitude to borrowing. That couldn't go on forever, and that is what's happening. We're seeing the withdrawal symptoms." From 1973 to 1981, long-term debt of less developed countries (LDCs) surged from $97.3 billion to $4252 billion (chart), an average annual growth rate of 20%. Debt owed by the East bloc alone soared from $7.9 billion to an estimated $80 bil- lion during the same period. And al- though government and supranational agencies such as the IMF and the World Bank played a part in recycling surplus dollars f-som OPEC to LDCS, their share of cial banks in the West held $327 billion, or 65%, of total LDC and East Bloc debt, up from 45% a decade earlier. But the world turned upside down for third-world borrowers when, in an effort to halt the inflationary spiral in the U. S. and strengthen the dollar overseas, the Federal Reserve System in October, 1979, began managing the money supply rather than " targeting interest rates. Real interest rates-those adjusted for inflation-had averaged only 0.85% from 1973 to 1980, rocketed to 10.68% in 1981, .and averaged 16.1% in the first half of this year. Each percentage point rise in the Lon- don interbank offered rate-the rate to which most loans to governments are tied-translated into an annual increase in debt service of $350 million each for the largest government debtors, Mexico and Brazil. _ . While borrowing costs climbed, the price and volume of commodity exports fell, and global recession dampened de- mand for third world goods and services. The impact on growth rates was severe: The rise in Latin America's gross domes- tic product, for instance, fell from 5.8% in 1980 to 1.2% in 1981. . Worse yet, LDC borrowers were forced into borrowing short term by banks that had soured on granting riskier medium- and long-term debt. The tendency be- came so widespread that by yearend 1981 fully 49% of Mexico's $57 billion in bank debt was coming due within one year. In 1982, Argentina must repay or refinance 47% of its bank debt, while South Korea, Chile, Venezuela, and the Philippines face similar pressures. Con- sidered less risky than term debt, short- maturity loans are generally cheaper and easier for borrowers to obtain, since a wide variety of institutions-including credit unions, insurance companies, and investment firms-are willing to extend such credit. But these institutions are- also the quickest to run at the first sign of trouble. "I worry about how every thing now is so short," complains the.. BUSINESS WEEK: September 6, 1982 81 Approved For Release 2009/04/01 : CIA-RDP84B00049RO01102640014-1 Approved For Release 2009/04/01: CIA-RDP84B00049RO01102640014-1 executive vice-presiaenc of a major U. S. 'bank. "Everything in the whole damn world comes due between now and next Tuesday." The high cost of cash and the clobber. ing of commodity prices have also hit the major oil producers. With the OPEC surplus projected to fall from about $60 billion in 1981 to near zero this year, several OPEC nations -themselves will have to borrow in world credit markets. Their new presence could easily crowd out some LDc borrowers and possibly put upward pressure on interest rates. And while the decline in oil prices would be expected to benefit nonoil-producing developing countries, some fear that the relief will be minimal. A study by econo- mist William R. Cline of the Institute for International Economics in Washington asserts that "for each $1 billion reduc- tion in the OPEC surplus, the deficit of nonoil developing countries 'declines by only $140 million, or 14%." Some bankers worry that the medicine used to bring the fever down-a heavy dose of monetary restraint-may have been too strong. "You get to the stage where the additional impact of monetar- ism gives you smaller and smaller re- turns in terms of reduction in inflation at a bigger and bigger cost in terms of the level of unemployment and the dislo- cation in the industrial and financial sys- tem," says Harry Taylor, president of Manufacturers Hanover Cori). Corporate casualties International bankers leave the New York Fed after a hastily called meeting, where they listened to Mexico's finance secretary plead for debt relief and new cash. Corporations, bankers point out, have a "bankruptcy option" that countries cannot afford. Says one U. S. bank econ- omist: "The portfolio weighted toward foreign sovereign debt is far more ee- cure than one weighted to private sector debt. A borrowing country cannot refuse to service its debt. It would be black- balled from the system." Problem loans to corporations are largely responsible for the swelling of loan loss reserves and "nonperforming" loans at U. S. banks. And while lower ...rates will mitigate financial strains for s -411b some corporations othe bl , r e una e The turnaround in economic conditions to recover from months of poor sales worldwide has whipsawed corporations and pitiful cash flow. Furthermore, cor- just as surely as it has devastated na- porate casualties lag behind recessions, tion-states. Until recently, the after-in- and bankers expect problem loans to flation and after-tax benefits of short- continue to climb in coming months. term bank borrowing, especially in the Evaluating the quality of loan portfo- U. S., encouraged companies to flock to lios and determining the size of loss re- the banks, rather than raise long-term serves needed to cover problem loans debt at high fixed rates. By the time will be the "hardest, most complex, and declining inflation had pushed real rates 'challenging task" confronting the bank- of int t t eres o record levels, corporate borrowers were caught in a vicious cir- cle. In order to pay off bank loans, they had to borrow still more money. The consequences of this squeeze are now becoming apparent. Such corporate giants as Germany's AEG-Telefunken, Mexico's Grupo Industrial Alfa, and In- ternational Harvester in the U. S. are struggling under a mountain of debt and asking their bankers for relief. Numer- ous other smaller companies are throw- ing in the towel, filing for reorganization and protection from creditors under bankruptcy laws. Corporate bankrupt cies and reschedulings promise to put a far deeper dent in bank earnings than do sovereign debt problems. "Compared with what the French steel industry owes us, Polish debt is a minor prob- lem," says an official at a French bank ing industry in coming months, says Thomas H. Asson, chairman of the bank- ing group at Coopers & Lybrand. Man- agement response to problem loans is "very judgmental," Asson says. "You can put 100 people in a room with 100 different portfolios, and they can come up with 100 different ways of dealing with the same credits." This variability is ultimately reflected in bank earnings. Because banks are in' the business of assuming credit risks, they constantly maintain a cushion, known as a loar, loss reserve, to cover potential losses. Additions to the reserve are deducted from earnings, so they have a critical bottom-line effect. As of June 30, the aggregate reserve level for 35 major U. S. banking companies had surged to $6.1 billion, or 1.02% of total loans, according to Salomon Bros. Inc. More nonperformers C 0 Only a tiny portion of this reserve was ali,;cated to cover possible losses on sov- ereign lending. Loans to countries have been viewed as "evergreen" because of continuous rollovers and government re- luctance to take the "bankruptcy op- tion." Regulators have looked the other way,' but now they. are considering a tougher stance (page 83) that would mandate reserve allocations against re- scheduled sovereign debt. Even if a Mexican rescheduling is successfully ac- complished, concedes one Texas banker, "anyone who thinks the risks aren't there for write-offs is kidding himself." The biggest risks, of course, still he in the corporate sector, and portions of Grupo Alfa's $2.2 billion in bank debt are reportedly already being reserved against possible loss by some banks. For those institutions with heavy ex- - posure to Mexico (table), a rescheduling MONEY & BANKING Approved For Release 2009/04/01: CIA-RDP84B00049RO01102640014-1 Approved For Release 2009/04/01 CIA-RDP84B00049RO01102640014-1 agreement that postpones principal pay- ments but keeps interest payments cur- rent will spare a huge addition to non- performing loans. The reason is that nonperformers fxe loans on which inter- est payments are in arrears,-usually by 60 days or more, loans that have been restructured with a lower interest rate, and foreclosed real estate- Increases in the nonperforming list are the best.-indication of trouble spots in a bank's loan portfolio. As of midyear, these problem loans at the 35 bank hold- ing companies that Salomon Bros. fol- lows amounted to $14.7 billion. Bank stock- specialists at Keefe, Bruyette & Woods Inc_ find that the nonperforming loans for 24 top banking companies amounted to 2.58% of total loans and foreclosed real estate. While on the rise, this figure is nonetheless well below the record 4.9% logged by the banks a fe?.; ' years ago. - Unsold condominiums Among the newest additions to the nonperforming lists at banks are energy and real estate loans. Inflationary expec- tations propelled banks to leap into these lending areas, but lower oil prices, mo- derating inflation, and high interest rates have rendered rauntless drilling projects and condominium developments uneconomical. Energy equipment manu- facturers such as Nucorp Energy Inc. and TOS Industries Inc. have filed for protection from creditors under bank- ruptcy law. Continental Illinois, strug- gling under the weight of $1.3 billion in problem loans, is owed $188 million by these two companies alone. The bank has also reserved against, and put on its nonperforming list, a portion of the $1 billion in energy-related loans it pur- chased from Penn Square. Crocker National Bank's nonperform- ers will rise $32.7 million as a result of the Tos bankruptcy filing. In a lending specialty where the,ability to predict the future value of oil reserves is- critical, too many bankers, says Philadelphia Na- tional Corp. President Richard S. Raven- scroft, "sure as hell weren't watching the downside." . In Florida and California, thousands of condominium units have gone unsold and developers are in arrears to banks that financed the developments. In Cali- fornia, where 60% of all recent housing starts have been for multi-unit develop- ments, there is an inventory overhang of some 50,000 new and unsold homes. San Francisco-based Bank of America is tracking 2,500 new units as "critical" and has already foreclosed on .550 units. BofA may try to unload .50 condo units in Southern California within the next 60 ,days by holding an auction. Despite the real-estate problems, BUSINESS WEEK: September 6. 1982 63 Approved For Release 2009/04/01: CIA-RDP84B00049RO01102640014-1 bankers insist that their difficulties are different and Jess severe than in 1975-76 following the collapse of real-estate in- vestment trusts. Says Joseph J. Pinola, chairman of First Interstate Bancorp, which has two-thirds of its $876 million in nonperformers in real-estate-related loans: "I'd rather have nonperforming loans collateralized by California real es- tate than some of the bad loans of East- ern banks." - The fallout from lending for real-es- tate ventures that have turned sour is not limited to U. S. banks. Canadian banks lent heavily to developers active in the U. S., and some of those develop- ers are now in serious trouble. Vancou- ver-based Daon Development Corp. re- cently suspended interest payments on its debentures and is furiously trying to get bankers to reschedule $1.9 billion in debt. And Canadian banks face myriad problems domestically, where nonper- forming loans, at $5 billion, are already four times greater than last year. Be- sides real estate, the trouble spots- in- clude the energy, mining, forestry, , and fishing industries. Eyeballing new customers Britain's Barclays Bank suffered a second-quarter drop in earnings because of loans made by its U. S. operation to troubled corporations here. Dresdner Bank and other German banks are owed $1.6 billion by AEG-Telefunken and hold nearly 60% of the insolvent company's stock. And Belgium's third-largest bank, Kredietbank, is owed $210 million by a Saudi Arabian money exchange-opera- tion that went bust a month ago. European banks have been forced to ante up embarrassingly large reserves to provide a cushion against losses. Around the world, major banks have been reporting lower earnings, and an international investment commu- nity worried about the possibility of large write-offs is. chipping, away at bank stock values. De- clining interest rates and the chance for banks to profit from sizable lending spreads over the near term may offset loan losses to some degree, but it is still an )J}ljf!/// rlliillti~llL SL.It Ye Citicorp's Theobald: "No statistical evidence" that the system is in crisis. follow the credits more closely," says one executive at a major Texas bank. On the international lending side, bankers concede that they have not paid sufficient heed to country-risk analysts who warned of heavy concentrations in certain areas: Now bankers, especially in the U. S., are looking toward what they hope will be greener pastures. For in- stance, lending spreads on local currency loans to prosperous Asian corporations can be especially lucrative and consis- tently reward international bankers with profits exceeding the paltry returns they can earn by buying a piece of a- sover- eign debt syndication. For all their difficulties, though,-bank- ers insist that the international financial system is resilient and that a major cri- sis will be averted, provided public confi- dence is sustained. "The market is react- ing as though these are the last signals were a modest $52 million during the first half of the year, or 0.18% of its average commercial loans outstanding. Says Theobald of Mexico's current dif- ficulties: "It's not a near-crisis point of unprecedented dimensions that's been visited on the financial system. There isn't any statistical evidence to say we're in a period of mom pressure and more strain than, At any other time." Theobald is not alone. Manufacturers Hanover's Taylor.contends that the re- cent spate of reschedulings has not dam- aged bank earnings but could improve them. "These countries, by and large, have been able to cope with meeting their interest payments," Taylor says, adding: "In fact, to the extent to which these events have broadened spreads, they're going to have a beneficial effect upon bank earnings." How many skeletons? Bankers point . out that individual banks fail every year and that while many people thought the failure of West Germany's Herstatt Bank in 1974 was a catastrophe, the system did not collapse. "There are hundreds of thousands of decisionmakers acting as lenders, deposi- tors, and borrowers," says Theobald. "No single event transmits itself to the marketplace. Mexico is not going to dis- appear, just like California is not going to disappear." The safeguards, Theobald and others contend, lie in the very diver- sity of the system. Bankers also assert that measuring whether a borrower can repay all of the principal owed is an unfair way of judg- ing the borrower's economic state or, for that matter,. the bank's prudence in granting the loan in the first place. They note that such worthy borrowers as the U. S. government .and American- Tele- phone & Telegraph Co. are not expected ever to repay their. entire debt, yet lenders continue.-'to extend money to them. - . Whatever strains the system is suffering, the biggest comfort to bankers and borrowers alike is the plunge in interest rates. Only if lower rates are sustained will the debt-service load on sover- With, their bankruptcy option, . .it's_ companies --more than countries--that -vex the banks inauspicious time for banks to acquire- much-needed capital through the sale of new equity. . Already there is talk of retrenchment and re-evaluation of lending practices, especially in those areas where banks have gotten caught. Texas banks, with long experience in energy lending and still relatively unscathed energy portfo- lios, nonetheless are scrutinizing pro- spective customers in the oil and gas industry more carefully. "We've told our loan officers they've got to watch the quality of receivables, debt levels, and before collapse," contends Bank of America Executive Vice-President Rich- ard Puz. "The news is not good, but the banks are strong." Indeed, Citicorp Vice-Chairman Thom- as C. Theobald points out that while Citi- corp's assets have grown at a compound annual rate of 5% during the past 2Yz years,- its international loans have ex- panded at only a 1% rate. The bank.hold- ing company's equity capital has grown at a 9.3% rate in the same period. Mean- while, Citicorp's actual losses on com- mercial loans outstanding worldwide Approved For Release 2009/04/01: CIA-RDP84B00049RO01102640014-1 eign and corporate borrowers lighten, world economies recover; and I.DC ex- ports revive. Meanwhile bankers will have to suffer the suspenseful and wrenching experience of rescheduling debts, foreclosing on properties, and swallowing losses of both money and pride. While many bankers believe relief is in sight, observers are not so san- guine. Having seen a host of problems, both expected and unexpected, hit the banks recently, they wonder, as Home of Smith Barney does: "How many live skeletons are there in the cupboard?" ^