Despite growing evidence that major banks face possible defaults by borrowing countries, and an absolute certainty that there will be significant "rescheduling" of payments that will reduce profitability, bank stocks are soaring, running well ahead of other booming Wall Street values.
The mounting exposure of commercial banks in the Third World and in Eastern Europe is demonstrated by the fact that nine major U.S. money center banks have outstanding loans just to Mexico and Brazil that more than equal their total equity, or capital.
According to a compilation prepared for The Washington Post by the Institute for International Economics of Washington, D.C., the nine banks have loaned Mexico $11.6 billion and Brazil $10.6 billion. That total of $22.2 billion exceeds their combined capital, amounting to $21.07 billion.
The nine banks, in no particular order of exposure, are Bank of America, Chase Manhattan, Citicorp, Manufacturers Hanover Trust, Bankers Trust, Chemical, First Chicago, Continental Illinois, and Morgan Guaranty.
If their equity were to be defined more broadly as capital plus subordinated debentures plus reserves against losses, the total comes to about $26 billion. In that case, the nine banks' loans to Mexico and Brazil come to 85.1 percent of equity. And the total exposure of the nine banks in the Third World and Eastern Europe comes to 240.1 percent of broadly defined capital [see chart].
Bank specialist George Salem of Bache & Co., ticking off spectacular increases in individual bank stock prices since they hit a low on Aug. 12, said: "The market is taking a lot on faith, when you consider the synchronized stagnation in the world's economy. We've gone from the deepest gloom of the post-war period to the most euphoric."
For example, Citicorp stock has jumped from 22 1/2 on August 12 to 38 1/2 on Friday, a gain of 71 percent; Chase Manhattan, from 32 to 54 1/2, a gain of 70 percent; Morgan Guaranty, from 48 3/4 to 68 1/2, a gain of 41 percent; and Manufacturers Hanover, from 27 1/8 to 39 3/4, a gain of 47 percent.
Euphoria on Wall Street hasn't convinced many others that the crisis has been somehow mitigated. Sen. Henry M. Jackson (D-Wash.), for example, calls on the United States and the other major powers to take concerted action to restore confidence in "the creditworthiness of banks."
From the standpoint of the developing countries, World Bank economist Chandra S. Hardy argues that unless the problem is seen and attacked as a global one, and not as "a quick fix" for Mexico and Poland, there will be massive defaults on that part of the debt due in the next three years -- $300 billion.
This past summer's Mexican crisis (debt: $80 billion), coming on top of the Falkland Islands war (Argentine debt: $37 billion) and a quasi-default in Poland (hard currency debt: $23 billion) sent a 1930s-like chill through world financial markets.
Total Third World external debt is estimated at more than $600 billion -- of which 60 percent is owed to banks. Latin America alone, with economic growth slipping, accounts for about $250 billion of that. Manufacturing company bankruptcies and bank/S&L troubles in the United States and Europe don't add to public confidence in the financial structure.
IMF Managing Director Jacques de Larosiere, in the midst of tense negotiations for an emergency loan of close to $5 billion to Mexico, has warned that the developing countries are caught in the cross-currents of rising debt service payments, low commodity prices, and slack demand for their exports. Banks will have to avoid a counter-productive pullout, while the poor countries will have to undergo still more belt-tightening, he says.
From the standpoint of the overall financial system, Salomon Bros. expert Henry Kaufman warns that because much of the commercial bank lending in the past decade has bought inflation rather than real economic growth, "none of us in finance should look with any confidence at the massive debt rescheduling facing us today." As it stands, according to Hardy, 90 cents out of every dollar being borrowed is going to service old debt.
The interest payments due from Mexico and Brazil this year to the nine banks in the economics institute study amount to $3.66 billion. Since total profits at these same banks last year were only $2.76 billion, it is clear that if any significant postponement of interest payments is required to tide those countries over, the bottom line for those banks would look pretty grim -- regardless of what Wall Street is saying at the moment.
Banking, of course, is a highly leveraged industry, and it is common practice for total loans to run 20 to 30 times capital. There is no "country limit" on the amount a bank can lend to a single country: the only restraint is that not more than 10 percent of capital can be loaned to any one "entity." Thus, by dividing loans to a foreign country among several agencies or departments, nothing except a common-sense approach inhibits a bank from lending many multiples of 10 percent of capital to any one country.
One view in the banking world, best articulated by Citicorp Chairman Walter Wriston, is that banks have and should have considerable leeway in their lending because sovereign nations don't go broke. But other bankers, like Robert V. Roosa of Brown Bros. Harriman, have challenged that view.
Economics institute economist William R. Cline believes that the time has come "to think of some concept of country limits" because the banking system has become so exposed to what happens in a number of developing countries around the world. Just what that might be is debated at the highest levels. Federal Reserve Governor Henry Wallich has suggested that there are many lessons to be learned from the present crisis, including the need for "more careful work" in analyzing the creditworthiness of individual borrowers.
Kaufman noted in a recent speech in Tokyo that "to believe, as some do, that debt rescheduling by sovereign nations is the equivalent of the U.S. government rolling over its debt at weekly Treasury bill auctions fails to recognize simple but crucial differences."
In an article on this subject in the Columbia Journal of World Business, Cline noted that default by any major borrower would cause "severe liquidity problems, and could conceivably cause insolvency for some banks."
But because the borrowing countries have a strong incentive to avoid an outright default (to maintain credit access for the future), as do the banks (to avoid having to write the loans off their books), rescheduling -- a fancy word for renegotiation and postponement -- has come into vogue.
A study by Hardy for the Overseas Development Council shows that since 1975 to the end of 1981, there have been 25 reschedulings for 14 Third World countries, involving total debt of $10 billion, compared with 30 for 11 countries involving $7 billion between 1956 and 1974.
The amount in arrears rose in 1975-81 from only $500 million to $5.5 billion. Both the number of renegotiations and the arrearage are bound to increase in the years ahead, she says.
Although rescheduling is infinitely preferable to default, it is not a costfree procedure. Hardy argues that the process has served neither the banks nor borrowers well, because the process is crisis-oriented and uncoordinated. She believes the present situation cries out for someone or some country to take leadership in a massive transformation of debt into longer maturities at much lower interest rates.
Cline notes than in a typical large rescheduling (such as the one now underway with Mexico), the bargaining position of the borrower "is sufficiently strong that below-market interest rates" are likely to be negotiated, causing losses for the banks -- although less than would happen by way of an outright default.
He notes that the banking establishment takes the view that the system will muddle through -- that it always has in the past. "You have to be myopic to hold to that view today," Cline said.
How, then, explain the boom in bank stocks? Bache's Salem, who concedes he's stunned by the explosion in bank share prices, says "sometimes I think I'm a voice in the wilderness." He feels the boom is hard to explain, given the international crisis, plus the fact that barely two months ago experts were compiling lists of banks that might not survive.
On the other hand, analyst Irving S. Geszel of Bear, Stearns & Co. finds a logical explanation for rising bank stock prices "in [today's] disinflationary environment, [where] the likelihood is that investors are willing to buy shares in financial assets." The move, Geszel feels, is away from real asset hedges like gold and oil toward financial assets, like bank and insurance stocks -- which have also been rising. Declining interest rates, he adds, increase the ability of banks to take losses, and improve the quality of their loan portfolios.