"Any banker that thinks he will get repaid is living in a fool's paradise."

A senior New York financier closely involved in the Third World debt crisis.

Although U.S. bankers with outstanding loans to developing nations are concerned about repayment, some financial experts believe that the critical issue facing the banks is whether borrowing nations can continue to pay the interest on their debts.

If they stop interest payments, bankers must write down their loans as "nonperforming assets," and take a loss. For many large U.S. banks, their loans, or assets, in the developing world are so big that such losses could be devastating.

The most ominous threat hanging over the world banking system is that a big borrower, such as Brazil or Mexico, will give up trying to honor its debts and declare default. But this would deliver such a blow to the system--hurting borrowers, lenders and bystanders alike--that banks, governments in the industrialized and developing world and international agencies will do all they can to avoid it.

What is worrying a number of experts is that the costs imposed on developing countries by the financial rescue packages that have been designed thus far are so great that they actually increase the chances of a default, or something close to it, such as a unilateral refusal by a big borrower to pay interest on time.

The packages focus on the short-term, liquidity aspects of the debt problem, stressing the need for deflationary policies in borrowing nations to reduce their dependence on foreign cash and avoiding any move to make banks take losses.

This "approach risks forcing excessive costs on borrowers that would increase the chances of nonrepayment of interest or principal," Morgan Guaranty Bank points out in its latest monthly issue of "World Financial Markets."

So far, no debtors have taken that step. Apart from Poland, which bankers say is effectively insolvent, borrowing nations are still trying to service their debts.

But it is a measure of the crisis facing the world's financial system that the big borrowers can service their debts only by piling still more debts on the billions of dollars that they already owe to foreigners.

Over the next three or four years, bankers will have to add to their overseas lending by at least 7 percent a year in order to save borrowing nations from going bankrupt, experts calculate. But this new money will not enable Brazil, Mexico and others to buy more from overseas. It will be needed simply to enable them to service the debts that they already have.

In order to meet their interest payments fully, debtor nations will also have to shrink their demand for imports and boost exports. Economist William Cline of the Institute for International Economics estimates that, for the next three or four years, there will be a net transfer of resources out of developing countries (excluding members of OPEC, but including Mexico) as these nations' interest payments to overseas lenders exceed the inflow of new capital from abroad.

The recessions necessary to achieve that kind of transfer are painful. Brazil, owing more than $80 billion overseas, has already found it impossible to stick to the original economic program to which it agreed with the International Monetary Fund. It is now in its third year of recession, and the military government faces considerable opposition to further austerity measures.

However, officials are now struggling to come up with a new package that will satisfy Brazil's creditors, and persuade them to go on lending.

Mexico, which also has foreign debts of between $80 billion and $90 billion, is at present in compliance with the IMF. But Finance Minister Jesus Silva Herzog recently warned that the nation's political stability would be threatened if it had to endure more than two years of recession or stagnation.

There is a two-fold reason for Mexico, Brazil and others to take the unpleasant medicine. First, default would be even more costly because it would cut off all access to credit markets and would probably also lead to trade sanctions against borrowers. Second, debtor nations hope that, as recovery comes and their economic performance improves, they will be able once again to borrow overseas to fund domestic investment and growth.

Banks, likewise, have an incentive to go on lending now: they do not want to turn their old loans bad. But a very delicate balance must be struck between the interests of the borrowers and the banks to ensure that banks go on lending what the nations need, but at a price they can pay.

The price that banks have charged so far is high. They actually have improved their earnings as a result of their "rescue" efforts during the first wave of troubles over Third World debts. This was accomplished by collecting hefty fees in return for agreeing to refinance maturing debts and pump new loans into nations like Mexico and Brazil. More important, the banks are charging these nations interest rates that are substantially higher than the cost of money to them.

As European and Japanese banks made concerted attempts to increase their Latin American loan portfolios in the late 1970s and early 1980s, they drove down rates to razor-thin margins over the cost of money.

One official of a major U.S. bank that is a heavy lender to Latin America but was not directly involved in the negotiations said he was flabbergasted at the terms on the Mexican and Brazilian refinancings. He said his bank is earning between 2 and 3 percentage points over the cost of money, compared with less than 1 percentage point before.

"I think that is ridiculous. Now is the time when they need our help and we're sticking it to them," another senior banker said. When banks try to help troubled companies like International Harvester, he said, they ease the terms on the loan--settling for lower profits on the loans but making it more likely that the company will continue to be able to repay.

"I think the banks are being rather foolish," said Geoffrey Bell, a member of the Group of Thirty, a New York-based study group that includes many current and former international financial officials and bankers. "It won't be that long before we get to the stage when countries find it difficult to continue to pay interest," he said, adding that "one of the first things that's got to go is excessive margins" between the cost of money to the banks and the interest rates they charge.

"What Brazil and maybe some other Latin American countries need is the moral equivalent of capital--long-term, fixed-rate loans--rather than floating-rate loans that could balloon in cost if interest rates go up again," said a senior banker.

He said banks would make less money if they converted many of their current loans to a long-term, fixed rate basis. But the underlying assets, the loans themselves, would be far less risky, he said. The less the borrowing nations have to pay to service their debts, the smaller the risk that they may choose instead to repudiate them.

"I'd be willing to pay that price," this banker said. "But I've got a lot smaller percentage of my portfolio tied up in Latin America than some banks. If you were Citibank, with 20 percent of your profits coming from Brazil, you'd be a lot less eager to substantially ease the terms."

That is the problem. Not only would other banks be "less eager" to ease terms, but "writing off portions of existing obligations" would be so costly to the banks that "it would jeopardize new flows of money to the LDCs and to domestic borrowers as well," Morgan Guaranty argues. In other words, such a scheme would achieve precisely the opposite of its aim, opponents argue, by choking off the urgently needed additional financing for developing countries and "turning good debt into bad debt."

The rationale for higher margins is, of course, that new and rescheduled loans to developing countries are riskier than the less profitable lending of the past. Indeed, since banks are now lending to many Third World borrowers only because they are forced to, it is possible to argue that even today's high spreads are below the "market rate," one official said.

The problem is that there does not seem to be a "market rate" in the sense of a rate that would attract sufficient voluntary lending to enable borrowers to pay their bills and service their debts. The terms of new loans are "less a point of discussion than just the do-ability" of raising new money, one New York banker commented. Cline agreed that "the key issue in the availability of funds."

But he also believes that higher margins probably do work to encourage lending, even though bankers would prefer not to lend any more money to troubled nations at any interest rate and are doing so because they are forced by institutional arrangements rather than attracted by the prospect of commercial gain.

The additional cost to borrowers of wider spreads will have only a minimal impact on the incentive to default, he said, while it has a substantial impact on banks' profits and therefore on their willingess to lend more.