Federal regulators began meeting in secret yesterday to consider requiring U.S. banks to downgrade some of the $22.4 billion in debt owed them by Brazil.
If the regulators decide some of the debt is worth less than the full amount, banks would have to set aside money in a special reserve to cover Brazilian loans that go bad. Such a move, which would be on top of the general reserves banks keep for potential loan losses, would depress bank earnings at a time of great fragility in the financial markets.
It also would be the first time that the government has declared that loans to a major debtor nation were worth less than their face amount, or "value-impaired" in banking jargon. Regulators have made those declarations in the past for such smaller countries as Poland, Zaire and Nicaragua.
Altogether, Latin American nations owe their public and private creditors nearly $400 billion.
However, experts said regulators, fearful of injecting more uncertainty into the tumultuous financial markets, were likely to bend over backward to avoid the downgrading.
"It would set a tremendous precedent in terms of a major debtor being classified as value-impaired at a time when there are much bigger fishes in the pond," said Christine Bindert, senior vice president of Shearson Lehman Bros. "This is not something the market needs right now. We don't need any more bad news."
On the other hand, Brazilian negotiators have indicated here and in Brazil that they are aware they can use the decline in the U.S. stock market to their advantage. If the regulators do not require downgrading of a portion of the Brazilian loans, such other debtors as Mexico and Argentina could become skeptical about the banks' frequent warnings of the dangers of downgrading if payments are not kept current.
"I think it would be a pity indeed if our government blinked," said one banking source. "It would be a hollow threat to other countries. I think we are all waiting and biting our fingernails."
Brazil suspended payments on its $67 billion of commercial debt last Feb. 20, but in the last two months has begun negotiations intended to lead to a resumption of payments. In the meantime, the accumulation of back interest has made Brazil the largest Third World debtor, owing a total of about $111 billion. Mexico, the former number one debtor, now is second with a debt of about $108 billion.
Most recently, Brazilian negotiators have told U.S. government officials and bankers that they might make a token payment or other gesture to induce the regulators to postpone the downgrading. Consideration of the downgrading is required by a 1983 law that empowers a committee comprised of three agencies -- the Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corp. -- to evaluate a country's credit risk on a regular basis.
Although results of the meetings of the Interagency Country Exposure Review Regulatory Committee will not be known for at least several days, analysts said the collapse of the stock market makes it likely that regulators will try to sidestep the rules requiring that a country's debt be reclassification if it meets certain conditions. Brazil has met most of those conditions, which include being behind on interest payments for six months and refusing to cooperate with economic reforms imposed by the International Monetary Fund.
Last week, chief Brazilian debt negotiator Fernao Bracher met with Fed Chairman Alan Greenspan and Assistant Treasury Secretary David C. Mulford and said his country would consider making a token interest payment that would be deposited in a sort of "escrow account" with the Bank of International Settlements, an international financial clearing house.
Earlier this year, major banks made large additions to their general reserves to cover potentially sour debts to Third World nations. The additions to reserves were subtracted from the banks' income, leading the banks to lose more than $10 billion in the second quarter of 1987. The additions to the special reserve fund would probably be smaller, perhaps 10 to 15 percent of the banks' Brazilian debt, but also would reduce the banks' bottom line