Let Banks Close the Value Gap : Secondary Markets Could Be Route Out of Latin Debt Crisis

Citicorp’s bold and dramatic decision to set aside $3 billion of reserves against its outstanding loans to Third World countries carries several messages to financial markets.

One of the most important is that for the first time, the difference between the face value and the market value of these loans--the “value gap”--has been publicly recognized.

Financial innovators have recognized this gap for more than two years, and so-called secondary markets, in which banks sell each other their developing-country loans at substantial discounts, have cropped up to help close it. The rapid development of these markets has made it possible to reduce the debt burden on lenders and borrowers alike--and without bankrupting either.

Secondary markets make clear just how much banks overvalue their developing-country loans by keeping them at original book values. By last September, commercial banks had on their books $77 billion in outstanding loans to the 12 biggest problem debtor nations. Secondary markets valued these loans at no more than $50 billion. Thus Third World debt remains a problem, largely because this $27-billion “value gap” remains open.

Foreign governments have been quick to recognize the worth of secondary markets in reducing the value gaps that their banks face. The Japanese in particular have begun to draft rules allowing their banks to take advantage of the new opportunities.

Unimaginative regulators in this country, however, have hobbled U.S. banks in their efforts to compete. America’s dominant position in global finance may be shaken badly before Washington wakes up.

Regulators remain fairly unconcerned, perhaps because secondary markets were born not in the corridors of multilateral development banks, or in the offices of regulatory authorities, but on the profit-oriented trading floors of the world’s major banks. Traders literally buy and sell the rights to receive interest and principal payments from Third World debtors. Buyers of such loans pay less than face value because of the risk that these payments will be made late or even never. Sudan’s debt, for instance, trades for as little as two cents on the dollar. Secondary market volume came to about $6 billion last year, most of it U.S. commercial bank loans to the very biggest developing-country borrowers now in trouble.

What makes all this buying and selling so important to reducing the debt problem? Secondary markets now offer a compelling way both to value high-risk debt and to transfer this debt to those who can bear the risk best, and sometimes even use it. Market-generated alternatives now exist to the familiar lend-and-reschedule formula.

Last month’s deal between commercial banks and the Philippine government illustrates how secondary markets give new flexibility. The Philippines will soon start to cover part of its interest payments with zero-interest investment notes convertible into equity there.

But such debt-equity swaps are not the only way to use a thriving secondary market to make sovereign debts more flexible, more bearable and more payable. Trading debt also allows banks to clear their balance sheets of developing country loans, freeing capital to support more profitable fee-based activities such as note issuance facilities. The question now is whether enough buyers can be found to absorb the billions in debt that banks would like to sell.

The Japanese, ahead of the pack in exploring the potential of secondary debt markets, have already come up with one possible answer to this problem: create a company jointly owned by banks to buy and hold developing country loans. The cleverly designed plan is supposed to have little or no impact on either the Japanese government’s tax revenues or Japanese banks’ tax payments.

But while Japan and the Philippines push back the frontiers in the use of secondary markets, the United States lags far behind. A new American approach is needed, with three main elements.

- Some regulation of secondary markets is needed to ensure that full information on traded debts is available to buyers. Such regulations would tend to broaden the range of buyers and help prevent dubious practices.

- Bank regulators should borrow ideas from the Securities and Exchange Commission on how to regulate trading and how to use market costs rather than historic costs. Bank regulators know loans best. The SEC knows tradeable instruments. As the securitization of debt continues, bank regulators must supplement loan regulations with trading regulations.

- Legislation should be enacted obliging the accounting profession to prepare a softer playing field for U.S. banks. Especially needed are provisions permitting written-down loans to be charged off over several years instead of immediately.

The prime goal of creating a new regime would be to shut the value gap in commercial bank portfolios of developing country debt. This $27-billion gap needs to be closed before U.S. banks can be considered out of grave risk from defaults on sovereign debt. Regulatory changes that free banks to solve their problems will be cheaper and simpler in the long run than a government bailout of a crippled major bank.

The alternative is to stay chained to an unstable cycle of crises, reschedulings and involuntary lending. Today’s regulatory environment offers banks no real choices, no real escape.