For all the Reagan Administration's efforts to resolve the Third World debt crisis, the longstanding rivalry between two big banking firms here--venerable J. P. Morgan and brash Citicorp--played a far bigger role in creating last month's dramatic breakthrough on Mexico's foreign debt payments.
Last May, while Treasury Secretary James A. Baker III was formally opposing any acknowledgment that Third World nations would not be able to fully repay their huge debts, Citicorp Chairman John S. Reed set the stage for a new understanding by abruptly announcing that he would set aside $3 billion to absorb potential losses on the bank's Latin American loans.
The move stunned and infuriated many bankers and government officials because it was unilateral and came without warning. But, with the young and relatively new Citicorp chairman receiving widespread acclaim outside the industry for finally admitting the obvious about Third World debt, Morgan's chairman, Lewis T. Preston, wanted to recapture the initiative, industry officials say.
Within weeks, Morgan officials presented Mexico with their own innovative approach. Baker was brought into the planning only a couple months ago, when Mexico asked the U.S. government for help in putting together the final pieces of the puzzle.
The result was a complex plan, involving up to $10 billion in Mexican bonds backed by a new issue of U.S. Treasury securities that would allow Mexico to retire between $5 billion and $10 billion of the $78 billion it owes to international banks with a relatively modest cash outlay. The banks, in return for accepting less than face value on current unsecured loans trapped in their portfolios, would receive from Mexico a more secure bond that would be freely tradable on the open market.
"Nothing beats revenge as the mother of invention," one senior banker at a major regional firm said. "Citicorp may have forced everyone to start dealing with reality, but Morgan has now established a new framework for a positive approach to the problem."
Banks Lead the Way
And Morgan officials, while praising the Treasury for its support, acknowledge that they could have put together a similar deal without official U.S. government help simply by purchasing the Treasury bonds, which will be used as collateral on the open market and not cost the government anything.
"After five years, you had creditor fatigue and you had debtor fatigue," Dennis Weatherstone, Morgan's president, explained. "The timing was right for a different kind of solution."
The jockeying between Morgan and Citicorp over Third World debt is only one of many recent cases in which the major banks are dragging government officials along in key economic policy arenas. Now, Morgan is helping to lead the assault on the Depression-era Glass-Steagall Act, which prevents banks from entering the securities business and keeps banks and securities firms from competing against each other.
"We have been preparing for these new opportunities for some time and have been disappointed at the rate of progress," Weatherstone said. "The world has changed. Our customers' needs have changed because we're in a global marketplace. . . . By necessity, it's time to open up these markets to improve their efficiency."
For Morgan, such activity is particularly intriguing. Morgan Guaranty, J. P. Morgan's commercial bank, has long been one of the stodgiest and most private of the nation's major banks. Despite having the strongest capital of the big U.S. banks, it was the slowest to follow Citicorp last year in boosting its reserves against potential Third World debt losses. But, buoyed by its recent success, Morgan has been coming out of its shell.
The Mexico-Morgan proposal marks a major turning point in the struggle to ease some of the burden that is holding down the world's deeply indebted countries, mostly in Latin America but also including the Philippines. Although Mexico--with much more foreign exchange in its coffers than most other debtor nations and with a record of improved economic performance--is uniquely situated to buy up its own debts, other countries should be able to take advantage of similar plans.
"Each one may have to be tailor-made for other debtor countries," Weatherstone said, "but if this deal is successful, we think there will be opportunities for other countries fairly promptly."
Already, Venezuela, Latin America's fourth-largest debtor, is looking at a similar plan to buy back part of its $33 billion of foreign debt at a discount, using a new issue of bonds as payment. Other countries lacking substantial reserves may look to Japan, West Germany, and the World Bank as potential sources of credit and guarantees for different kinds of debt payoff arrangements.
Indeed, "everyone will be clamoring to do similar financial engineering deals," said Alan Stoga, senior economist for Kissinger Associates here. "It's a way of rewarding debtors for playing the game by the right rules."
Before Morgan developed the Mexican debt scheme, commercial banks and government officials had been locked into a strategy demanding that debtor countries should continue to meet their interest payments on their full debts. At the same time, banks were being continually squeezed by U.S. officials to lend additional sums to tide the major debtors over until their economies could generate robust export surpluses to meet those increasingly burdensome obligations.
While avoiding government-imposed debt writeoffs, the new approach creates a voluntary, market-oriented path for banks that helps shrink the existing pile of Third World debt rather than adding to the already immense $1 trillion in outstanding loans.
"In effect," said Richard E. Feinberg, vice president of the Overseas Development Council in Washington, which specializes in Third World issues, "Morgan Guaranty and the U.S. Treasury have joined the debt-relief club."
Under the plan, Mexico will be able to reduce its current debts, saving an estimated $400 million to $600 million in annual net interest costs. In exchange for eliminating between $15 billion and $20 billion of its current debts, Mexico will dangle in front of the banks the lure of receiving up to $10 billion worth of new bonds on which it will pay a somewhat higher interest rate than those on its existing loans.
Because the Mexican bonds will be backed by a special issue of U.S. Treasury bonds guaranteeing repayment of the principal in 20 years, many banks will have a powerful incentive to sell loans in their portfolios back to Mexico at discounts of as much as 50 to 70 cents on the dollar. Banks would formally have to accept big losses on those assets, but in return they would replace practically unsalable loans of dubious value with a smaller amount of more secure bonds that could be freely traded on the open market.
Mexico's cash outlay on the deal would be only about $2 billion because the Treasury Department would issue special zero-interest bonds, to be held in safekeeping by the Federal Reserve, that would be worth $10 billion in 20 years. (Zero-interest bonds do not pay any regular interest, but they are sold at discount prices. When redeemed for face value at maturity, they yield the equivalent of interest.)
For the U.S. government, the plan is a winner as well, because the effective interest rate it would end up paying on the bonds would be slightly less than its current borrowing costs.
Given the advantages to all the players in the Third World debt situation, why didn't it happen earlier? "The timing for Mexico, for the banks and for the U.S. was right," Weatherstone said. "A solution of this nature, if it had been premature, could have had severe, adverse, systemic consequences."
For example, if it had come before other U.S. banks followed Citicorp's earlier move and themselves set aside substantial reserves for potential Third World loan losses, the banks would not have been in a position to respond and the backlash from Latin America would have been severe.
Nonetheless, Weatherstone hinted at Morgan's peeve over Citicorp's earlier move to make provision for future Latin American loan losses. "The provisioning was a decision on the part of the lending banks alone," Morgan's president said. "We regarded this as an effort to change the method of dealing with a particular debtor situation involving all the parties, rather than just one group."
Now that Citicorp and Morgan have both changed the terms of Treasury Secretary Baker's debt strategy, the two banks finally seem to be finding common ground. Citicorp immediately praised Morgan's proposal as offering "a new element of market-based flexibility for banks." Mexico, Citicorp said, "is well-placed to make such an exchange offer."
Policies Finally Right
As the U.S. banking industry slowly recovers from the overwhelming burden involved in keeping one step ahead of the evolving Third World debt crisis, the next move on the horizon is to expand its powers to compete with Wall Street investment houses for the right to underwrite corporate securities.
Retiring Senate Banking Committee Chairman William Proxmire (D-Wis.), a longtime supporter of the Glass-Steagall Act of 1933, which separates investment and commercial banking, has called for its repeal as part of a broad effort to bring financial regulation in line with the reality of a global marketplace.
Morgan, once the nation's premier bank and lender of last resort in the days before the Federal Reserve was established in 1913, has long been itching to get back in the investment banking business. And the politics may finally be right for the banks to call the tune once more.
"We've got a united position among the banks and a more divisive position among the securities firms," Weatherstone said. "So we think this is a very opportune moment for some legislation."