Junk-bond specialist considers job purveying third-world debt
Coming soon: third-world junk bonds? Drexel Burnham Lambert, the folks that made junk bonds famous, think a market in the debt of less-developed countries (LDCs) may be opening up.
``We like large markets,'' said Drexel chief executive Frederick Joseph last week. ``We like inefficient markets. And we like markets where it's difficult to analyze the debt. Banks are recognizing a need for an aftermarket in this debt.
``We are very excited'' by this opportunity, Mr. Joseph said.
Last month, Citicorp dumped $3 billion into its loan-loss reserve to cover possible writeoffs of Latin American loans. Citicorp chairman John Reed, meanwhile, has outlined plans to become a major player in debt-for-equity swaps - one means of getting these loans off the bank's books.
Other large New York and even regional banks are taking similar steps. Indeed, Bank of Boston is now negotiating a deal that would give it a $20 million stake in a Philippines bank.
``Citicorp has fundamentally changed this market,'' says Jerry Finneran, a senior vice-president in Drexel's Beverly Hills, Calif., office. ``It's created an environment of mutual pressure on banks and the LDCs to solve these problems in the marketplace. We see a real opportunity here to securitize this debt.''
But others disagree that there are major opportunities - or at least are more qualified in their assessment.
``Over the coming years, this market will be blossoming,'' says Kenneth Telljohann, a vice-president with Salomon Brothers.
Last year, about $8 billion in complex LDC loan swap deals were made. A growing percentage of the marketplace consists of debt-for-equity deals.
Typically, banks sell a shaky loan to an international company at a discount, say 60 cents on the dollar. Then the company swaps the IOU with the debtor country for local currency valued at, say, 80 cents on the dollar.
The company usually must then invest the money in an economic project in the debtor nation, stimulating business. This allows the country to reduce some of its indebtedness and the bank to extinguish some of its problem loans.
There are also deals of debt-for-debt (a bank swaps a Mexico loan for a Poland loan); debt-for-cash; and sophisticated chain-linked combinations and variations. This year, Salomon Brothers predicts the market will grow to $10 billion to $15 billion.
Counting the new reserves being set aside by banks, the market now may be as large as $25 billion.
But therein lies the problem. The banks are ready to sell these loans, and only Chile, Mexico, and the Philippines have active debt-equity programs.
``There's a tremendous amount of supply and few buyers,'' says Mr. Telljohann.
The Citicorp move has sent prices of loans already for sale plummeting. A month ago, some Mexican loans were priced at 60 cents to the dollar. By this week the bid had dropped to 56 cents.
``A one or two point drop for this market is volatile,'' notes Telljohann.
To attract buyers, two things need to happen, he says. ``We need to see more debt-equity programs getting off the ground. We'd like to see Argentina, Brazil, and Venezuela doing more, as well as Ecuador, Dominican Republic, and Jamaica.''
And, ``securitization has to happen before the market can explode. But we're still very much in the research and development stage,'' says Telljohann.
In that regard, the investment bankers are trying to dream up new instruments and unusual deals to broaden the investment appeal. Debt swaps tied to perpetual floating rate notes, airline purchases, and various real estate deals have been tried.
Martin Schubert, chairman of European InterAmerican Finance Corporation, is one of the pioneers of debt-equity swaps. He has tried many variations. But Mr. Schubert thinks the expectations for the debt market are overblown.
``I can't see when this indebtedness will ever be securitized in a way that will be attractive to investors,'' he says. ``It won't be a capsulized junk bond. Who's going to buy any instrument secured by Latin American indebtedness when the principal payment is uncertain at best?''
Schubert allows that the interest payments could be stripped from the principle and sold as a security. Such an investment might appeal to sophisticated clients, such as those that buy Drexel's junk bonds.
But each time a country renegotiated its interest payments, this security would be at risk. And for the most part, interest payments by third-world debtors have been pushed lower, not higher.
Schubert sees other flaws with a stripped security.
``I don't know if the banks will even sell the interest payments alone. Then you have the problem of who'll buy the principal. The banks don't want to keep the principal on their books. That's what this is all about.''
The only marketable solution, Schubert says, involves a World Bank orchestrated product. If the World Bank creates, securitizes, and guarantees a long-term debt instrument, investors would find that palatable, he believes.
``Unfortunately,'' he adds, ``the World Bank wants no part in restructuring debt and securitizing it.''
At this point, only a few believe the debt-equity swap market will develop to the point where it can handle a significant portion of the loans banks want to get off their books.
``How many Mexican hotels can you buy? Are there really enough good investment opportunities worth swapping this debt for?'' one banking analyst wonders.
But Wall Street and Citicorp, in particular, are mounting a determined effort. Citicorp is mobilizing its huge Latin American investment banking group to dig up equity investments. The bank also has 20 venture capitalists fanning out across the continent.
But if a liquid market in debt-equity swaps can be developed, there's sure to be a lot of interested players, including foreign and US regional banks.