Citicorp Breaks Ranks

By Stephen Koepp

Rumors of what Citicorp Chairman John Reed was about to say had already roiled stock and bond markets last week as the trim executive stepped up onto a rostrum in Manhattan. Soon the confirmation flashed around the world: the largest U.S. bank (1986 assets: $196.1 billion) had made an almost heretical break with the U.S. financial community's long-standing practices in handling its crushing burden of $62 billion in Third World debt. Reed declared that Citicorp intends to set aside, effective immediately, no less than $3 billion in additional reserves to cover loan losses on its $133 billion portfolio, bringing its total reserves to $5 billion. The drastic move will give Citicorp a net loss of $2.5 billion in revenues in the second quarter of the year, its first red ink since 1934 and the second largest quarterly deficit in U.S. corporate history (the largest: AT&T's $4.8 billion in 1983). The bank will also show a $1 billion deficit for all of 1987. Said Reed: "We believe this step will significantly strengthen the institution."

Citicorp's tough decision is intended to buttress the bank's financial statement, which until now has been steadily profitable (see chart). But the move could have a profoundly unsettling effect on the hundreds of other international banks and dozens of debtor countries involved in the five-year- old Third World debt standoff. At one stroke, Reed had admitted that Citicorp, and probably most other large banks as well, may never collect on major portions of the onerous Third World debt burden.

That admission could bring on increasingly stormy international debt negotiations, since banks may no longer be willing to continue the seemingly interminable cycle of stretched-out loans and infusions of cash that have so far characterized the debt tango. At the same time, Citicorp's move could jar the Reagan Administration's so-called Baker Initiative to ease the international debt problem by encouraging moderate Third World growth through measured dollops of additional loans. Citicorp's decision to set aside funds puts pressure on other heavily exposed U.S. banks to do likewise. That policy, in turn, could help push up interest rates as the institutions seek to recover the costs of their set-asides.

Despite those risks, Wall Street gave Citicorp a vote of confidence. At first, apprehensions about the bank's write-off announcement rekindled the stock market's hair-trigger fear of a banking crisis. Partly as a result, the Dow Jones average of 30 industrial stocks took a nose dive of 37.38 points on Tuesday, just before Chairman Reed made his disclosure. The market quickly stabilized the next day, and Citicorp's stock rose to close the week at 55 3/ 8, up 4. Investors praised Citicorp's openness. Said an approving Lowell Bryan, a director of the Manhattan-based McKinsey consulting firm: "This is the start of realistic accounting."

Treasury Secretary James Baker gave Reed a more tepid endorsement. Said he: "I venture that all in all it will be seen as a positive step." Baker, who presumably had concerns that Citicorp's actions might discourage other banks from participating in his Third World initiative, nonetheless expressed hope that the bank will continue lending in Latin America, where it has $14.8 billion in loans outstanding. Citicorp is particularly exposed in Brazil ($4.6 billion), Mexico ($2.9 billion), Argentina ($1.5 billion) and Venezuela ($1 billion).

In Third World countries, government officials were loath to criticize Citicorp's new hard-nosed policy. Brazil's Finance Minister, Luiz Carlos Bresser Pereira, said he saw the bank's move as a prudent shoring up of its foundations. Said a top Argentine official: "It's the first sign that U.S. ^ banks are prepared to share the burden of the debt crisis." Other foreign moneymen welcomed Citicorp's action because it might mean that all U.S. banks will start treating Third World debt under the same terms as Japanese, West German and Swiss banks, which have already established substantial loss reserves. A "spectacular maneuver," said Michel Cahier, a commentator for La Tribune de l'Economie, a Paris financial daily. "American financial circles appear to be ready to stop fooling themselves and the rest of the world."

For Reed, 48, who has been Citicorp's chairman since 1984, the daring new policy highlights his emergence as the country's most influential banker (see box). By making such a turnabout on the loans, Reed is moving out of the shadow of his predecessor and mentor, Walter Wriston, who was largely responsible for Citicorp's eightfold expansion between 1967 and his retirement. Wriston was also the premier spokesmen for the go-go lending policies of U.S. banks in the 1970s. Even though to some extent Reed's current action repudiates his former boss's strategy, most bankers think Wriston would have done the same thing. So does Wriston. Said the retired chairman in Manhattan last week: "The world has changed, and Reed's doing what has to be done now."

What Reed was doing could perhaps best be described as preventive medicine. The youthful chairman could see that Citicorp's hefty Third World commitment, which forms more than 10% of the bank's total loan portfolio, posed a severe threat to the bank's future prosperity. The income from those loans was dwindling because of all the concessionary terms -- lengthened repayment schedules, lowered interest rates -- that creditors worldwide have been granting to Third World debtors in order to keep them from defaulting. Then the entire international credit edifice was badly shaken last February when Brazil announced an indefinite moratorium on payments of interest and principal on $68 billion of its $108 billion in total debts, the largest in the Third World. Citicorp alone stood to lose about $450 million this year as a result of Brazil's decision.

Revenue from Third World loans in the past has made up an important share of Citicorp's profits. In 1986 the bank earned $257 million, or about 24% of its total income, on loans to countries in the Caribbean and in Central and South America. The growing threat to the bank's welfare was therefore extremely dire; at the same time, the potential for default on these debts was depressing Citicorp's reputation on Wall Street.

Thus, long before last week's announcement, Reed had embarked on a two-part strategy to try to maintain profits on Citicorp's foreign debts while reducing the bank's dependence on them. Citicorp's new, hard accounting line first emerged last September, when a committee representing more than 350 banks was negotiating a debt package with Mexico. Breaking ranks with his U.S. banking colleagues, Reed protested the terms of the final deal. Mexico successfully rescheduled $44 billion of old debts at bargain rates and got $6 billion in fresh cash that helped, in part, to make the interest payments. Reed finally went along after he was prodded by Federal Reserve Board Chairman Paul Volcker, among others. Citicorp nearly balked again this year when banks renegotiated $13.2 billion in loans with the Philippines and $30 billion with Argentina.

Reed was especially worried by the seemingly endless flow of fresh money to major Third World creditors. That cash outflow only served to increase the bank's vulnerability, creating a vicious cycle with which other major banks are also painfully familiar. To reduce that exposure, Reed in 1985 directed that Citicorp begin to build up its offsetting reserves. That year the bank set aside $1.2 billion. Last year the total jumped again, to $1.7 billion.

Citicorp needed to act boldly because the foreign-debt uncertainty was sapping its ability to compete with aggressive rivals, such as the Japanese, British and Swiss. Only three years ago, Citicorp ranked as the world's No. 1 banking company. Last year it slipped to No. 5 behind a group of Japanese banking companies that are "beating Citicorp's pants off in international lending," according to Joan Goodman, who follows the industry for the Pershing brokerage firm. Because most of Citicorp's foreign competitors have already set aside large reserves against potential Third World losses, those banks have enjoyed higher international credit ratings and therefore lower costs in raising money and capital. Reed's draconian new effort, says a top West German finance official, "certainly represents an effort by Citicorp to catch up with its competitors on the Continent."

The sweeping $3 billion move was completely in character for Reed, who has made bold strokes before during his meteoric rise at Citicorp. As an executive vice president, for example, he led the bank into the computer era, field marshaling the firm's early entry into the area of teller automation and then directing Citicorp's heavy involvement with Visa and MasterCard credit cards. When it came to making a convincing move last week, Reed reached for a large number. Said he: "Obviously it's a judgment call. Any number with nine zeros can only be approximate. We're clearly costing stockholders a year's earnings."

The cost could have been much greater. The bank's anticipated $2.5 billion loss in the second quarter is expected to be offset by three profitable quarters, to bring the year-end loss back to $1 billion. The company aims to return to profitability next year. And within three years, Citicorp plans to reduce its Third World debt portfolio by about one third, or $5 billion. The bank intends to sell some of the loans at a discount and transform others through so-called debt-for-equity swaps, in which the loan becomes an investment in the borrower country.

Citicorp's bolstered reserves give the bank a cushion against a default by any of its Third World debtors. That alone, predicts the head of a U.S. banking office in Brazil, "will change the renegotiating process forever." Says he: "The idea that a debtor can threaten the international financial system with collapse and get whatever it wants just won't work anymore."

Maybe not, but the noise level at debt-negotiating sessions is unlikely to decrease, since the conditions of many Third World countries is, if anything, more parlous. Most debtors have fallen victim to a general sluggishness in the world economy, which has reduced their export income and thus their ability to pay. "Lack of economic growth in the U.S. and abroad is the real time bomb," says John Heimann, vice chairman of Merrill Lynch's Capital Markets Group.

Citicorp's decision could also bring an eventual clampdown on additional lending to Latin America and other developing regions. Certainly the Reagan Administration has reason to be concerned at that eventuality. The Administration's Baker Initiative calls for $20 billion in private loans to be issued to the Third World over the next three years in order to foster growth. The program has been slow to get rolling. Said one Manhattan economic consultant: "Some bankers believe Reed has killed the Baker Initiative."

Reed's approach is unlikely to win universal applause in the banking industry either. For one thing, the measure will force other holders of Third World loans, most notably such profit-parched institutions as BankAmerica ($7 billion in Third World loans) and Manufacturers Hanover ($7.5 billion), to agonize over whether to match it. Not all the big banks are in the same relatively good shape as Citicorp, and thus they are less able to take such action. Says one top New York City banker: "Reed is being really selfish. The stakes are much higher than the future of a single bank." Reed felt sensitive enough to the issue that he called BankAmerica Chairman A.W. ("Tom") Clausen and Manufacturers Hanover Chairman John McGillicuddy last week to inform them in advance of his action.

Someone liable to be just as irked at Citicorp's move is Fed Chairman Volcker. Some stories have it that he called Reed personally to complain about the write-off. Why? If banks rush to follow Citicorp's lead, the industry might be so weakened by losses that the Fed would eventually feel obliged to help out by putting downward pressure on interest rates. But that would run counter to the Fed's efforts to buoy up the weak U.S. dollar. Says Timothy Scala, money-market manager for Buffalo-based Manufacturers and Traders Trust: "This demonstrates just how grave the situation is now."

From Reed's viewpoint, of course, the opposite is true. Citicorp feels that continuing to view the debt problem as manageable through an endless series of interim solutions is by far the most dangerous way to handle his bank's, and perhaps the world's, economic situation. As Paris Financial Journalist Cahier wrote approvingly last week, "In the kingdom of numbers, sincerity is always rewarded." Citicorp clearly wants its rewards sooner rather than later.

CHART: TEXT NOT AVAILABLE

CREDIT: NO CREDIT

CAPTION: CITICORP PROFITS AND LOSSES

DESCRIPTION: Bar graph, 1980 to 1987. Background photo of Citicorp Building.

With reporting by Raji Samghabadi/New York and Frederick Ungeheuer/Paris