A Case of Bottom-Line Blues

By Barbara Rudolph

A cautious and circumspect breed, bankers are rarely surprising. Last week, though, U.S. lenders managed to startle some of the most seasoned financial experts. The first jolt came when Citibank and Chase Manhattan hiked their benchmark prime rate on loans to commercial customers from 7.5% to 7.75%, its first rise in nearly three years. Several major banks soon followed suit. Two days later, seven leading banks had announced that they would take the serious step of reclassifying their loans to Brazil to a "nonperforming" status. That means that the banks' books will no longer maintain the fiction that Brazil is still paying interest. The decision will sharply slash the lenders' first quarter profits.

Both moves were surprising on several counts. A rise in the prime usually follows an increase in the banks' cost of borrowing. But this time these expenses have remained relatively stable. Says Nicholas Sargen, an economist at Salomon Brothers: "We were scratching our heads over why they did it." The timing of the Brazilian loan action was equally puzzling. Since Feb. 20, when Brazilian President Jose Sarney declared his country would suspend interest payments on $68 billion of its foreign debt, observers wondered whether banks would have to reclassify their Brazilian loans. But since federal regulations do not require such a step until interest payments are 90 days past due -- in this case no earlier than May 21 -- it was generally assumed that banks would respond later rather than sooner.

The banks' quick action was apparently designed to show Brazil and the financial community that they can weather the current Latin debt crisis. In part to compensate for the Brazilian losses, banks boosted the prime rate, which is widely used in determining the interest not only on commercial credit but on home-equity and other consumer loans. The rate hike means more interest income and profits for the banks.

Businesses and consumers wondered whether the rise in the prime heralded a new and sustained climb in interest rates. Surprisingly, the stock market, which can panic at even a hint of high interest rates, discounted last week's move in the prime. After plunging early in the week because of the decline in the dollar and concern about a possible U.S.-Japan trade war, stocks rallied strongly. On Friday the Dow Jones industrial average skyrocketed 69.89 points, a new one-day record. The Dow closed at an all-time peak of 2390.34, up 54.54 points for the week.

The bulls of Wall Street seem to be betting that the Federal Reserve Board will not allow interest rates to rise sharply. Such a policy would endanger a vulnerable economy, which grew only 2.5% in 1986. Last week's employment report from the Labor Department offered evidence that the economy is still in the doldrums. Though the overall unemployment rate fell slightly, from 6.7% to 6.6%, the number of jobs actually declined in the important manufacturing and construction sectors.

While the prime-rate rise will help bolster bank profits, it cannot begin to make up for the reclassification of $6.8 billion worth of Brazilian loans. Seven major banks will see their profits reduced by a combined $112 million for the first quarter. At BankAmerica, 40% of quarterly earnings could be lost, while Manufacturers Hanover could take a hit of as much as 20%. If Brazil does not resume making interest payments on its debt this year, 1987 earnings would be reduced by some $1.9 billion for all U.S. banks. Anticipating such losses, Standard & Poor's has lowered the credit ratings it assigns to several of Brazil's U.S. lenders, including Chase and Chemical Bank.

For the Mellon Bank, Latin debt is contributing to a dismal financial situation. Last week the Pittsburgh-based institution announced it would post a first-quarter deficit of between $55 million and $65 million, the first in its 118-year history. Mellon will also cut its quarterly stock dividend in half, to 35 cents a share. Besides the $10 million worth of losses on Brazilian credit, the bank is reeling from bad industrial, energy and real estate loans.

To many observers, the banks' decision to reclassify Brazilian loans is as much a negotiating ploy as a financial move. Brazil may have hoped that the prospect of forgone interest income and sharply reduced bank profits would force U.S. lenders to give in to its demands for easier terms. But now that several major banks no longer assume they will receive Brazilian interest anytime soon, the debtor's threat to withhold payment indefinitely is less menacing. Says one banker: "We are saying to Brazil, 'We can survive.' " New negotiations begin this week in Manhattan between representatives of U.S. banks and Brazilian banking and government officials.

The Brazilian posture was outlined by Finance Minister Dilson Funaro in a speech he gave last week before the ruling Brazilian Democratic Movement Party. Funaro repeated his vow to withhold interest payments until a debt- restructuring agreement is worked out. Any pact, he said, must involve a reduction in Brazil's interest obligations. Such a decline is necessary, Funaro argued, in order for the Brazilian economy to expand.

While the Finance Minister did not criticize U.S. lenders, many Brazilians did. Said Senator Severo Gomes, a member of the ruling party: "There can be no attitude of flexibility toward the banks." Said Aldo Lorenzetti, a Sao Paulo-based businessman: "Each side is baring its teeth and sharpening its claws to get the best possible result in the negotiations."

The meetings will probably drag on for months. American bankers have shown they are able to back up tough talk with firm action. Brazil, for its part, gives no sign of softening its aggressive posture. One side -- or both -- will have to give a lot of ground.

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CREDIT: TIME Charts by Cynthia Davis

CAPTION: COUNTING THE LOSSES

DESCRIPTION: Color chart showing the Brazilian losses for five American banks.

With reporting by John Barham/Sao Paulo and Frederick Ungeheuer/New York