In distress but business is booming: The secondary debt market is changing the way banks look at problem loans, reports Jason Nisse

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The Independent Online
PSSST] Want to buy some Maxwell Communication Corporation debt? In administration but likely to pay a decent dividend to creditors. A snip at 43p in the pound.

No? Well, how about Eurotunnel? Nice company. Long wait in prospect for payback, but you'll get the money in the end. Yours for 75p.

Want more of a gamble? How about Heron? Talks with bankers have been going on for a while now. Maybe they'll do a deal, maybe they won't. At 15p for a quid's worth of debt, you (almost) can't go wrong.

The market for 'distressed' company debt is booming in these troubled times. In recent weeks there has been trading in more than a dozen UK companies that are insolvent or have restructured their debts or are in the process of doing so.

The administrators of Maxwell Communication Corporation estimate that a third of the group's pounds 1.6bn of debt has been sold by its bankers; WPP Group has probably seen half its debt change hands; and brokers are trying to find buyers for pounds 85m of loans made by Chemical Bank and Citicorp to Canary Wharf, which is at a critical stage in its attempts to stave off liquidation.

In addition there is trading in what is called 'value-impaired' debt such as GPA or Eurotunnel, where the present value of the loans has fallen because the company is now likely to pay them back much later than originally thought.

There is also a market in high- quality corporate debt, particularly loans made at extremely tight margins in the giddy 1980s that would never achieve such rates these days.

Market estimates are that about dollars 10bn of distressed debt changed hands last year, mostly in the US, although about dollars 1bn was traded in London, and another dollars 20bn of corporate loans was either swapped or traded. This was double the 1991 figure, which in turn was double the 1990 figure. This year it could rise to dollars 30bn, with dollars 4bn-dollars 5bn traded in London.

Bankers Trust, probably the biggest player, says the market could potentially outstrip the Eurobond market in size.

'We think the biggest thing in the debt markets as a whole over the next five years will be the development of the secondary loan market,' enthused Robert Tyrwhitt-Drake, the London head of Bankers Trust's value-impaired asset group.

A year ago there was no significant market in the UK, although the US arena has been active since the late 1970s. Some banks occasionally swapped exposures but it was almost impossible for a bank to get rid of its bad corporate loans in the way that many lenders, including some British high street banks, have been able to sell some or all of their Third World debts to third parties.

But the restructuring of WPP, plus the emergence of buyers for the US assets of MCC, convinced the US vulture funds, which are the largest single buyers of distressed debt and are often subsidiaries of large firms such as Fidelity or Mutual Shares, that there might be some interest in the UK.

They were seeing signs of an upturn in the US economy pushing up the prices of distressed loans at home, and were interested in two UK companies with substantial US assets of interest to American investors.

As they piled in, banks such as Bankers Trust, Continental, Morgan Grenfell and SG Warburg, and brokers including James Capel and Klesh & Co, started dedicated operations to trade these distressed loans.

Many of these operations grew out of Third World debt trading teams. The Less Developed Country debt market took off in the late 1980s after banks had to make massive provisions that plunged them into large-scale losses, and the US-sponsored Brady Plan turned much of Mexico's debt into readily tradeable bonds.

Indeed, Continental integrates its Third World debt trading with secondary bank loan trading and dealing in junk bonds. From the spread of prices quoted by Continental, loans to Heron are deemed to be about as valuable as those to Peru, but less than junk bonds in RH Macy (the New York department store now in Chapter 11). It also shows the lowest-rated debt is that of Polly Peck, Asil Nadir's former conglomerate, which has an even lower quote than loans to the Ivory Coast.

The growth has come as banks, which grew like Topsy in the 1980s when 'global banking' was the buzzword, rein back their operations outside core business areas.

'The emphasis is on focus,' said Tony Tucker, head of international syndicates at Continental. 'For instance, Scandinavian banks are refocusing on Scandinavian business, so they look at, say, Maxwell, and say: 'Why the hell are we in Maxwell?' '

Sales have also been prompted by the banks' need for cash to fulfil their capital adequacy ratios. If they have already made provisions for their losses, cashing the loans bolsters their balance sheets.

However, some banks have taken an ostrich-like approach to provisions, particularly in value- impaired companies such as Eurotunnel, and so selling their debt can cause problems.

For instance, if they have a pounds 50m loan to Eurotunnel and sell pounds 10m-worth for pounds 7.5m, do they then have to write down the other pounds 40m, at a cost of pounds 10m more?

'Tax is also important,' said Alexandra McLeod, the head of Continental's value-impaired group. 'For instance in the US, provisions are not tax-deductible, only losses. If you sell the loan you crystallise the loss.'

Almost every nationality of bank has participated in the market, although British clearers are reluctant to be seen selling the debt of UK companies.

However, there is one exception. The Japanese banks, many of which have shrunk substantially in the past couple of years, have been held back because the Ministry of Finance does not like to see them getting out of companies that might conceivably be saved, and the Tokyo tax office will not allow losses to be set against tax.

Last year it loosened its approach to loans to companies in Chapter 11 of the US Bankruptcy Code. This prompted a wave of selling by Japanese banks, and brokers are expecting something similar in the UK this year.

The problem is a lack of buyers. 'The supply is enormous,' said Gary Klesch, chairman of Klesch & Co. 'The demand is not so enormous.'

There is a certain amount of demand from banks that have experience in particular areas for loans within their ambit, but the market depends on outside investors, and so far the only buyers have been American.

Mr Klesch reckons that there will be UK investors within the next year or two, but the response has not been encouraging. Mr Tyrwhitt-Drake agrees, although he thinks a couple of companies may dip their toes in the water with specialist funds quite soon.

'Distressed company debt has been marketed as a sub-interest grade investment,' said Mike Denham, head of fixed interest at Prudential Portfolio Managers. 'On the fixed-interest side we do not like that sort of credit risk.'

Mr Klesch said the institutions might be better off viewing the loans as risk assets, and investing in them through their equities operations. But for that to happen, the market will have to overcome its liquidity problems.

Trading is thin. And even when deals are agreed it may take up to three months for the documentation to be completed, as there are rarely any standard forms for transferring loan participations, with the exception of Eurotunnel debt.

This has caused problems with buyers or sellers who find the price of debt has turned against them after a deal has been struck, and try to get out by causing problems with documentation. Market participants have pressed for the Bank of England to impose a code of conduct on the market, and Bankers Trust, which is probably the largest player, operates a blacklist.

If the UK fund managers could be tempted into the market, it would widen it considerably. Mr Tyrwhitt-Drake reckons that in a few years' time companies will be just as likely to borrow money from pension funds as from banks.

'In the last year Bankers Trust has placed dollars 6bn of floating-rate debt directly with institutional investors,' he said. 'It is one of the big arguments as to why the secondary market for loans will grow so strongly.'

Step aside Midland. In future the listening bank could be Legal & General.

----------------------------------------------------------------- VALUES OF DISTRESSED ASSETS ----------------------------------------------------------------- Approximate percentage of face value Asset (countries in bold) ----------------------------------------------------------------- 95 News Corp, Hungary, Turkey, Greece, Iceland 90 ADT 80 MacMillan Bloedel, Mexico Discount Bonds 70 Eurotunnel 65 Mexico Par Bonds 60 GPA 55 WPP 45 Morocco 40 Maxwell, Argentina, Nigeria 30 Olympia & York 25 Panama, Brazil 20 Memorex/Telex, Peru 15 Brent Walker, Heron, Bulgaria 5 Ivory Coast 0 Polly Peck International ----------------------------------------------------------------- Source: Continental Bank -----------------------------------------------------------------

(Photograph omitted)

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