J.P. Morgan's Debt-Bond Exchange for Mexican Loans

J.P. Morgan's Debt-Bond Exchange Product

Rodney B. Wagner, vice-chairman of the credit-policy committee at J.P. Morgan, looked at various “bid-forms” that had arrived at the bank by Friday, February 26, 1988. The forms contained the bids of commercial banks from around the world to exchange holdings of Mexican loans for a new bond. Wagner, and several colleagues at Morgan had been responsible for the development of a “debt-bond exchange” for Mexican loans, in which as much as $10 billion of new bonds was offered in exchange for existing bank debt. Morgans plan had attained wide spread attention. Many acknowledged it as a major new way of dealing with the “debt-crisis.” But while Morgan scored high for its innovativeness and the bank’s ability to design “investmentbanking” type of products, the actual amount of the bids was lower than anticipated. Slightly over $6.7 billion of face value of loans was tendered. Even though the bid volume had been disappointing, Wagner was not unhappy with the attention Morgan and Mexico had gotten for structuring the transaction. J.P. Morgan (with principal subsidiary Morgan Guaranty Trust), had worked closely with Mexico in designing an innovative way to deal with the less-developed-country (LDC) debt problem. Still, Wagner was concerned that a small transaction would not be conclusive in showing the value of the new approach. He had few doubts that the basics of the exchange made a lot of sense, but what worried him was that another bank might take basically the same idea, adjust it and be more successful. Wagner knew that the Mexican government (advised by Morgan) could not extend the deadline on the bids beyond February 26. Also he knew that several investment banks, competitors of J.P. Morgan, had valued the exchange significantly differently from what had been calculated by the bank’s bond team. As he looked at the various bids, he wondered about Morgan’s assessment. He decided to once again look at the proposal and value it. Wagner realized that the exchange offer had to be attractive to two parties: Morgan’s client— the Mexican Government — and current holders of eligible bank debt that could be exchanged for the new bonds.

Case Questions

1. Describe the situation of LDC Debt in 1988.

2. What product had J.P. Morgan developed? Describe the features of the bank debt bond swap and explain the logic behind the design of the product.

3. Describe the principal collateral and other protective covenants.

4. How did the bid system for the product work?

5. Describe the U.S. Treasury and swap rates stated in the case.

6. Value the product. What is the swap ratio of bank debt to bonds implied by the bond’s characteristics and the U.S. treasury and swap rates you described?

(a) First, compute the value of the 20-year Treasury strip collateral. Note that coupon payments are made semi-annually.

(b) Assuming no default, compute the value of the semi-annual coupon payments of LIBOR + 1.625% for 20 years.

i. Hint: Use the swap quotes in the case to forecast future LIBOR.

ii. Hint: If the approximate duration of the coupon annuity is 14 years, one can use the yield on a 14-year Treasury to discount the coupons.

(c) Assuming that the market expects to receive only 50% of the no default value of the coupon annuity, what is the market value of the coupon annuity?

(d) What is the ratio of bank debt to bonds if the market currently values the bank debt at 50% of its promised value?