The WSJ finally publishes the ugly truth..... way late of course.
July 23, 2001
Page One Feature
As Loan Defaults Rise, Banks Shift
Some Risk to Individual Investors
By JATHON SAPSFORD
Staff Reporter of THE WALL STREET JOURNAL
In July 1998, fast-growing telecommunications company Teligent Inc. turned to J.P. Morgan Chase & Co. for an $800 million loan to fund its Internet strategy. Teligent's business has since soured and the company sought bankruptcy-court protection in May.
But Teligent will barely cause a blip on J.P. Morgan's balance sheet. That's because the bank syndicated the loan, keeping only a small, $80 million chunk on its books. Some of the remainder went to other banks. And a huge portion -- nearly $400 million -- wound up in the accounts of people like 60-year-old Judy Rosenfield. The Boston-area widow invested a chunk of her retirement money with Eaton Vance Prime Rate Reserves, one of a relatively new breed of mutual fund that buys loans from banks.
It's all part of a little-known, yet epic, shift in risk in the U.S. banking business. Ten years ago, when a bank made a big loan it would farm out pieces of it primarily to a few other banks. Now, most corporate loans are diced into infinitely smaller pieces, with nonbank investors such as mutual funds playing a major role as buyers. In the riskiest tier of smaller, unproven companies, mutual funds have actually surpassed banks to become the largest buyer of new syndicated loans.
Risk for Individuals
While this spreading of risk clearly has been good for banks, it is potentially controversial because some of the lending downside has been pushed onto individual investors. Many of these people, who have made what they believe to be safe investments, don't realize they could lose money if the economy falls into a deep recession, causing widespread loan defaults.
So far, they've lost little. And in any case, many economists say investor losses would tend to be widely spread and shallow, rather than concentrated and deep. That, they argue, would be a small price to pay for the enhanced stability of the banking system -- and of the economy in general. Indeed, the boom in syndicated lending goes a long way toward explaining why banks have navigated the current economic weakness with far less damage than in previous loan debacles.
"We have paid a lot in tuition over the years," says Marc Shapiro, vice chairman at J.P. Morgan Chase. "The one thing we've learned is the No. 1 protector of balance sheets is diversification."
Loans still go bad, of course, and can cause a huge headache for banks. Amid a burgeoning credit crisis in the telecommunications industry and a general downturn for many other corporate borrowers, banks are starting to acknowledge growing problems. At Bank of America Corp., for instance, nonperforming assets, or those more than 90 days past due, jumped 59% to $6.2 billion in the second quarter from the like period last year.
There's also worry on Wall Street that some banks may have made big loans to telecom companies, as yet undisclosed, that they weren't able to syndicate before the market collapsed. And as a result of ill-timed venture-capital investments in telecom and technology companies, some big banks, including J.P. Morgan Chase, have recently been forced to take some heavy hits to earnings.
Sounder System
There's no sign that any big institutions are close to failing. That's a sharp contrast to the last downturn, when falling property values ravaged a banking system that had binged on real-estate loans. Bad loans are now hovering around 2.37% of total assets, less than half the 6.15% peak of the recession 10 years ago. Even if problem loans continue to mount, as many expect, "the financial system is structurally much more sound now than it was a decade ago," says John Lonski, economist at Moody's Investors Service.
For that, the nation can thank diversification. A decade ago, "it was not uncommon to see a bank have 30% or 40% of its loan portfolio linked to real estate," says David Gibbons, deputy comptroller of credit risk at the Office of the Comptroller of the Currency, a bank regulator. Today, most money-center banks concentrate no more than 7% of their loans in any single sector.
Syndications have been a big factor in allowing banks to stay diversified. Banks syndicated $1.2 trillion in loans last year, up from $234 billion a decade earlier, leaving total syndicated loans at nearly half of the $3.9 trillion of all outstanding loans. Of new syndications last year, roughly a fourth, or $320 billion, involved loans to non-investment-grade companies.
Nearly 50% of those riskier loans, in turn, were snapped up by institutional investors, mostly mutual funds, according to Standard & Poor's. U.S. banks retained just 23.2% of such loans, with the rest spread out among foreign banks, specialty finance firms and brokerage companies.
That's turning out to be good news for banks, which lent heavily to telecom start-ups before they began toppling last year. The banks generated big underwriting fees for their efforts, but kept little of the risky credit on their own books.
The biggest player in the telecom market, J.P. Morgan Chase, has arranged $66 billion in new loans since 1999, according to Thomson Financial Securities Data. But the bank says it kept only about $600 million for itself. Even adding in longstanding loans to blue-chip telecoms such as Baby Bells, J.P. Morgan Chase still has only $11.6 billion committed to that sector, or about 6% of its overall loan portfolio.
Likewise, Thomson Financial says Bank of America has arranged $39 billion in telecom loans since 1999, and Citigroup Inc., about $20 billion. But both banks have told investors they kept less than 10% of that total on their books.
As banks shed loans, though, mutual funds picked them up -- and thus are now facing some turbulence. There are currently 67 so-called "prime rate funds" that specialize in bank loans, holding some $160 billion in assets. In recent months, prodded by a directive from the Securities and Exchange Commission, many have written down the value of their loan holdings to reflect the dimming prospects of troubled borrowers.
Drop in Returns
That has contributed to a sharp drop in returns. The largest funds -- including Eaton Vance Prime Rate Reserves, Van Kampen Prime Rate Income, Franklin Floating Rate and MSDW Prime Income Trust -- have seen returns fall to 2.67% over the 12 months ended June 30, on average, down from a five-year average of 5.45%, according to Morningstar Inc.
For some investors in these funds, the risks are only now becoming clear. "A lot of people were looking at them as something that would never lose principal," says Sarah Bush, a Morningstar analyst. "That's clearly not the case."
Some investors now say they were misled into thinking the funds were conservative investments. "The investors in these funds are not professionals. They're regular people, retirees," says Joel Bernstein, a lawyer for one Eaton Vance client who has sued the fund in Boston federal court, alleging that it failed to write down troubled loans in a timely manner. "But the funds haven't let these investors know that the value of loans can fluctuate, and more importantly, do fluctuate," he asserts.
Eaton Vance says that the case is without merit and that it will fight the suit in court.
Now, the telecom shakeout poses a question: Is the worst yet to come for mutual funds that invest in loans? There are reasons to be less than sanguine. After all, some fund managers, in search of high interest rates, piled on the telecom debt before that industry imploded late last year. S&P Portfolio Management Data says default rates among non-investment-grade telecom companies are now running at 17%.
That fuels the concerns over mutual-fund exposure. Van Kampen Prime Rate Income, for example, held 9.1% of its assets in telecom companies as of Jan. 31, including wireless-service providers and equipment makers, according to the most recently available government filings. In the same period, MSDW Prime Income Trust held 9.4% of its assets in such companies. The comparable number at the Franklin Floating Rate fund on the same date was 9.6%. At Eaton Vance Prime Rate Reserves, total telecom exposure at the end of December, the most recently available data show, stood at 12% of the total.
A Lot of History
Managers at Eaton Vance Corp. don't act worried. Located just off a wharf on Boston's harbor, it is one of the oldest and largest mutual-fund companies. Eaton Vance has been managing assets for 75 years and was one of the first to launch a loan fund, just over a decade ago. Its loan business has since blossomed.
If Eaton Vance were a bank, it would rank today among the top 100, with a loan portfolio of $9 billion in loans spread over a number of its mutual funds. Unlike a bank that size, however, Eaton Vance doesn't have hundreds of loan officers to keep in touch with borrowers. Instead, roughly a dozen professional fund managers and analysts manage the loan portfolio.
Sitting around a table at Eaton Vance's headquarters, the top loan managers explain that they need fewer people in part because their decisions are far more mechanized than at most banks. Manager Scott Page jumps up from the table and points to a computer screen, running his fingers past numerical data about each loan.
First, he says, Eaton Vance Prime Rate Reserves is as diversified as any bank, with assets spread across 350 companies in 64 sectors, from advertising and aerospace through food, funeral services and utilities. And these loans are what bankers refer to as senior obligations. That means when a company fails, the lenders get first dibs on its assets, ahead of stockholders and bondholders. Even if telecom recoveries are smaller than normal, say fund managers, large-scale losses are unlikely.
"What would it take for our fund to really blow up?" asks Mr. Page. "All of America would have to fail to meet its most senior obligations."
Yes, there are telecom loans in the prime-rate portfolio, and plenty of them, he says. But there are less today than a year ago, because loans today trade like securities -- allowing Eaton Vance to unload risk on others, just as banks unloaded on it. Last fall, troubles in the telecom sector had Mr. Page selling off a slew of telecom loans. Among those he sold: a loan to 360networks Inc., a fiber-optic cable concern that filed for bankruptcy-court protection in June, amid a glut in the industry. Today, its loans are trading at 23 cents on the dollar. But when Eaton Vance sold them, they were trading at around 96 cents on the dollar. Eaton Vance also has pared its position in Teligent to $3 million from $15 million last fall.
Fund managers argue that they may be better positioned to weather the storm than banks. They say bankers have a harder time selling off loans once they're on the books because they maintain a relationship with borrowers. After all, loans are only one of several financial services that banks provide. Loan funds have no other products to sell, and thus have less contact with the companies whose loans they hold.
Instead of loan officers, Eaton Vance has a full-time loan trader, who manages the sales and purchase of as much as $300 million in loans every month. "The risk is still there," says Mr. Page. "It's just managed differently."
Yet if funds have advantages over banks, in some ways they are also held to tighter scrutiny, as evidenced by the bombshell the SEC dropped in late 1999. The agency sent an open letter to the mutual-fund industry saying funds should use independent prices to value the loans in their funds. Each fund holding should reflect what managers "might reasonably expect to receive upon its current sale." The SEC declined to comment, but an official familiar with the matter says the commission was worried that some funds were carrying loans at face value when the secondary market was significantly discounting them.
Some fund managers complain that the SEC regulations force them to take a harder line on souring loans than the banks themselves. Regulators have long given banks broad discretion in deciding when to mark down the value of a loan. But many fund managers, because they don't get much slack, say they are less inclined to give any to borrowers.
Loan funds are already demanding borrowers change financing plans to meet their needs, charging increasingly stiff penalties for amendments or early repayment. "It's not like we're playing a round of golf with your traditional banker anymore," says John Brittain, chief financial officer at Nextel Communications Inc., which has $6 billion in loans outstanding to more than 100 investors, mostly funds.
It remains to be seen whether such vigilence will be rewarded over time, or whether there are big write-downs to come. Still, at a time when many stock funds have recorded double-digit losses for the past year, investors are often happy with any return at all. Even though Eaton Vance Prime Rate Reserves has lost a little principal to rising defaults, its client Ms. Rosenfield, the Boston widow, is happy. Her return last year of 3.86%, while down from 6.92% in 1998, was still adequate. "The checks keep coming every month," she says.
Write to Jathon Sapsford at jathon.sapsford@wsj.com1 |
