Time bombs in the bank vault
Like Enron, the nation's biggest banks have risky off-balance-sheet liabilities that are barely disclosed. Brace for the next disaster.
They didn't want to do it, but they had no choice: J.P. Morgan Chase, Citigroup, Bank of America and other banks shelled out unsecured loans of $3 billion to the doomed Enron Corp. in October, weeks before the firm collapsed into Chapter 11 amid accusations of fraud, self-dealing and a cover-up.
The fallout was ugly. The $3 billion loan sells at 20 cents on the dollar today, posing a potential writeoff of $2.4 billion for the 46 banks involved. All told, J.P. Morgan Chase's total Enron exposure cost it $450 million in the December quarter, pushing the bank into the red. Citigroup took a charge of $228 million and could be forced to take still more, given Enron's moribund state; the sum amounts to only 50% of its unsecured exposure to Enron. Northern Trust took a $43.5 million charge.
The banks were forced to throw good money after bad because, six months earlier, they had agreed (in exchange for meager fees) to cover Enron's financing needs should the high-flying, investment-grade energy giant ever find itself in real trouble. Hey--who knew? But this multibillion-dollar exposure was never shown on the banks' balance sheets as outstanding loans, because they aren't. Instead, the ill-advised promises were listed in the footnotes to the banks' financial statements.
In the Enron aftermath, "off-balance-sheet" has a bad ring. Regulators vow to force banks to disclose such promises more openly and increase their reserves against potential future losses from this activity. More reserves means lower earnings and lower stock prices.
The sad truth about lending: Bad things happen to good companies. Xerox, Lucent and Kmart, among others, have drawn down billions in bank loans as their credit ratings have sunk, calling in promises made by banks when these borrowers looked a lot more solid.
The stakes are huge. Last year corporate defaults set an alltime record with 211 issuers of debt unable to service $115 billion of obligations, says Standard & Poor's. U.S. banks' total obligation in off-balance-sheet promises is a staggering $5 trillion, more than triple the exposure in the last recession in 1991, says Prudential Securities analyst Michael Mayo.
A partial hit list:J.P. Morgan Chase has made $224 billion of such commitments, about as much as it has in outstanding on-balance-sheet loans. Citigroup has off-balance-sheet exposure of $200 billion, up from $176 billion in 1999. Bank of America carries $228 billion of commitments that "are legally binding," according to a footnote in its annual report.
Reserves for potential losses from these commitments: tiny. The accepted practice in bank accounting is to set up significant loan-loss reserves only when the commitment is availed of and the arrangement becomes an on-balance-sheet loan.
Some of this $5 trillion is for credit card limits that consumers have not yet exhausted. The scarier part,Mayo says, is $1 trillion committed to companies that could get into trouble.
Roughly a third of the $5 trillion total represents pledges to step up to the plate if the corporate borrower can't refinance its commercial paper. If the recession persists and credit ratings deteriorate for once-healthy titans, these backup loans will be taken--and banks will be worse off for it.
forbes.com
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