Banks Are Havens (And Other Myths)
By GRETCHEN MORGENSON
The New York Times
July 28, 2002
Since the bear market began in March 2000, investors have been told that even if the economy suffered, the risks of investing in bank stocks were far lower than they had been in the recession of 1990. New and sophisticated risk management practices had enabled the banks to unload much of their lending risks to other market players, the argument went, while the institutions' ability to generate fees continued apace.
But a risk that the banks cannot expunge is the fear taking hold among investors that the nation's largest financial institutions were central to the financing of the stock market bubble that has burst so spectacularly. That perception is not only punishing bank stocks, which were not long ago seen as a haven for investors, but it is also casting a pall over the entire market, fund managers say. If banks are found to have facilitated corporate misdeeds — such as hiding losses at Enron, as has been alleged in Congress — severe damage will be done to already battered investor confidence in the entire financial system.
"The banks have been both the least visible and the most important components of the financing of the new economy over the last 10 years," said Jonathan H. Cohen, portfolio manager at JHC Capital in Greenwich, Conn., and former head of Internet research at Merrill Lynch. "Investors know that most Internet and telecom companies were part of a bubble, and that many brokerage houses were involved in the sustaining of the bubble. Now people are getting around to focus on the role of the commercial banks."
Bank stocks, as measured by the Philadelphia Stock Exchange/KBW Banks index, have lost 10.4 percent in the last two weeks alone. The index consists of 24 major banks and large regional institutions. Leading the way down have been Citigroup and J. P. Morgan Chase, which both fell 15 percent last week.
Traditionally among the most respected financial institutions, Citigroup and J. P. Morgan were tarnished last week when their executives came under heavy questioning by Congress on their banks' role in the Enron fiasco. Both banks denied that they facilitated the hiding of debt at Enron, but several days after the testimony, the Securities and Exchange Commission said it would scrutinize the banks' Enron-related activities.
Until May, the bank stocks were a port in the stock market's storm, a group to which investors retreated as many other sectors collapsed. Holding up these shares was the belief that the recession's short duration meant not only that big banks would soon find increasing demand from corporate clients but also that heavily indebted consumers would not default on their loans as they might have if the recession were prolonged.
"Until recently, the feeling among investors was that banks have regulators and that will keep them out of trouble," said David A. Hendler, an analyst at CreditSights, a research firm in New York. "But no one was thinking that the banks enabled the rest of the world's business problems, and that will eventually get reflected in the operating performance of the financial companies."
As bank stocks outperformed the rest of the market, their weighting in the Standard & Poor's 500-stock index grew. That means that their recent downturn has hurt investors in the big, popular mutual funds that mirror the performance of the S.& P.
At the market's peak, for example, technology was the single biggest component of the S.& P. But as technology shares plummeted, financial services companies stepped into the top spot. At the end of June, financial companies accounted for 20 percent of the S.& P. The next-largest sector is information technology, at 14 percent.
Banks stocks have always been vulnerable in an economic downturn because they end up holding loans that sour with the economy. That will again be the case if the economy weakens, in spite of claims of advanced risk management techniques. But their role as potential facilitators of improper activities at companies like Enron or WorldCom or even as intermediaries that helped inflate the bubble is an additional worry for investors.
Some of the nation's biggest and most trusted banks are in this fix at least partly because of their increased reach in all areas of financial services in recent years. The Financial Modernization Act in 1999 eliminated most of the barriers to certain business set up for banks under Glass-Steagall, the legislation that came out of the Great Depression. This allowed commercial banks to compete with investment banks for the right to sell securities to investors. And the larger banks approached the business aggressively.
For example, in May 2001, WorldCom raised almost $12 billion in a bond offering managed by Citigroup. The offering came when WorldCom's was still a high-grade name in the credit markets, and was presented to investors as an issue against which other investment-grade bonds would be judged, known as a benchmark.
Because the WorldCom deal was a benchmark bond, any portfolio manager running a bond mutual fund had to own the security. So when WorldCom began its free fall earlier this year, a throng of bondholders were holding the bag. The bond sale allowed WorldCom to clear out a lot of its bank lines of credit and push back the maturity dates on the loans.
Now, with WorldCom filing bankruptcy a little more than a year after the bonds were sold, investors are questioning how much due diligence was conducted by the banks that sold the securities.
Adding to bondholders' doubts about whether this bond deal should have been done is the growing awareness of just how close Jack B. Grubman, the telecommunications analyst at Salomon Smith Barney, a Citigroup unit, was to WorldCom. Mr. Grubman has said that he attended board meetings at WorldCom. His relentlessly upbeat pronouncements on the company helped the $12 billion bond deal get done.
There are considerable risks associated with the growth of financial services conglomerates. One is that top management and the board of directors cannot possibly know what lower- and middle-level employees are doing inside the bank. "Senior management and the board of directors must have very comprehensive orientation, knowledge and understanding of what's going on, and in many instances that is not the case," said Henry Kaufman, the economist and head of Henry Kaufman & Company in New York.
And the nation's financial system, he said, is put at risk when these companies become huge conglomerates. "These conglomerates tend to move toward monopolistic practices," Mr. Kaufman said.
The banks' pitch, he said, is essentially this: "We want to be your banker, which means we want to make you the loan, syndicate the loan, underwrite your bonds and distribute them, we want to do your stock issues, we want to place your commercial paper and we want to manage some of the assets in your pension funds."
He added, "This not only diminishes competition, but it creates institutions that are too big to fail, because if they would fail then the response is they pose a systemic risk."
Some analysts say that in the interests of grabbing more of the lucrative securities underwriting deals that had been the province of the investment banks, commercial banks may have been eager to advise companies on how to get around tax rules and accounting regulations or leverage their balance sheets excessively. While such strategies may have been acceptable even as recently as last year, they are now drawing the attention of Congress and regulators and the ire of investors.
The work that J. P. Morgan Chase did for Enron, and which is now being examined by regulators, was plain-vanilla stuff, according to its executives. "They are a normal financing arrangement," William B. Harrison Jr., the bank's chief executive, said during a conference call last week. After Enron's failure, normal financing arrangements like these have become questionable.
It is perhaps predictable that just as commercial banks raced to generate fees from underwriting debt securities, more of the companies issuing them are falling on hard times. According to a study to be released on Monday by Moody's Investors Service, a total of 89 corporate bond issuers defaulted in the first half of 2002 with bonds totaling $64 billion. Twenty-one issuers defaulted on issues greater than $1 billion each. None of these numbers include WorldCom's bankruptcy filing, which occurred in the third quarter.
"A stubbornly high pace of defaults, assisted by the spectacular number and size of failures in the telecommunications sector globally and by other issuers based outside the United States, made the second quarter 2002 one of the most severe periods of credit stress since the Depression of the 1930's," said David T. Hamilton, who wrote the study.
MOODY'S said it expects the junk-bond default rate to hit 8.8 percent by year-end, down from the 10.7 percent peak reached in January, but still high. If the economy slips back into recession, banks could really be hurt.
"There are still big issues out there," Mr. Hendler at CreditSights said. "The C.E.O. sign-off date comes in a couple of weeks and there could be more of a shake-out from that," he said, referring to the new rule by the S.E.C. that chief executives must personally certify their company's financial statements.
"Banks still have venture capital issues, where valuations could go down," Mr. Hendler said. "And on the consumer side, some banks gave a good outlook for second half, but there's not enough evidence that the consumer is fine. All this weighs heavily on the banks."
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