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The new battle for the bulge

A battle royal is under way as megabanks like citigroup and j.p. morgan chase launch their assault on investment banking. Can wall street's underwriting elite defend their stronghold?

A battle royal is under way as megabanks like citigroup and j.p. morgan chase launch their assault on investment banking. Can wall street's underwriting elite defend their stronghold?

By Justin Schack
August 2001
Institutional Investor Magazine

Christopher Galvin was in a bind. The CEO of struggling Motorola needed a $2 billion bridge loan to help refinance $6.2 billion in short-term debt after Standard & Poor's placed the Illinois company on credit watch in February. Galvin turned to his usual investment banker, Goldman, Sachs & Co., which was already advising on the sale of Motorola's Mexican wireless assets to Spain's Telefónica. The proceeds of that sale would pay off the bridge loan.

Goldman was more than willing to provide the money. But there was a catch. Arranging the bridge loan could have put Motorola in danger of violating the net-worth covenant of a $1.5 billion credit facility with Citigroup and J.P. Morgan Chase & Co. Before the company could tap Goldman, it needed the banks to waive the covenant.

Not so long ago the banks might have yielded without a murmur. Not this time. In mid-March, after negotiations with the company, the two giant lenders agreed to waive the covenant. But they persuaded Motorola to bring them into the bridge financing as co-lead arrangers. What's more, the company agreed to split future investment banking business three ways among the firms, breaking Goldman's hold on a prized corporate client (see story below).

Motorola officials decline to comment, but behind the scenes, Goldman officials are crying foul, lambasting the banks as bullies taking advantage of a wounded company. "It's pure, unadulterated coercion," says one Goldman executive. "They are going to our clients and saying, 'If you want us to continue lending to you, you'll give us your securities business.' There are laws against that."

The banks naturally see it differently. "That argument rests on the premise that all the customers are stupid," counters a J.P. Morgan executive. "The customers must all be a bunch of dumb people who have no choice but to use us for M&A because they're desperate for loans. We have plenty of M&A clients who don't even borrow. So that argument rests on nothing more than an outdated notion of the world."

Across corporate America similar scenes are taking place as commercial banks, led by J.P. Morgan and Citi, flex increasingly powerful muscles in a bid to win new business. In the process they are alarming and antagonizing their rivals on Wall Street - chiefly that coterie known as the bulge bracket - which have dominated investment banking in the U.S.

In its original sense as an underwriting cartel, the bulge was defunct by the 1980s, but its members - Morgan Stanley, Merrill Lynch & Co., Goldman Sachs, First Boston Corp., Salomon Brothers and, to a lesser extent, Lehman Brothers - continued to reign, thanks to willpower, competitive savvy and shrewd marketing. By the mid-'90s Merrill, Goldman and Morgan Stanley, the so-called MGM group, had broken out of the pack to create a sort of superbulge that dominated the profitable stock underwriting and merger advisory businesses.

Commercial banks, forbidden by law from chasing underwriting business, stood by and watched their rivals carve up the lucrative business. Then, when restrictions eased, they fared poorly in their quest to join the ranks of leading underwriters and advisers. But now they have become the aggressors in a fierce struggle to determine who will be the survivors in an investment banking donnybrook that is being waged around the world. J.P. Morgan, Citi and Credit Suisse Group are leading the attack, trailed by a phalanx of ambitious banks that include Bank of America, Deutsche Bank and UBS Warburg.

The Wall Street firms jostled for market leadership for years, fighting off upstarts like Drexel Burnham Lambert in the 1980s. Their fortunes varied in keeping with the health of the economy and the consequences of their smart strategic moves - or miscues. But the stakes today are higher, and the battles more fiercely pitched. Industry experts argue that, in the best of times, only a handful of firms - maybe four, maybe six - will be able to make enough money (translation: win enough market share) to finance truly global, diversified investment operations. Meantime, today's wretched markets mean dried-up business and intensifying pressure on margins, even as commercial banks accelerate their assault.

And the threat from the banks is real. The Glass-Steagall Act, which had separated commercial and investment banking businesses since 1933, is gone. The biggest banks, after making huge acquisitions, have tightened their stranglehold on lending to the largest corporations and bolstered previously mediocre securities units. Citigroup, after all, now owns what were once Salomon Brothers and Smith Barney. Credit Suisse includes First Boston and Donaldson, Lufkin & Jenrette. Not only are the banks bigger, they are savvier, stocked with recruits and refugees from their Street rivals. They are gleefully using their balance sheets to win new business, aggressively offering credit as an inducement to secure underwriting and advisory mandates.

"We are now going at the heart of the MGM business - right at the mergers and equities businesses," says J.P. Morgan vice chairman Geoffrey Boisi, the former investment banking chief of Goldman.

Certainly, the banks have grounds for boasting. Consider what happened in May, when J.P. Morgan and Citi co-led the largest corporate bond offering ever in the U.S. - a nearly $12 billion issue for WorldCom. Old-line investment banks were shut out of the deal entirely after they declined to take part in a companion bank loan (see Clinton story below).

The banks have made their strongest inroads in areas where they have their greatest experience - credit-related products. Citi and J.P. Morgan now dominate the issuance of investment-grade bonds. Citi, fourth in 1998, moved up to first in 2000 with a market share of 16.3 percent. It increased its share in this year's first half, to 22.5 percent, according to Thomson Financial Securities Data. Together the two banks command a 37 percent share - almost as much as Merrill, Goldman, Morgan Stanley, Lehman and Bear, Stearns & Co. combined.

Banks insist that it is only a matter of time before companies begin to give them more higher-margin business - the plum equity and M&A assignments that have long been the franchise of the Morgan Stanleys and Goldman Sachses. And there are signs of movement. In June Citi and Credit Suisse First Boston co-led the $8.7 billion initial public offering of Kraft Foods - the biggest and most coveted stock transaction of the year; Goldman and Merrill failed to secure even co-manager slots (see Grand Central story below).

"Now, not only can some of these banks give you credit, but they also have some pretty good capabilities in terms of the fee-based business that they didn't have before," says Martina Hund-Mejean, the treasurer at Lucent Technologies, which has rewarded the commercial banks that gave it much-needed credit in February with coveted securities mandates (see story below). "It's a little bit easier to give them that business now than when they asked for it three years ago and didn't have the capability."

Still, through the first half of the year, Goldman Sachs and Morgan Stanley remain at No. 1 and No. 2, respectively, in M&A advisory and equity underwriting in the U.S. But CSFB is nipping at their heels, and others are gaining. Wall Street is taking notice of the competition. "Clearly it's put a different competitive element in the market than anything we've had to deal with in the past," says David Komansky, the chairman and CEO of Merrill Lynch, which ranked fourth in M&A and equity underwriting, just behind CSFB. "They have the balance sheet, they have the history of lending that the pure investment banks don't have. In this part of the cycle, where everyone seems to be averse to lending, I think that strength is magnified."

Says John Thain, co-chief operating officer at Goldman Sachs: "There's no question [that the commercial banks' strategy] has been effective in the high-grade-debt business, and that's partially because the high-grade-debt business is a commodity, and so you can compete on price in a commodity product." He argues that because bank accounting rules don't require loans to be marked to market (brokerages must do so), the banks can use cut-rate pricing to buy market share. But, he cautions, "the banks are going to have a very hard time using discounted pricing to break into the high-value-added businesses, particularly M&A and equity underwriting."

With so much riding on league table standings and bragging rights to high-profile deals, the commercial banks' successes have clearly put the elite investment banks on edge. To an extent, of course, continuing to talk about "commercial banks" and "investment banks" after the repeal of Glass-Steagall is anachronistic. Everyone can do just about everyone else's business, but the current competition carries echoes of old rivalries among the antagonists before consolidation and regulatory reform shuffled all the names and faces. Investment bankers still tend to deride commercial bankers as slow, ponderous "universal" banks, offering all things to all people but little of excellence to anyone. In turn, the commercial banks like to dismiss the MGM group as weak "monolines" that lack the breadth of corporate services - from credit lines to custody and cash management - that J.P. Morgan likes to portray in its marketing materials as "the new competitive model."

An undercurrent of triumphalism pervades the commercial banks, so long kept out of the high-margin business and tired of being slighted by the slicker, better-paid investment bankers. "To me, there's no question anymore that we have the winning model," says James Lee Jr., vice chairman of J.P. Morgan. "The corporate consolidation of the '90s has given us a lot of giant companies that used to have relationships with ten firms, but now they want only two or three, and they want them to be able to do anything, anywhere in the world, any size, any time. Bigger is not better. Bigger is absolutely mandatory. It's like saying: 'I'm only 6 feet tall, I weigh only 175 pounds, and I run the 100 meters in 15 seconds, but I'm going to go out to the Giants' training camp and try to get recruited as a middle linebacker.' Sorry, the game has changed."

The rivalry is fueled by the strategic decisions that firms have made about their futures. In some cases, it's also powered by a whiff of personal vindication. Chase Manhattan Corp. bought J.P. Morgan late last year after Goldman Sachs decided not to; Chase and Merrill nearly merged in 1999 in a deal that might have given Merrill executives the upper hand; and J.P. Morgan, among others, looked at buying DLJ last year before Credit Suisse did. On the personal front, onetime Goldman investment banking chief Boisi now co-heads that business at J.P. Morgan; John Mack, Morgan Stanley's ex-president, took over at CSFB last month; and, of course, former Goldman co-chairman Robert Rubin is happily ensconced at Citi as consigliere to Sanford Weill, überbroker.

Corporate loans occupy the white-hot center of the battlefield today. Banks have begun using their historical strength in credit, packaging investment banking services with old-fashioned loans at a time when major companies are increasingly anxious for credit, to break into Wall Street's great honey pot of fees.

Their advantage is enormous. A decade of U.S. bank mergers, thin profit margins from lending and the continuing crisis in Japanese banking have cut the number of major corporate lenders by half in just the past two years, according to financial information service Standard & Poor's/PMD. Three big banks - Bank of America, Citi and J.P. Morgan - have effectively cornered the market for syndicated loans, with a 67 percent share of volume, according to Loan Pricing Corp. The top five banks control 79 percent of the market. Four years ago the top three had a 42 percent share; the top five, 60 percent. Today J.P. Morgan Chase alone arranges nearly four out of every ten syndicated loans.

Wall Street firms have gladly made loans in recent years. But these have tended to be transactional, high-priced deals: bridge loans, acquisition credits and the like. They have steered clear of the everyday, low-margin credit businesses - such as lines backing commercial paper issuance, called commercial paper "backstops" - that have been commercial bank staples for decades. Goldman, for example, refuses to participate in any backup credit lines. The firm argues that the pricing is too low, in part because of bank accounting treatment, to justify the potential risk of the backup lines being utilized. Xerox Corp., just before it went into a tailspin, drew down nearly $7 billion in backup lines when it could no longer get financing in the commercial paper market.

But commercial banks keep pitching this business to corporations, and companies increasingly are demanding the service from investment banks, especially as the number of lenders diminishes. Anyone who has gone looking for an ATM on a dark night and in a bad neighborhood will appreciate the welcoming allure of commercial banks these days. Says Carter McClelland, senior securities executive at BofA, "It's a great time to be a big bank with a big balance sheet."

Investment banks increasingly must choose whether to provide credit or risk losing a client. When Lear Corp. debuted in the European high-yield bond market with a $233 million offering in April, the auto-parts manufacturer excluded from a 23-bank syndicate its longtime investment banker, Morgan Stanley, which had declined to take part in a credit line for the company. Lear instead hired Deutsche Bank and Citi, both of which participated in the loan commitment (see story below).

Lucent needed to refinance a $6.5 billion revolving credit line by February 22 or risk losing access to the commercial paper market. Citi and J.P. Morgan delivered the package just hours before the deadline, while Goldman and CSFB declined to participate. Lucent promptly removed Goldman and CSFB as co-managers on the IPO of its microelectronics subsidiary, Agere Systems. Lucent then gave J.P. Morgan and Citi the hugely lucrative mandate to sell its fiber-optics business.

"If you're sitting in a company with a choice between giving the high-margin business to the people who supported you on the credit side and giving it to a group of competitors who are not necessarily going to do the job any better and who haven't made credit available to you, what are you going to choose?" sums up Michael Carpenter, CEO of Citi's investment banking unit.

The issue of credit extension even strained Goldman Sachs' relationship with Ford Motor Co., which dates back to the automaker's 1956 IPO. Last year Ford's then-treasurer, Malcolm MacDonald, told firms, including Goldman, that they would be shut out of future bond offerings if they didn't commit to the company's credit lines. Goldman declined but managed after some adroit maneuvering to stay involved in the automaker's bond business (see Dearborn story below).

"A lot of customers have become pretty vocal about demanding that their investment banks start providing credit. If you look at WorldCom, the underwriters were only the people who have been lending the company money for years," says Christopher Donnelly, who tracks the corporate loan market for Standard & Poor's. The credit-rating agency on July 16 downgraded its outlook for Merrill, Goldman and Morgan Stanley from "stable" to "negative," citing the likelihood that they would have to make risky loans to compete with commercial banks. Indeed, in a recent survey of CFOs by this magazine, 40 percent said they had demanded credit as a condition for giving inestment banking business.

Today's firefights are fierce - and emotions are fevered - because deals are so hard to come by. Even without the threat from gargantuan commercial banks, old-line firms would be scraping for business. The lower-margin business of bond underwriting, the strongest area for commercial banks, has accounted for about 52 percent of all financing this year, according to Dealogic CommScan. Meanwhile, stock issuance is on pace to decline 36 percent in 2001 from last year's levels, according to Thomson Financial. At the current rate, M&A volume is poised to fall by 57 percent.

Certainly, all the firms are motivated to get new business. Earnings at the houses that make their living from these markets are off markedly from last year. Wall Street has already laid off thousands of workers, as firms suffer from the slowdown in mergers and stock underwriting. In the second quarter Merrill's earnings fell 41 percent, in large part because of a 49 percent decline in profits from its investment banking unit. Net income at Morgan Stanley fell 36 percent, and Goldman's earnings declined 28 percent.

To be sure, the pain is not confined solely to the investment banks: J.P. Morgan reported sharply lower earnings (down 77 percent in the second quarter) after it was forced to write down $1 billion in venture capital investments. Citigroup, on the other hand, despite absorbing a 21 percent decline in its securities business, suffered only an 8 percent drop in overall earnings in the second quarter.

The danger in today's competition is that the banks and brokerages will drive to the bottom, courting unacceptable risks while stretching further for business. "If history is any guide, using the balance sheet to win business has never been a great strategy," says veteran Silicon Valley investment banker Thomas Weisel. "If you harken back to the bridge loans of the late '80s that almost carried First Boston out, it's never been a great strategy." Weisel sold Montgomery Securities to BofA in 1997 to gain a bigger balance sheet. Disenchanted, he soon struck out on his own.

In 1990, following a decade of bridge-loan-financed M&A wars, First Boston found itself with $1.1 billion of unrefinanceable loans. These "hung bridges" for deals such as the Ohio Mattress Co. buyout - known on the Street as the Burning Bed - nearly bankrupted the firm. Says Weisel, "It's being used increasingly with very risky companies, where it's not really clear that the loan you're making is going to get repaid."

Adds Dean Eberling, a brokerage industry analyst at Keefe, Bruyette & Woods: "Seismic shifts in the league tables usually don't take place because a few firms merge or start throwing around their balance sheets. Look at it from a portfolio- management standpoint. Would you want to own a position in a company that has lent billions to win a mandate? That's a pretty risky approach to winning business."

But in some respects, the loan-related deal-making environment is tamer than the go-go 1980s. Commercial banks have gotten much better at routinely syndicating any jumbo credits these days.

In fact, despite a year of plunging stock prices and deteriorating credit quality, no major financial institution has yet to announce any dire loan-related problems. "We've been decreasing the amount of commercial credit outstanding in all of our heritage companies for 15 years," says J.P. Morgan vice chairman Marc Shapiro. "Our commercial credit outstanding today is lower in absolute dollars than it was 15 years ago, even though our capital and earnings are almost three times what they were 15 years ago."

Nonetheless, a lending war played out against the backdrop of a weakening economy and a stalled equity market carries risks for both sides. Investment banks are fond of citing a recent report by Prudential Securities banking analyst Michael Mayo, which warns that bank off-balance-sheet exposure, in the form of unused credit lines, has more than tripled in the past decade, from $1.4 trillion to $4.7 trillion. These backup lines - often the very same facilities used by banks to win securities business from the borrowers - are being drawn down more often by companies falling on hard times, increasing the risk that these loans will eventually have to be written down against bank earnings, Mayo argues. Just last month Lucent announced that it had drawn down $2.3 billion of the $6.5 billion of credit lines it had arranged in February.

But investment banks are also juggling some shaky credits to win banking business in this new environment. Morgan Stanley, for example, was able to hold on to its lead manager role on the IPO of Agere Systems. But in doing so, it took on $2.6 billion of parent company Lucent's debt, including commercial paper obligations, even as Lucent battled earnings shortfalls and credit rating downgrades. Alan Jones, Morgan Stanley's head of leveraged finance, insists that the firm's exposure to Lucent's debt was always well protected. But, notes an executive from a commercial bank, "this is clearly not the kind of deal Morgan Stanley had in mind two years ago."

It's apparent that the investment banks realize they must meet the challenge of the big banks' balance sheets. Morgan Stanley has created a committee of senior executives to evaluate when it should extend credit to investment banking clients. And the firm last month hired Stephen Holcomb, the head of risk-rating assessment at J.P. Morgan, to be its chief credit officer, a new position. Morgan Stanley's loan commitments outstanding have jumped tenfold, to $14.6 billion in 2000 from $1.4 billion in 1998. The firm could significantly increase the $4 billion it actually funds for clients if necessary, says Jones.

Merrill is trying to build bank deposits from its vast network of retail brokerage clients so that it has more capital for corporate lending (the firm now boasts $70 billion in such deposits). In May, notes S&P loan analyst Donnelly, Merrill and Lehman surprisingly turned up in a $2.5 billion revolver and term loan for HCA-The Healthcare Co. Four months earlier Merrill was lead underwriter with Bank of America on a $500 million high-yield deal for HCA. "We are clearly fighting back in ways that we can and at times that we think it appropriate," says Merrill chairman Komansky. "We certainly will use our balance sheet to facilitate our clients. We don't go out and buy business, but we facilitate our clients where it's called for. Certainly it's a competitive issue."

Says Bennett Goodman, global head of leveraged finance and a member of the executive board of CSFB: "I think we're in for a real slugfest, and it's not going to end soon. You now have these behemoths, and they definitely have staying power. But you're not going to get firms like Goldman and Morgan Stanley backing down that easily."

But the old-line firms suffer a distinct disadvantage when it comes to making loans. Citi's $69 billion in equity capital and J.P. Morgan's $47 billion outmuscle the roughly $20 billion held by each of Morgan Stanley and Merrill, and Goldman's $17 billion. Moreover, their enormous loan portfolios make it easier for Citi and J.P. Morgan to absorb losses related to individual credits. Perhaps most significant, investment banks lack the credit expertise and syndication power that the largest commercial banks have built and honed for decades. Thus some critics argue that Street firms like Merrill, Goldman and Morgan Stanley will need to find a way to grow - by acquiring, being bought or forming alliances - to be able to wield enough heft to compete with the commercial bank behemoths.

In the meantime, the investment banks must draw the line somewhere. Goldman Sachs, the most outspoken on this issue, has told clients it will not provide commercial paper backstops - unfunded credit lines that even the soundest companies must obtain to guarantee their short-term borrowings in the $1.6 trillion commercial paper market - although it might mean losing investment banking business. Other firms, such as Morgan Stanley, aren't excluding the possibility of any particular loan arrangement but are trying to stick to short-term loans aimed at facilitating transactions.

Goldman also has complained loudly of late that commercial banks enjoy an unfair competitive advantage in the battle for corporate relationships. Because they are not required to carry loan commitments on their books at their market values, and thus do not suffer immediate earnings hits related to bad loans, the firm argues, the big banks can offer huge amounts of underpriced credit to corporations in a bid to win their more profitable underwriting and advisory business. Goldman is lobbying regulators for a change in accounting rules that would require banks to mark these commitments to market (see story below).

Commercial banks believe their recent success validates the one-stop-shopping strategy they have been pursuing for more than a decade. Loans, underwriting and other types of investment banking advice should naturally be integrated, this theory holds. That's especially true, commercial banks say, following the repeal last year of Glass-Steagall, which had kept the banking and securities businesses legally divided, in response to the Great Depression. And while banks have been making this argument for years, their enhanced investment banking capabilities are finally allowing them to put the theory to work.

"There's a whole new model - it's back to the future," says J.P. Morgan vice chairman Lee. "And the point of the matter is that the customer likes it. When you step back from this issue, remember that these businesses were artificially separated by Glass-Steagall. It was a regulatory event. It wasn't a market event. The market is just trying to glue all the pieces together again."

Investment banks insist the good times for commercial banks on Wall Street will abate when the economy and the stock market improve and credit is not in such demand. Indeed, despite the ideal environment right now and a few high-profile wins, commercial banks are still struggling to land major assignments in the more lucrative areas of equity underwriting and M&A advice. Citi remains fifth in equity issuance so far this year, though its market share has risen to 12.9 percent from 8.8 percent in 2000. J.P. Morgan has fallen from sixth to tenth, with just 1.8 percent. J.P. Morgan and Citi are fifth and eighth, respectively, in the advisory rankings, well behind the elite firms. In terms of disclosed fees, Morgan Stanley and Goldman Sachs account for 36.3 percent of all equity compensation, up from 31 percent last year, according to Thomson Financial.

It remains unclear how long this tight financing market will persist and whether commercial banks can permanently leverage this experience into elite investment banking status. For the time being, the two sides are waging a war that is as much public relations, marketing and image-making as it is finance. Taking a company public is not really a feat of financial engineering, but a few investment banks have managed to keep an iron grip on the high end of this profitable market by asserting a unique status as the symbol of good underwriting. The mystique of the bulge bracket has been one of its members' biggest assets.

The commercial banks' chances of getting past the mystique have never been better. Still, their Wall Street rivals also are sure to enjoy some relief once economic conditions improve. Indeed, even some corporate treasurers who are now being helped out by commercial banks are vague - or diplomatic - when it comes to predicting the ultimate winners. "In general, I'm one of those people who does not really need one-stop shopping," says Lucent treasurer Hund-Mejean. "I feel very comfortable taking the best in breed for each transaction."

The megabanks like Citigroup and J.P. Morgan Chase have a window of opportunity in which to demonstrate that they can finally supply the brain along with their brawn. If their investment banking capabilities can match those of the leading Wall Street firms, they stand a chance of demystifying the allure of their rivals and building long-term relationships that could reorder the investment banking hierarchy for years to come.

"If the balance sheet is combined with a quality work force," says Thom Weisel, "it could very well redefine what the bulge bracket is going to be."

Additional reporting by Jenny Anderson and Hal Lux.

the schaumburg salient

Playing golf still makes a difference. When William Harrison Jr. and Christopher Galvin paired for a round at Georgia's Augusta National Golf Club this spring, much more was at stake than the pride of two chief executives. According to people familiar with the matter, Harrison, the head of J.P. Morgan Chase & Co., sought out Motorola CEO Galvin to pitch a piece of business during the members-only outing held annually in advance of the Masters tournament.

Galvin, facing a potential liquidity squeeze after Standard & Poor's placed Motorola's credit rating on watch for a possible downgrade, was looking to refinance some outstanding debt with a $2 billion bridge loan from Goldman, Sachs & Co., Motorola's longtime investment bank. J.P. Morgan sensed an opportunity to wedge open its relationship with the Schaumburg, Illinois-based company. Between drives and putts, Harrison persuaded Galvin to meet with his bankers.

Motorola had good reason to agree. Setting up the bridge could have put the wireless equipment maker in danger of violating a net-worth covenant in an existing, $1.5 billion credit facility arranged by J.P. Morgan and Citigroup. Motorola asked the bankers to waive the covenant, which they did; but the bankers also wanted to discuss the structure of the bridge loan. They advised against securing the bridge with proceeds to be received later from Motorola's $1.8 billion sale of Mexican wireless assets to Spain's Telefónica (as Goldman was suggesting); doing so, they said, would compromise the position of the company's commercial bank syndicate, whose obligations were unsecured. This and other provisions made it less likely that the bank lenders would renew Motorola's short-term credit facility when it expired in September. The banks deny any suggestion that their advice veiled a threat or that they were tying their credit to other business.

After some tense back-and-forth, Motorola, the two megabanks and Goldman came to an agreement. The bridge was left unsecured; J.P. Morgan and Citi joined the loan as co-lead arrangers with a steaming Goldman. And Motorola agreed that, going forward, it will divide securities mandates among the three firms - a major coup for J.P. Morgan and Citi, neither of which had ever acted as lead underwriter for the company on a securities offering or as adviser for a merger or acquisition. - J.S.

the charge up murray hill

Few engagements in the war for investment banking fees better illustrate the resurgent power of commercial banks than the battle over Lucent Technologies.

Lucent was spun off in 1996 by AT&T Corp. in an IPO co-led by Morgan Stanley & Co. and Goldman, Sachs & Co. By last winter shares of the onetime market darling had plunged to the mid-teens; just 13 months earlier they had peaked at $82. Worse, Lucent desperately needed to obtain $6.5 billion in short-term credit lines by February 22 or risk being shut out of the commercial paper market.

Though other banks hesitated, J.P. Morgan Chase & Co. and Citigroup each committed $1.25 billion and lined up the rest just hours before the deadline. Goldman and Credit Suisse First Boston declined to take part in the credit package. Murray Hill, New Jersey-based Lucent didn't waste time rewarding the banks for their support, revamping the lineup of underwriters for the IPO of its microelectronics unit, Agere Systems, that had been set weeks earlier. It tossed out co-managers Goldman and CSFB, opting to do the deal entirely through firms that had subscribed to the credit facility.

That included Morgan Stanley, which aggressively protected its lead role in the Agere deal by agreeing to take on $2.6 billion in Lucent debt, including commercial paper. It paid itself back in shares from the $3.6 billion Agere offering, but only after pushing the deal to market amid dismal conditions for IPOs and exercising the underwriter's traditional "green shoe" option to sell investors $540 million in additional shares. Morgan Stanley pocketed more than $100 million in fees from the IPO. J.P. Morgan and Citi made far less, but they are now advising Lucent on the $2.75 billion sale of its fiber-optic business to Furukawa Electric Co. and Corning, which stands to yield the banks hundreds of millions in fees.

"Lucent is really the signature deal when you talk about the commercial banks exploiting credit," says one rival banker. "Morgan Chase and Citi get the strategic advisory business because they were there when the company really needed money. That was kind of the shot heard 'round the world in some respects." - J.S.

the defense at dearborn

Sometimes breaking up is so hard to do that it doesn't happen. Ask former Ford Motor Co. treasurer Malcolm MacDonald.

Last year MacDonald warned Wall Street investment banks that if they didn't start committing funds to the company's bank credit lines, they would no longer be considered as underwriters for Ford's frequent bond offerings. (It issued more than $40 billion in 2000.) Goldman, Sachs & Co., which has enjoyed a close relationship with Ford since leading the Dearborn, Michigan-based, automaker's 1956 initial public offering, politely declined. One of the most storied relationships in investment banking appeared to be headed for the rocks.

But much to its rivals' chagrin, Goldman continued to win Ford's business. Particularly galling: Ford's $5 billion global bond sale on January 25, which Goldman co-led with Deutsche Bank and Morgan Stanley. Citigroup, J.P. Morgan Chase & Co., Credit Suisse First Boston and a host of other firms had helped underwrite other Ford offerings in late 2000 and early this year. Infuriated officials of banks that had extended Ford credit called Elizabeth Acton, MacDonald's successor, demanding to know why the company had not carried out its threat. Acton, say people familiar with the matter, told these bankers that top management did not agree with that policy and had made an exception.

Ford's about-face demonstrated the power of Goldman's decadeslong relationship with Ford. Sources say that the firm went over MacDonald's head and persuaded Ford CEO Jacques Nasser to make Goldman an exception to MacDonald's dictum.

"We are proud of the relationship we've built with the Ford Motor Co. over the years and look forward to continuing to earn its business," says a Goldman spokeswoman, declining further comment.

Though Goldman advised Ford last year on a brilliant, if controversial, recapitalization, the automaker has awarded its longtime adviser fewer mandates of late. Goldman didn't take part in any of Ford's four acquisitions last year. Sources say MacDonald, who is now in charge of handing out the M&A business under Acton, thought Goldman had not invested enough time and care in the relationship.

Fortunately for Goldman, MacDonald's bosses don't seem to share the gripe. - J.S.

the envelopment at clinton

In May WorldCom threw the biggest party in corporate bond market history. But Merrill Lynch & Co., Goldman, Sachs & Co. and Morgan Stanley, the cream of Wall Street society, weren't invited.

Instead, the Clinton, Mississippi-based telecommunications carrier ladled out an estimated $120 million in fees to a group of underwriters owned by commercial banks, headed by joint book runners J.P. Morgan Chase & Co. and Citigroup.

What happened?

Concurrent with the bond sale, WorldCom needed $4.3 billion in loans, including a $2.65 billion credit facility to secure its short-term financing activity in the commercial paper market. With banks increasingly wary of extending credit to telecom companies, WorldCom wanted to bring in a wider group of lenders. It told a number of investment banks that they would stand a better chance of being picked as bond underwriters if they took part in the loan package. None took the bait, so WorldCom completely excluded them from its record $11.9 billion bond sale, even though traditional stand-alone investment banks, including Goldman, Lehman Brothers and Bear, Stearns & Co., had underwritten deals for the telecom giant in recent years.

To be sure, existing relationships played a major role in WorldCom's approach. Citigroup's Salomon Smith Barney had been a longtime adviser to WorldCom, largely on the strength of telecom analyst Jack Grubman's close relationship with WorldCom CEO Bernard Ebbers. "Ebbers and Grubman have some kind of lovefest going on," snipes one snubbed banker.

But the big winner was J.P. Morgan, which co-led the $4.3 billion loan package with Bank of America and had been only a minor player on previous WorldCom securities transactions. This time, however, it won a far more lucrative role as joint book runner on the bond sale with Citi. BofA was joint lead manager. Dutch bank ABN Amro, Deutsche Bank and France's BNP Paribas, among others, earned supporting parts after committing funds to the credit facility.

"We've got their attention," exclaims J.P. Morgan vice chairman Marc Shapiro of WorldCom. "The likelihood of us being involved in future M&A transactions or equity transactions for them is hugely higher today than it was a year ago, by virtue of our effectiveness in their debt offerings." - J.S.

flanking at grand central

When Philip Morris Cos. picked investment banks to manage the June 12 initial public offering of its Kraft Foods unit - at $8.7 billion, the second-largest IPO ever in the U.S. - it passed over the world's top two equity underwriters, Goldman, Sachs & Co. and Merrill Lynch & Co.

Why? Relationships certainly had something to do with it. The Kraft IPO had been planned as part of Philip Morris's purchase last fall of Nabisco Holdings from rival tobacco concern R.J. Reynolds Tobacco Holdings. Credit Suisse First Boston, co-lead manager on the Kraft IPO, also served as one of three advisers to Philip Morris on the acquisition. J.P. Morgan Chase & Co., another adviser on the Nabisco transaction, won a co-manager role for the IPO along with Morgan Stanley, which helped structure the complex Nabisco deal as adviser to RJR.

But there was another factor in determining who divvied up an estimated $237 million in fees for underwriting the offering: which firms provided Philip Morris with the funding it needed for the $19 billion Nabisco deal. Citigroup, which played a key role in a $9 billion credit facility backing the acquisition, won a co-lead manager slot with CSFB. But Merrill and Goldman declined to join the credit. Their roles went up in smoke.

Neither firm had much of a relationship with New York City-based Philip Morris previously. But the absence of Goldman and Merrill is striking nonetheless on so big a deal in tough markets. Among the 60 underwriters who got a piece of the action were investment banking also-rans such as SG Cowen Securities Corp. and HSBC Securities, both of which committed to the credit facility. Most deals close to Kraft's size include all of the top equity underwriters, if only to maximize the syndicate's ability to place the shares with investors. Other landmark deals in recent years, including United Parcel Service's $5.4 billion IPO in November 1999 and AT&T Wireless Group's $10.4 billion offering in April 2000 - the largest U.S. IPO ever - excluded none of the top-tier houses, let alone the top two. Times change. - J.S.

the retreat from southfield

Sometimes the best tactic, even for the most accomplished generals, is retreat. But when companies are pressing their investment banks for loans, the maneuver can be costly.

Take the case of Morgan Stanley and Lear Corp., which had done many deals together. Donald Stebbins, CFO of the Southfield, Michigan-based maker of automobile and aircraft seats, had chosen Morgan Stanley to help underwrite large secondary equity offerings in July 1996 and June 1997 and as sole book runner for a $1.4 billion high-yield bond sale in May 1999, yielding the investment bank millions of dollars in fees.

But things were different late last year, when Stebbins sought underwriters for Lear's debut offering in the European high-yield bond market. In addition to the bond deal, Lear needed to refinance a $1.7 billion revolving credit facility.

Underwriting high-yield bonds, of course, reaps far higher fees than committing to a credit facility. But with credit availabilty tight, Stebbins wanted the junk underwriters to put their capital on the line for Lear's revolver. "We were trying to reward people who did step up on the facility," says Stebbins. "We encouraged those who were going to participate [in the high-yield offering] and made them aware that it was important for us to get our bank revolver refinanced."

When Morgan Stanley declined to participate in the bank deal, Lear shut the firm out of its $233 million bond offering entirely, depriving it of as much as $10 million in fees. Citigroup and Deutsche Bank, which both committed to the credit line, co-led the junk sale.

Stebbins acknowledges that there are still some areas where Morgan Stanley can beat the commercial banks. But it will have to line up behind those that anted up credit for the loan facility. "Morgan Stanley has expertise that others don't have," he says. "But for plain-vanilla transactions, they might be at a slight disadvantage."

That's the message the banks want to deliver. - J.S.

the feint at norwalk

In April Goldman, Sachs & Co. opened a new front in the war for investment banking business, and in an unlikely place: Norwalk, Connecticut. That's the home of the Financial Accounting Standards Board, which sets the accounting rules that U.S. public companies must follow. In a letter to FASB, Goldman urged that commercial banks be required to carry unfunded corporate loan commitments on their books at the market value if the loan were to be sold, a practice known as "marking to market."

What sounds like accounting gobbledygook in reality holds great strategic importance for Goldman and its peers. Currently, commercial banks need not carry on their books unfunded loan commitments, such as revolving credits that back up commercial paper issuance. So even if problems at the borrowing companies increase the likelihood of funds being drawn down, thus reducing the market value of the line, bank earnings are not affected. When funds are drawn down, they are carried on the books as outstanding loans, at full value. Under Securities and Exchange Commission guidelines, brokerage firms such as Goldman are required to treat the loans like securities, immediately recognizing changes in their value according to secondary market prices.

This disparity gives commercial banks a powerful incentive to extend credit to companies, even risky ones. Goldman contends that they have been doing so at cut-rate prices to win securities underwriting and merger advisory business from the same clients.

The rule change Goldman wants would force banks to continuously book paper gains and losses on these credits, leveling the playing field for investment banks. In its letter, Goldman likens the commitments to credit derivatives, which all companies must now mark to market, under a FASB rule implemented in January 2000: "We believe that lenders' financial statements will be more representationally faithful of the risks and benefits of lending arrangements if loan commitments are treated as derivative instruments."

Goldman's interest is more than academic. Marking to market would make it much more expensive for banks to offer loan commitments, blunting an important strategy in their drive to capture investment banking business.

Argued J.P. Morgan Chase & Co. in a May 15 letter to the FASB rebutting Goldman's position: "Developing and implementing sufficient systems to capture the proposed loan commitment population, mark it to market and systemically provide for the drawn/undrawn dynamic of revolvers would take several years and cost hundreds of millions of dollars."

Perhaps that's because banks have more than tripled their unfunded loan exposure in the past decade, to $4.7 trillion, according to Prudential Securities banking analyst Michael Mayo. In contrast, federally insured commercial banks had approximately $1 trillion in funded loans on their balance sheets during the first quarter, according to the Federal Deposit Insurance Corp. As debt defaults soar to record levels, such aggressive lending practices may soon come back to haunt commercial banks, Mayo warns in a recent report.

Some commercial bank executives admit privately that it's hard to argue with Goldman's logic. "There is no economic rationale for not marking to market," says one. "You could go throughout the course of economic history, and all not marking to market accomplishes is the delay of a time bomb."

One current example: Lucent Technologies. Citigroup, J.P. Morgan Chase and Morgan Stanley & Co. all extended credit to the company and won valuable investment banking mandates as a result. But now that Lucent has announced horrendous losses and has drawn down $2.3 billion of the facility, Morgan Stanley must mark its piece to market while the commercial banks have discretion regarding when to declare it a troubled loan.

Nevertheless, it's unlikely that regulators will force banks to change their accounting overnight. Some banks would take a big enough hit on their books to send waves through the banking system. Says the commercial bank official, "You couldn't legislate, effective tomorrow, that the banks have to mark, because it's a stability issue."

Like it or not, Goldman and other investment banks will have to fight this battle for clients on the big banks' turf. Indeed, Goldman's effort to publicize its views on the issue backfired. Several financial publications used it as a starting point for articles on the firm's vulnerability to competition from commercial banks. - J.S.