Commercial banks are encountering some dangerous terrain as they invade investment banks’ turf.
By Jenny Anderson and Justin Schack
April 2002
Institutional Investor Magazine
It was only a year ago that an unprecedented shift in the balance of power appeared to be under way on Wall Street. After years of largely fruitless efforts, a handful of big commercial banks, led by J.P. Morgan Chase & Co. and Citigroup, had begun to make impressive inroads into the lucrative underwriting and merger advisory businesses of traditional investment banks like Morgan Stanley and Goldman, Sachs & Co.
Fresh from an acquisition spree that saw them gobble up a slew of brokerage houses, the commercial banks were elbowing aside their smaller Wall Street rivals on one big high-profile deal after another. They scored coups with coveted clients like Lucent Technologies, Motorola, Philip Morris Cos. and WorldCom, which either excluded the investment banking firms from deals or marginalized their roles. The banks brought deep pockets and a willingness to reach into them. Their weapon of choice: an open tap for credit lines , in particular, commercial paper backstops, which they freely dispensed to companies, hoping to win a piece of the action on lucrative stock and bond underwritings and merger advisory mandates. Many companies responded by demanding that their investment banks also extend credit as a precondition for doing other business.
“It’s a great time to be a big bank with a big balance sheet,” crowed Carter McClelland, a veteran Morgan Stanley investment banker who now heads Bank of America Corp.'s securities business, to this magazine last summer (Institutional Investor, August 2001).
Now it is no longer such a great time. Even before Enron Corp. melted in December like a mountain of cotton candy, a number of big borrowers found themselves struggling as the economy soured and the technology boom fizzled. In short order they beat a path to the banks’ doors, looking to draw down their loans. Since December at least $16.4 billion in CP backstop loans has been drawn down, for the most part unexpectedly. Banks aren’t withdrawing from the field, but their weapon of choice has been blunted and their strategy of attack has become riskier and more costly. “Simply providing tons of capital has not proven to be the answer,” says Bruce Ling, global head of corporate banking at Credit Suisse First Boston.
In retrospect, something like this was bound to happen. The cooling economy, after all, helped banks make their inroads in the first place. Scores of companies needed cash to see them through the rainy days, and commercial banks seized the opportunity, arranging big loans. Investment banks like Goldman, Merrill Lynch & Co. and Morgan Stanley anted up for bridge loans and term facilities, but they generally shied away from CP backstops because the pricing was so aggressive and the accounting treatment of the facilities was less favorable for them than it was for banks.
CP lines should be worry-free: Lenders guarantee that a company can draw down a specified amount if it is unable to roll over the short-term commercial paper debt it uses for day-to-day funding. Historically, companies have so rarely failed to roll over their commercial paper that backstop facilities resembled hurricane insurance in Montana , easy money.
But that changed radically in the past few months as companies’ credit standings deteriorated in a record year for bankruptcies. Enron drew down $3 billion from a CP backstop just before filing its record $63 billion bankruptcy in December. The company owes J.P. Morgan some $2.6 billion and Citi roughly $1.2 billion. Enron’s woes got investors so concerned about opaque corporate accounting and credit risk that more companies now face liquidity problems of their own. Some have drawn down backup facilities to ensure working capital.
Drawing on a backstop is “like a neon sign on the side of the building that says, ,I can’t fund myself,’ ” says Brad Hintz, a securities industry analyst at Sanford C. Bernstein & Co. But the list of humbled companies tapping lines is growing despite the taint. Late last month Swedish engineering giant ABB drew down a $3 billion line to pay back short-term debt. In early February Tyco International exhausted its $5.9 billion backup credit line after concerns about its accounting practices shut the company out of the CP market. Broadband communications concern Qwest Communications International faced a similar fate about one week later and drew down $4 billion.
None of this is good news for banks. Drawn-down loans are significantly more expensive for them. Banks are required to reserve capital only for contingent liabilities with a maturity of one year or longer; shorter-term facilities are thus cheaper to offer, which is one reason that 72 percent of CP backstops issued in 2001 carry terms of 364 days or less, according to Loan Pricing Corp. But once the facilities are drawn down, the banks must back them with capital, creating a drag on their returns.
Unlike commercial banks, investment banks have to mark to market their loans and contingent liabilities. Hence they can’t offer the CP lines as cheaply, and they’ve been loath to take on the risk.
To be sure, Wall Street is not crying out for capital. Balance sheets have grown rapidly in recent years, plumped by fat bull market profits, mergers and IPOs. Merrill Lynch led all Wall Street firms last year with $76.8 billion in capital, securing first place in Institutional Investor’s 2002 capital rankings.
That does not really mean that Merrill has more capital than Citigroup, however. (The rankings reflect capital allocated to a firm’s securities business.) In the case of commercial banks, this figure refers to the portion of overall capital being used by securities subsidiaries. It doesn’t include capital backing loans and other businesses. For instance, according to its annual report, Citi’s total capital is $79.7 billion , far more than the $38.9 billion it dedicates to investment banking.
All that capital should remain a big comfort to commercial banks: Observers expect that more companies will be knocking on their doors in the future as increasingly risk-averse investors shy away from commercial paper in the wake of deteriorating corporate credit quality. In the fourth quarter alone, CP issuance by nonfinancial companies fell 34 percent from the year-earlier period, to $225 billion, according to Standard & Poor’s. Issuers such as AT&T Corp., Eastman Kodak Co., the Gap, General Motors Corp. and Walt Disney Co. have been downgraded from the coveted A-1 rating to A-2 by S&P during the past six months. Banks have begun to demand higher fees and interest rates for renewals, prompting some companies to tap their cheaper lines. In March, rather than go to the CP market, Sprint Corp. inked an unusual $1 billion nine-month loan secured by its phone directory publishing business.
“The bad news is you still have some seasoning , there are a lot of loans yet to come due,” says Prudential Securities bank analyst Michael Mayo. “Corporations are sensing tougher terms once lines roll over, and they’re drawing down rather than accepting the tougher terms.”
Despite its shortcomings, capital remains a potent factor in the competition for investment banking business. Facing rivals with much more capital at their command, investment banks that want to maintain client relationships must also lend those clients money from time to time. Last month Merrill created a new group to coordinate lending across all of its businesses, from corporate to consumer loans. Morgan Stanley made a similar move last year, inaugurating a more sophisticated, rigorous approach to lending to better manage risk.
Even as banks hike their pricing and tighten the terms of new credit facilities, some are shying away from the CP backstop market. That reluctance seems especially pronounced among the smaller banks in lending syndicates, which don’t enjoy as much of the issuer’s higher-margin investment banking business. “That used to be the sweet spot of the market,” says Bram Smith, head of global lending at Morgan Stanley. “Now you see [banks that] would have committed $250 million three months ago saying the number’s $100 million. That’s a huge difference.”
As a result, leading lenders must take on more exposure or, alternatively, pull back. BofA reduced its corporate loan portfolio from $99 billion in August 2000 to $67 billion at the end of 2001; it plans to reduce that by up to an additional $20 billion. In the same period it reduced unfunded commitments from $160 billion to $125 billion. J.P. Morgan Chase is trimming its loan commitments by offering smaller amounts when rolling over credit revolvers. But the bank doesn’t think such a move will jeopardize its foray into investment banking. “It’s not as if all of a sudden the majority of backstops are going to be drawn down,” says Don McCree, co-head of J.P. Morgan’s North America credit and rates business. “The universal, one-stop premise is still something we are totally committed to.”
Indeed, there is a silver lining. Faced with the short-term credit squeeze, many companies are looking to refinance with longer-term bonds. For commercial banks that’s the bonus they’ve been seeking , having lent the short-term money, they’re better positioned to win underwriting business. There are numerous deals pending in the profitable high-yield bond market to pay off bank debt; many are being led by commercial banks. In U.S. high-yield underwriting J.P. Morgan leapt from ninth in the first quarter of 2001 to third in the first 11 weeks of the first quarter of 2002, while BofA rose from seventh to fourth. In M&A, Citigroup jumped from eighth to second this year.
“There will be less borrowing, a shift in the kind of borrowing from loans to more medium-term notes and bonds and an increase in the cost of borrowing,” says Meredith Coffey, a Loan Pricing Corp. analyst.
Banks may benefit from this move into the capital markets, but they’ll still have the possibility of loan drawdowns singeing their earnings. J.P. Morgan increased its loan-loss reserves to 1.6 percent of its commercial portfolio at the end of 2001 from 1.3 percent the year before. Citi raised its reserves to 3.3 percent, up from 2.9 percent. But BofA cut its reserves to 3.7 percent from 3.8 percent. During the first half of 2001, says Prudential’s Mayo, banks’ contingent liabilities grew from
$4.7 trillion to $5 trillion. “That’s $5 trillion with a capital T,” says Mayo. “That’s triple the level of the last recession. Logically, you’re going to have a faster pace of drawdowns. There’s a real threat of additional significant earnings shortfalls.”
The hit to earnings would be bigger if commercial banks, like investment banks, were forced to mark the value of their outstanding loans to market prices on a continuous basis. Currently, banks have wide discretion on when to write down or even write off bad loans. Often they do so over time to smooth out earnings.
The current credit cycle will embolden investment banks to step up their crusade to change the accounting rules. Many of them believe the disparate treatments give commercial banks an advantage in going after underwriting and advisory mandates. In December the Financial Accounting Standards Board ruled that commercial banks must mark some loans to market, likening backstop facilities to credit derivatives which must be marked to market. Then last month FASB reversed course.
But investment banks like Goldman, which actively lobbied for the change, may have a more powerful case for defining how the rule is applied in the current credit environment. “It makes the case stronger to account for these contingent liabilities,” says Lehman Brothers accounting analyst Robert Willens. “There’s a sense that these lines of credit are not theoretical , that they do actually get drawn down and they should be accounted for as soon as the commitment is entered into.”
