Commentary: A Rude Awakening for Go-Go Lenders

By Lewis Braham

For investors in financial-services stocks, it's time to shift gears. During the roaring '90s, all that mattered was earnings. But now that the junk-bond market has fallen off a cliff, asset quality matters much more. "Everyone needs to be checking balance sheets twice," says Lanny Thorndike, chief investment officer of Century Shares Trust, a financial-services mutual fund.

Just look at what happened to American Express Co. (AXP ) On Apr. 2, it took an 18% hit in earnings because of a $185 million loss in its insurance unit's investment portfolio, due mainly to junk bonds. Such bruisings will become common. Junk-bond defaults, already 5.7% of the $600 billion outstanding last year--the highest rate since 1991--are expected to peak at 9.9% in 2002, according to Moody's Investors Service. "The recovery rates on these defaulted issues are just awful: 16.5 cents on every dollar invested," says Moody's credit analyst David Hamilton.

AGGRESSIVE LENDING. The syndicated loan market, for loans that banks trade between one another, hasn't fared much better. In the past month, Bank of America (BAC ), Bank One (ONE ), and First Union (FTU ) have announced earnings slides because of nonperforming loans. Bank of America alone charged off $772 million in its latest quarter, up from $420 million in the same quarter last year. Bank One is setting aside about $1.2 billion for loan losses this year, double last year's amount. Worse yet, because of the vagaries of accounting regulations, junk bonds held by insurance companies and syndicated loans held by banks can be priced at face value until they mature, default, or are sold--even if they trade at a deep discount in the market, as debt of the telecom, health-care, and asbestos industries now does.

Banks are more vulnerable than insurers because they lent much more aggressively. Salomon Smith Barney (C ) says banks have $51 billion in loans that could default. A fifth of them are loans to companies facing asbestos-related lawsuits: Owens-Illinois, Crown Cork & Seal, and Federal-Mogul. Top lender was Bank of America, with a $4.2 billion exposure, followed by Bank One ($2.2 billion), J.P. Morgan Chase ($2.1 billion), and First Union ($1.1 billion).

Banks downplay the situation's severity. "The banking industry has experienced credit problems as the economy has worsened over the past several months," says Mary Eshet, a spokesperson for First Union. But First Union expects "nonperforming loans not to rise as fast they did in 2000." Bank of America spokesman Robert Stickler is also unconcerned: "We're well-positioned to take care of any problems because of the size of our reserves to cover losses and the diversification of our loan portfolio." J.P. Morgan Chase declined to comment ahead of its pending earnings announcement.

In the insurance industry, life companies are most at risk because they tend to invest more in junk. The average life insurer had 4.8% of its $37.6 billion investment portfolio in junk at the end of 2000, says Colin Devine, an insurance analyst at Salomon Smith Barney. For some, though, the risk is much higher: At American Express, the weighting is 11%; at John Hancock Financial, 8.9%; and at Conseco, 7.6%.

AmEx spokesman Michael O'Neill says the 11% junk weighting is typical for the firm. "The aggregate economic benefit of our high-yield investing has been favorable," he says. Conseco (CNC ) sold most of its lower-quality bonds last year and only uses market prices for its portfolio, says Max Bublitz, head of Conseco's investment management group. John Hancock's representative says it never invests more than 10% in junk bonds, most of which are "just below investment grade."

SNAIL'S PACE. Regulators have been slow to act. On Mar. 15, for example, the Financial Accounting Standards Board toughened the pricing standards for asset-backed debt to more accurately reflect market reality. AmEx said $34 million of its reported $185 million loss resulted from the rule change. Meanwhile, an FASB proposal to require banks to value syndicated loans at market prices may take years to iron out.

Until the dust settles, investors are better off buying into large, slow-growing banks and insurers with clean balance sheets than aggressive up-and-comers. Since their loans are the shakiest, smaller regional banks and thrifts may be in particular danger. Their returns may look good in a bull market, but they're bear bait.

Braham covers investing.

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