Are Banks Throwing Good Money after Bad?

Welcome to the wacky world of defensive lending

On May 1, battered telecom startup Net2000 Communications Inc. was trading around $1.75--a fraction of its $31 initial public offering price. Even the company's most bullish analyst had downgraded it. Net2000's bonds were rated junk, and lawyers were starting to put together shareholder suits. But the very same day, Toronto-Dominion Bank, First Union Corp., and others made a $325 million loan to Net2000.

You might think the banks would be crying uncle by now. By some estimates, they may eventually have to write off nearly half the $320 billion they've lent to telecom outfits since 1999. Despite harrowing losses, of which Nortel Networks Corp.'s (NT ) $19 billion write-down on June 15 is the latest, the banks continue to lend. Between Mar. 1 and June 15, they made $10.1 billion in syndicated loans to telecom companies, says Thomson Financial Securities Data. Sure, that's less than the $25 billion for the same period last year, but it means deals are still getting done.

Of course, some of what critics call "defensive lending" is to well-established companies that aren't expected to fail, such as the $4.2 billion that Bank of America (BAC ), J.P. Morgan Chase (JPM ), and Citigroup (C ) extended to WorldCom Inc. (WCOM ) on May 1. Nevertheless, many of the loans made since Mar. 1 are classified as risky high-yield loans. Bankers say they are backing companies they think are survivors. "Clearly, there are going to be winners and losers," says one telecom banker. "It's just a question of making sure you pick the right one."

But such lending can become a habit. First Union and Toronto-Dominion, for example, were already on the hook for $200 million to Net2000 when they made the new loan. They're not alone. On Mar. 16, J.P. Morgan Chase, Goldman Sachs, and Morgan Stanley lent $400 million to Level 3 Communications. The three lent $2.5 billion to Level 3 in August, 1999. The company isn't expected to have a positive cash flow until 2005, at the earliest. None of the banks would comment. But rival bankers say the new loans for Net2000 and Level 3 were hard to sell on the syndicated loan market, where banks trade loans with one another. Indeed, they were so unpopular that they had to be offered at a 20% discount.

Why are banks willing to take the risk of piling on more lending? Their idea is that in addition to earning fees from the loans, they can win long-term customers by lending in hard times. "If you're willing to make a loan now to a company that's facing tough times, you're going to have a company that's going to love you forever," says Thomas Okel, head of syndicated capital markets at Bank of America.

BOLSTERED RESERVES. For now, that sounds like whistling in the dark. Risks for the lenders to the telecom industry are steeper than they ever have been, in part because telecom bank debt is so out of favor with investors. "People don't know where the bottom is," says Okel. Generally, when an industry experiences the sort of consolidation and contraction that is occurring in telecom, distressed-debt investors rush in and buy up bank loans on the cheap. But that's not happening. Instead, the banks are having to set up reserves against possible losses on loans. On June 27, Toronto-Dominion said it was upping its loan-loss reserves by $400 million for the rest of the year. The bank has lent more than $6.1 billion to the telecom industry, or 53% of shareholders' equity, says analyst Quentin Broad of CIBC World Markets. Of that, $3.2 billion is considered risky.

Worried regulators will ensure that banks' loan losses provisions keep rising. "Problem loans are increasing, and we expect reserves to go up," says David D. Gibbons, deputy comptroller at the Office of the Comptroller of the Currency. And that will prove expensive to banks that will have to finance the reserves from their profits.

Corrections and Clarifications Toronto-Dominion Bank ("Good money after bad?" Finance, July 9) is upping its loan-loss reserves to a total of $400 million for 2001--not by that amount, as incorrectly stated.

By Heather Timmons in New York

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