Surprise! The Little Guy Loses

Big banks offloaded their risk--mostly to small investors

Stocks of financial behemoths Citigroup (C ), J.P. Morgan Chase (JPM ), and Bank of America (BAC ) plunged on June 26 on fears that they'd be dragged down by huge losses from WorldCom Inc.'s collapse. They and other banks underwrote $29 billion in bonds and arranged $8 billion of credit lines for it. But most of the pain from the telecom giant's implosion will be felt on Main Street, not Wall Street.

The banks have become masters at offloading the financial risks of their lending by repackaging and selling it to pension and mutual funds, insurance companies, and even ordinary investors. That ability was a big plus during the roaring '90s because it enabled them to bankroll the New Economy. The outstanding debt of nonfinancial companies more than doubled, to $4.9 trillion in the first quarter of 2002 vs. $2.4 trillion during the same quarter of 1990, according to the Federal Reserve. Trouble is, easy credit hatched highly leveraged upstarts such as WorldCom that are now floundering under their huge debt loads.

Here are the likely losers if WorldCom goes bankrupt:

Pensions and 401(k) plans: Citigroup underwrote WorldCom's last bond deal, an $11 billion issue in spring 2001. But the biggest holders of WorldCom's $29 billion in bonds include Prudential Securities, California Public Employees' Retirement System, and MetLife, according to bond researcher Capital Access International. Together, the three hold $1.25 billion worth of the bonds, which traded at 13 cents on the dollar on June 26, down from 65 cents the day before. Also, since the start of the year, WorldCom stock has lost more than $40.4 billion in value. The biggest holders are all leading asset managers that run pension and mutual funds: Alliance Capital Management, Wellington Management, and Barclays Bank.

Bank-loan funds: Big banks have lent WorldCom $2.65 billion in unsecured loans. Typically, they keep under 10% of loans they arrange, syndicating the rest to smaller banks, insurers, and loan funds sold to individual investors. Asset managers, such as Eaton Vance, Van Kampen, and Fidelity Investments, had $22 billion in bank-loan funds at the end of May, according to Lipper Inc. Owners of such funds tend to be "individual investors who thought they were savvy and turned out not to be" because the investments are turning out to be high risk, says Donald Cassidy, a senior research analyst at Lipper.

Consumer spending: Analysts say that because banks have offloaded so much risk, a WorldCom bankruptcy could put a severe squeeze on consumer spending, one of the economy's stronger spots. "People are feeling poorer, and they will have a statement to prove it at the end of the quarter," says Cassidy.

Research analysts: New York State Attorney General Eliot Spitzer said on June 26 that he will investigate Wall Street research on WorldCom. First in line is controversial telecom analyst Jack Grubman of Citigroup's Salomon Smith Barney, who issued a downgrade on the stock the day before WorldCom's bombshell. A spokeswoman for Grubman says he was "just as stunned as everyone else" by the announcement.

Oddly enough, even though bankers may have dodged the WorldCom bullets for now, they're the ones holding a gun to the company's head. Because WorldCom is in default on $2.65 billion in bank loans, bankers can force it to file for bankruptcy. The company's 21 lenders could then liquidate WorldCom's assets and pay themselves back before anyone else. A few are hesitant. "I don't think it's sensible for banks to push this company into Chapter 11," says one lender. But others are gung-ho to do just that. Says one, "They're not getting any more money from us unless they file for bankruptcy."

By Heather Timmons in New York

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