Less Credit Where Credit Is Due

After WorldCom, Enron, and the rest, getting a corporate loan will take longer and cost more

Banks have been paring back lending for the past 12 months, and venture-capital money and equity issues have all but dried up. But the collapse of telecom giant WorldCom Inc., coming on the heels of a record number of corporate bankruptcies, threatens to throw the credit markets into a new tailspin.

Institutional investors such as insurance and pension funds now face huge losses from $32 billion in WorldCom debt. That's on top of $40 million wiped off the value of WorldCom's equity this year as well as losses from Enron, Kmart, Global Crossing, and others. They swear they aren't going to get stuck again. And, because of the way credit markets now work, that could have a dramatic impact.

In the past decade, banks have moved aggressively to get risk off their balance sheets by packaging loans and selling them to institutional investors. Banks generally keep 10% or less of the stock, loan, or bond they underwrite. "It's a totally different practice from 10 years ago," says Thomas D. McCandless, an analyst at brokerage Keefe, Bruyette & Woods Inc. "Then, the policy was, `If it's good enough to underwrite, it's good enough to keep."'

The shift made it much easier for companies to raise money, and helped bankroll the economic boom of the 1990s. Outstanding corporate credit has doubled in the past decade to reach $4.9 trillion in the first quarter of 2002. All this financial liquidity, though, relies on the willingness of institutions to buy loans, bonds, and stock from banks.

But the recent spate of "fallen angels"--companies that slipped from investment grade to junk at a rapid clip--has opened a rift between the two groups. Bondholders argue that banks, which enjoy the cheapest source of funding, need to step up to the plate and take on more risk. "Bankers have special responsibilities, because they have special privileges," says Paul McCulley, managing director of Pacific Investment Management Co. "We need to put some [risk] back onto bank balance sheets. If they don't want to do it, Mr. Greenspan needs to put a shoe in their backsides and make them."

The battle between banks and the institutions is spilling over into the courts. A group of 11 insurers are locked in an ugly legal battle against J.P. Morgan Chase (JPM ) over Mahonia, an Enron Corp. off-balance sheet partnership the bank helped create. The insurers refuse to pay a $1 billion claim filed by the bank, saying Mahonia was a sham. The bank says these insurers are just trying to shirk their obligations. Off-balance sheet transactions created by both Citigroup (C ) and J.P. Morgan Chase for Enron will be the subject of a Congressional investigation later this month. Both banks were big lenders to the energy concern, underwrote its bonds, and recommended its stock. Enron pension funds are also suing the energy company's bankers.

WorldCom's meltdown has angered the institutions even more. The company issued a record $11.8 billion in bonds in May, 2001. About half the amount raised went to pay back short-term bank loans. When the company admitted to accounting fraud and restated five quarters of earnings in June, banks were left with about $2.7 billion in exposure and bondholders were stuck with $30 billion in debt that now trades at huge discounts. "There has to be due diligence, responsibility, and accountability by the underwriters," adds Seymour Sternberg, CEO of New York Life Insurance Co. "Might there be a lawsuit on this? If the facts warrant it, you bet."

Both J.P. Morgan Chase and Citigroup, lead underwriters on the WorldCom bonds, say they relied on company numbers and couldn't have foreseen the fraud. The bonds were underwritten based on WorldCom's 2000 numbers. Its restatement goes back to the start of 2001, though its 1999 and 2000 numbers are now being reviewed by the Securities & Exchange Commission.

Some politicians are jumping in. "Obviously, when you're getting the type of fees that are generated here and you're not putting a lot of your money at risk, you have to make sure [transactions are] being done properly," says Representative Paul E. Kanjorski (D-Pa). On July 8, he wrote Salomon Smith Barney analyst Jack Grubman, who was close to former WorldCom CEO Bernard J. Ebbers, asking if WorldCom executives had received shares in sought-after initial public offerings underwritten by the Citigroup unit. A Citigroup spokeswoman says the bank is reviewing the request, but adds that no analyst is responsible for IPO allocations.

Despite the WorldCom furor, corporate credit markets aren't going to dry up completely. After all, money managers wouldn't be happy with a portfolio comprised entirely of Treasury bills. And some controversial big names are still getting bank loans. For instance, AOL Time Warner Inc. secured a $10 billion line of credit on July 8, replacing loans that come due in the fall.

All the same, companies hoping to raise money in any shape or form in the next six months had better be ready to be poked, prodded, and cross-examined--and pay up for the privilege. Lenders, investors, and bondholders alike are treating all numbers they're given by debtors with suspicion. The increased scrutiny of existing companies could have a twofold effect, experts say. "For companies that are actually doing poorly, their decline will be accelerated," says Jonathan Schiff, a professor of accounting at Fairleigh Dickinson University and president of Schiff Consulting Group. "Those that are actually doing well will prosper."

Any company that relies as WorldCom did on EBITDA, or earnings before interest, tax, depreciation, and amortization, is now under the magnifying glass. The measure, once considered a fair judge of cash flow, was easily manipulated by WorldCom. But even before the WorldCom fraud was revealed, not everyone was a fan. In February, CEO Warren E. Buffett told Berkshire Hathaway Inc. shareholders in his annual letter: "References to EBITDA make us shudder--does management think the tooth fairy pays for capital expenditures?" Still, EBITDA was used routinely in media, hotels, and gaming, as well as telecom. Now, bankers and investors are reevaluating most such companies.

Also on the line: the swashbuckling CEO. Jokes one banker: "We're not lending to any company whose CEO is known by their first name." After the recent problems faced by Bernie [Ebbers], Martha [Stewart], and Dennis [Kozlowski], the appeal of a low-key, down-to-earth CEO seems obvious. Bond guru William H. Gross, managing director of Pacific Investment Management, says in his most recent newsletter: "We're shunning corporations whose CEOs are the cover boys and cover girls at bookstore magazine stands[and] management that's paid themselves tens of millions per year. We're looking for common sense, not star worship."

Companies with grounded management and straightforward numbers aren't off the hook if they want to raise funds. "You'll see lenders doing more audits themselves," says Michael Loughlin, chief credit officer for commercial banking at Wells Fargo Co. His bank plans to hire outside auditors to examine numbers from companies that aren't existing customers--probably passing the costs along to borrowers. Wary bond buyers have the same idea. New York insurer American International Group has set up a new risk-management group independent of its investment department to review all of its large transactions. "We'll have an additional set of eyes" looking at investments, says AIG CEO Maurice R. "Hank" Greenberg.

As WorldCom teeters, there isn't a part of the credit market that isn't touched by the fallout from its woes. Even healthy companies that want to borrow are likely to suffer from the contagion for months to come.

By Heather Timmons in New York

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