The Breakdown in Banking

Trust is eroding, and profits may follow as business models falter

In the 1990s, the sky seemed the limit for financial institutions. Once restricted to taking deposits and making loans, banks broke into the business of selling securities. Wall Street investment houses began making loans to companies. The result was a flood of money to promising new companies, existing businesses, and consumers. That fueled the New Economy with its rapid productivity growth and made the American financial system the envy of the world. Moreover, the financial system seemingly sailed through the 2001 recession and the accompanying stock market decline in good shape. Commercial banks had record profits in the second quarter of this year, and their balance sheets were far stronger than in previous recessions.

But now, the ever-closer partnership between commercial banking and investment banking is showing signs of strain. Putnam Lovell Securities estimates that earnings at five of the largest firms--Citigroup (C ), J.P. Morgan Chase (JPM ), Merrill Lynch (MER ), Goldman Sachs (GS ), and Morgan Stanley (MWD )--could stay stuck below 1998 levels this year. On Sept. 17, J.P. Morgan Chase & Co. warned that its third-quarter operating profits will be "well below" those of the second quarter as losses on corporate lending may more than quadruple, to $1.4 billion. One possible reason: Many of those loans were made to now-struggling or failed telecom companies in a bid to win investment banking.

That's a small part of the unprecedented wave of bad debt flooding the financial system. A record $880 billion worth of corporate bonds and loans are distressed or in default, according to Edward I. Altman, a professor at New York University's Stern School of Business. As the losses mount, the biggest firms are facing the threat of legal action from investors who see themselves as the victims of a massive con game.

At issue is the economic recovery. Banks are indispensable links in the flow of money, and they must be perceived as honest players. Yet after a year of revelations about their questionable practices and conflicts of interest, investors have become increasingly skeptical of everything Wall Street sells.

That partially explains why the stock market is tanking even as the real economy shows signs of recovery. It also accounts for the higher rates that investors demand before they'll hold corporate bonds. Ford Motor Co. (F ), for example, is paying four percentage points more than the government on borrowing. With stock prices low, as well, the cost of capital for companies is rising, discouraging needed investment. And as long as investigations drag on, investors will steer clear of what they perceive to be a rigged game. "Until we have some finality around recent regulatory and legislative reforms that make people feel it's safe to go back in the water, we're not going to get the confidence and credibility back in the marketplace," says Lehman Brothers Inc. Chief Financial Officer David Goldfarb.

How did we come to this? In the 1990s, market forces penetrated the once heavily policed U.S. financial system. The 1999 repeal of the Depression-era Glass-Steagall Act accelerated an existing trend of commercial and investment banks coming together--or invading one another's turf--by sweeping away barriers that were designed to protect corporations, borrowers, and investors from banks' conflicts of interest. The change sanctioned financial behemoths such as Citigroup and J.P. Morgan and allowed commercial banks such as Bank of America (BAC ) and FleetBoston Financial Corp. (FBF ) to jump on the investment-banking wagon. All were seeking to leverage low-margin lending into much more profitable fee businesses such as underwriting shares.

The result: Competition in investment banking became cutthroat. Research analysts became shills for stock offerings instead of investment advisers; investment bankers dangled allocations of initial public offerings to CEOs to get business. Loans were offered to entice lucrative investment-banking business. "The whole financial system has become corrupt," says Felix G. Rohatyn, who runs financial advisory firm Rohatyn Associates LLC.

At the same time, market forces had begun to change the straitlaced culture of big commercial banks. They sold off pieces of their corporate loans to smaller banks, insurers, and mutual funds in a booming syndication market of more than $2 trillion. Then they moved on to repackaging consumer loans into securities, from mortgages to credit-card receivables, and sold them to institutions in what's now a $7 trillion securitization business. By selling off their loans, banks were able to lend to yet more borrowers because they could reuse their capital over and over. But it also meant that they made lending decisions based on what the market wanted rather than on their own credit judgments. The wholesale offloading of risk made the banking system less of a buffer and more of a highly streamlined transmitter of the whims of the market.

The more businesses that financial institutions assembled, the more conflicts of interest they faced. Heightened competition encouraged banks to use rosy stock recommendations, low-interest loans, and handouts of shares in hot IPOs to CEOs to win lucrative investment-banking business. It also led bankers to make unwise loans and underwrite securities that never should have come to market. The boom-time excesses of the banking system are "a train wreck waiting to happen," says D.Quinn Mills, a finance professor at Harvard Business School.

Meanwhile, the resale of loans created moral hazard: a temptation for banks to scrutinize borrowers less carefully than when their own money was at stake. "The banks abdicated credit judgment, and the people to whom they sold the paper had no credit judgment," says Martin Mayer, a guest scholar at the Brookings Institution and author of The Bankers.

Other problems may yet emerge. While the market for securitized consumer loans remains healthy, investors who took loans off banks' hands could get stung if the economy stumbles. Moreover, it's tougher for the Federal Reserve, which supervises banks, to fix systemic credit problems once the debt is in the market. Says Mayer: "This is the first time that the banking system has ever predistributed losses."

Many of the stocks and bonds floated during the 1990s boom probably never should have come to market. For example, 45% of junk bonds are distressed or in default, up from 5% in 1998, according to Stern's Altman. Now, investors balk at loading up on more junk bonds. And some are shying away from new issues of asset-backed securities from banks. "There have been many deals we have turned away recently that have not passed our credit stress tests," says Dan Ivascyn, portfolio manager at Pacific Investment Management Co., which manages $274 billion of assets.

Compounding the stress on the economy is a loss of faith. Financial institutions are under siege from thousands of investor lawsuits. And some in Washington are starting to question if the one-stop financial shops allowed by the repeal of Glass-Steagall should continue to exist at all. To be explored, says a top Democratic Hill aide, is whether legislation "pushed commercial and investment banks to take on greater risks than they otherwise would, and whether [the law] caused conflicts" by placing bankers at odds with clients' interests.

Now, it's clear that in their race to become jacks-of-all-trades, many financial-services companies ended up mastering none. Many failed in their attempt to turn into one-stop financial shops selling everything from merger advice to credit cards. FleetBoston shut its investment-banking unit Robertson Stephens earlier this year largely because high-tech IPOs, its specialty, dried up and left big losses, says CEO Charles K. Gifford. Adds Wells Fargo & Co. CEO Richard M. Kovacevich: "Almost 70% of banks buying investment banks fail." Wells Fargo itself has avoided the bidding. A growing share of profits at big banks comes from trading, which is inherently uncertain. "Banks are playing the interest-rate market, and it is starting to explode," says David A. Hendler, an analyst with CreditSights, a bond research firm.

Things will get worse if more bad debts surface. J.P. Morgan wrote off $3.3 billion in bad loans in the nine months through June 30. And it's impossible to tell how exposed banks are to losses from derivatives, another market that boomed as banks sought profits from new trading opportunities, says Randall Dodd, director of the Derivatives Study Center in Washington. For example, J.P. Morgan has derivatives with a face value of $25 trillion. But investors don't know how vulnerable that enormous portfolio would be to, say, a sharp rise in rates or a fall in the dollar.

Wall Street also faces a potentially huge legal bill. Some pension funds and insurers are striking back. CalPERS has joined with several other pension funds to sue J.P. Morgan and Citigroup, the underwriters of WorldCom Inc.'s last bond issue, an $11 billion deal, for alleged lack of due diligence. Banks may have to pay up to $5 billion to settle over 300 class actions involving everything from hyping lousy IPOs to favoring their best banking clients, according to James Newman, executive director of research firm Securities Class Action Services. On top of that, there are 25 class actions pending against firms' research analysts.

Financial giants accelerated the growth of the New Economy in the 1990s. But they're looking shakier as the U.S. economy struggles to get out of the doldrums. "You don't see a raft of companies trying to become the next Citigroup," says Brock Vanderfleet, a Lehman Brothers analyst. Putting the financial system on a solid foundation will be critical to putting the economy back on track.

By Emily Thornton, Peter Coy, and Heather Timmons in New York, with bureau reports

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