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December 29, 2000

Wall Street Tries to Spot Which Loans And Banks May Face Problems Soon
By Carrick Mollenkamp, The Wall Street Journal

2001: A Funding Odyssey ... Weiss comments

NEW YORK - There is a grim new parlor game on Wall Street: figuring out which bank loans are going to turn sour and hurt bank earnings in the process.

Big problem loans -- loans with broken covenants, missed interest payments, or those simply deemed uncollectable -- have increased by billions of dollars this year. According to an analysis by Goldman Sachs Group Inc., nine highly leveraged companies defaulted on a total of $2.2 billion in debt during the second quarter of 2000, the most recently available period, compared with none in the same period in 1999.

Banks don't have to identify the names of their borrowers, and there appears to be no clear pattern to which loans might turn bad. Huge loans that now appear headed south were originated throughout the late 1990s and as recently as earlier this year. The debts have surfaced at theater, drug-store, consumer-product, asbestos, health-care and textile companies.

At his office in Dallas, Harold Schroeder, a manager at hedge fund Carlson Capital, has combed through securities filings and compiled a list of 150 loans that he believes bear close watching. His conclusion: "It's a really big iceberg, and we've only seen the tip of it."

To be sure, many of the debtors bear close monitoring, even though they might not end up in default. And the solvency of major banks isn't threatened. The deteriorating credit picture, however, portends a new period of uncertainty for banks, their corporate customers and their investors far into next year. As the economy slows and the number of bad loans rises, banks are growing more reluctant to grant new loans to riskier companies and may have to cut earnings as they provide for debt losses. Some in the industry think banks could be facing the biggest string of loan losses since the recession and real-estate overbuilding in 1990 and 1991.

Banks with increasing bad loans face a double jab to their profits. When bad loans increase, banks have to boost their loan-loss reserves, which means taking a charge against earnings. The second punch comes if debtors start missing interest payments. "The marked increase in nonperforming loans we are currently witnessing can have a particularly deleterious effect on net interest income," says Charles Mulford, a professor of accounting at the Georgia Institute of Technology in Atlanta.

That crashing sound you hear is the credit bubble bursting. Not only will banks have to boost their loan-loss reserves to protect themselves from mounting numbers of bad loans, but the era of easy credit is over.

Banks were far too lenient when handing out loans in the late '90s, and now their earnings will take a hit as the slumping economy pushes one debt-laden corporation after another into bankruptcy. Less cash for corporate investment means less productivity enhancement, less research and development, fewer new products, and less growth overall. All of these things add up to shrinking earnings and falling stock prices.

Investors don't reward companies for slowing growth. We've seen a parade of corporations fall prey to investors displeased with earnings. Many companies were punished because they didn't grow as much as investors had hoped. Stocks will suffer even more when companies stop growing altogether.

The last half of the year 2000 saw the bear rear his ugly head and take some vicious bites out of the market. But that was just an appetizer. 2001 will see many more overpriced and underperforming companies trapped in a credit crunch -- and they'll be easy pickings for the bear.

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