Re: [A-List] Enron "profits" and the dismal science

["Charles Brown" <CharlesB@xxxxxxxxxxxxxxxxxxxxx>]

Won't this squeeze investment and make recovery more difficult ?

Charles

>>> Michael.Keaney@xxxxxx 02/18/02 07:55AM >>>
A New Credit Crunch 
Business Week; New York; February 18, 2002; Rich Miller in Washington
and Heather Timmons in New York, with Andrew
Park in Dallas, Charles Haddad in Atlanta, and bureau reports; 

Sub Title:  Fears about shaky accounting have all sources of credit
pulling back

When the economy was last struggling to come out of a recession more
than a decade ago, it was held back by what Federal Reserve Chairman
Alan Greenspan described as financial headwinds. Banks, smarting from a
string of loan losses from a commercial real estate boom gone bust,
curtailed credit to all but the most worthy. Rather than roaring out of
the recession, the economy was forced to fight its way through a credit
crunch into a tepid recovery.

Sound familiar? The implosion of Enron Corp. in a mushroom cloud of
scandal has profoundly rocked Americans' perceptions of financial
markets, accounting practices, and corporate ethics. And it has led to a
fundamental reassessment of risk throughout the economy as investors,
banks, and rating agencies grapple with the realization that profit
statements may not be what they seem. All that heightened doubt is
leading in one direction: costlier credit that will put a crimp in
corporate spending plans and act as drag on growth just as the recovery
is getting under way.

For the Federal Reserve, that means holding off on raising interest
rates as it struggles to rev up the economy. For banks, it means bracing
for another hit to profits. Bank earnings are expected to fall 10% in
2002 as bad loans eat into profits. And for companies, it means
treacherous waters in which any hint of trouble could threaten to
capsize the ship. The latest: Shares of Computer Associates
International in Islandia, N.Y., tumbled 13.5% on Feb. 6, after Moody's
Investors Service said it might downgrade the software maker's credit
rating because of ebbing cash flow.

Worried that other Enrons are lurking in the shadows and stunned by the
meltdown of such high-profile companies as Kmart Corp. Investors are
treading cautiously. They're selling shares of former highfliers that
use accounting gimmicks they don't understand and even questioning such
blue-chip stars as General Electric Co. (page 34). And they're demanding
that many companies pay top dollar for access to debt markets, in some
cases forcing companies to turn to banks for even more costly cash. A
prime example: Tyco International Ltd. and its finance arm, CIT, which
in early February had to tap up to $14.4 billion in credit lines from
its banks after being shut out of the commercial-paper market (page 35).

But banks are getting stingier, too. Stung by the demise of Enron and
other high-profile bankruptcies, they're tightening lending terms and
cutting off companies that don't pass muster. ``Banks are nervous,
investors are nervous, everyone's nervous,'' says Howard E. Janzen, CEO
of embattled telecom Williams Communications Group Inc. in Tulsa, which
is in heated loan negotiations with its banks.

Throughout the boom of the 1990s, banks stretched lending to the limit,
extending cash to companies and consumers at a rapid pace. Now, this
aggressive lending is coming home to roost. Bad loans at big commercial
banks have jumped nearly 30%, to more than $25 billion, according to the
Federal Deposit Insurance Corp. Throughout the fourth quarter of 2001,
lenders warned that they were slashing their earnings estimates to write
off bad loans and take reserves against bad debt through 2002. At
FleetBoston Financial Corp., the cost was $1.2 billion. J.P. Morgan
Chase & Co. lopped off $807 million. PNC Financial Services Group Inc.
knocked off $615 million--then subtracted $155 million more after the
Securities & Exchange Commission advised it to change its accounting. In
the first half of 2002, bad commercial loans are expected to jump 20%,
says Salomon Smith Barney.

That may not be the worst of it. There's also the credit banks have
extended that isn't on balance sheets--and for which they have no
reserves. Banks have nearly tripled their off-balance-sheet credit lines
since the last recession, to about $5 trillion outstanding, notes
Prudential Securities Inc. analyst Michael Mayo. Banks tack these lines
of credit onto a loan to sweeten the terms of the deal. Generally,
they're unused until a company gets in trouble.

As if that weren't enough, banks have heartily embraced another
off-balance-sheet risk in the past decade that analysts say is nearly
impossible to quantify. ``Credit derivatives'' act as insurance for a
company that invests in a corporate bond or loan. If the debt goes bad,
the company that issued the derivative pays the debtholder. Banks,
including J.P. Morgan Chase, Citigroup, and Bank of America are the
major issuers of derivatives in the $1 trillion market.

But don't expect to find their exposure on the balance sheet.
Credit-derivative activity is generally listed in the footnotes, if at
all. The downside can be brutal. J.P. Morgan Chase surprised markets
when it said in mid-December that its unsecured exposure to Enron was
triple original estimates, in part because of credit derivatives.

When you add it all up, the outlook could be grim for banks and their
borrowers. Expect banks to play cleanup well into 2002. That means many
will opt to lend less. Says the head of commercial lending at a top five
bank: ``You're going to see banks get tougher on terms, loans, and
prices.'' Most affected will be corporate borrowers that rely on the
same sort of aggressive accounting that Enron did--financial
engineering, a steady stream of acquisitions, or off-balance-sheet
entities to make their numbers. But even conservative companies could be
hurt. ``We're concerned that the general credit market will tighten up
more,'' says Bruce W. Smith, CFO of Atlanta-based biotech Theragenics
Corp. ``Enron is just putting further pressure on large banks that
already feel under the gun.''

Enron's demise has sent shock waves throughout the financial markets as
well. The multibillion-dollar commercial-paper market that companies use
to raise short-term money had already shrunk by a third last year as
investors simply refused to finance many firms deemed too risky. Now, in
the wake of Enron's collapse and growing doubts about corporate
accounting, many companies still in the market are finding they're
having to pay more to issue commercial paper. In some cases, they're
paying up to a quarter percentage point extra.

Enronitis has also sent borrowing costs higher in the corporate-bond
market in recent weeks as nervous investors cut their exposure to risky
companies with questionable accounting. The junk-bond market has been
smacked hard, but many higher-rated companies have been hit, too.
According to Morgan Stanley Dean Witter & Co., on average, borrowing
costs for the 35 most active investment-grade corporate borrowers jumped
by over a quarter percentage point in early February.

Credit-rating agencies are also doing their part to raise the cost of
credit throughout the economy. Even before the collapse of Enron, they
were aggressively slashing corporate credit ratings as the economy
deteriorated. Downgrades soared to record levels in the fourth quarter
of last year, raising corporate borrowing costs.

Now, ratings agencies have ratcheted up their oversight even further.
``We've accelerated and heightened our credit-review process,'' says
Edward Z. Emmer, executive managing director of Standard & Poor's,
which, like BusinessWeek, is owned by The McGraw-Hill Companies. S&P is
spending more time looking over company accounts and broadening its
review to include customers and competitors. In the wake of Enron,
ratings agencies are also paying more attention to equity and corporate
bond prices as early warning signs that a company may be in trouble.

This wide rethinking of risk probably won't send the economy back into
recession. But the post-Enron environment will temper growth and delay
the onset of a full-fledged expansion. Just tack it on to the growing
list of migraines that Enron has wrought.

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx