Buyout backlog threatens big banks

From combined dispatches

NEW YORK — Wall Street’s five biggest investment banks are stuck with $75 billion of leveraged-buyout loans, which could reduce earnings as much as 5 percent this year, an analyst at Citigroup Inc. estimated.

Lehman Brothers Holdings Inc. and Bear Stearns & Co. Inc., the fourth- and fifth-biggest U.S. securities firms, may each lose 5 percent of this year’s earnings per share by marking down the value of their loans, Prashant Bhatia wrote in a report to investors yesterday. Merrill Lynch & Co. could suffer a 2 percent reduction, while Goldman Sachs Group Inc. and Morgan Stanley may lose 3 percent and 4 percent, respectively.

Mr. Bhatia described the problem as “very manageable,” and recommended investors buy the beaten-down shares of Merrill Lynch and Morgan Stanley. “We believe that [their] diversified model is better positioned to weather a potential credit storm,” he wrote.

Following the report, both companies helped lead stocks higher for a third consecutive day yesterday.

Meanwhile, Bear Stearns this week began sending letters to clients reassuring them the firm was financially sound in an effort to keep people from withdrawing their business.

The letters, along with a list of client talking points provided to employees, are aimed at allaying fears about the company’s fiscal shape. Clients have been seeking reassurance since the company put two distressed hedge funds in bankruptcy, ousted Co-President Warren Spector and came under review for a rating downgrade by Standard & Poor's.

The wipeout of the two multibillion-dollar Bear Stearns hedge funds triggered concern about Wall Street’s exposure to the distressed mortgage and corporate buyout markets.

“The Bear Stearns franchise is financially strong,” the letter said in part. “Rest assured, Bear Stearns has seen challenging markets before and has the experience and expertise to serve you and us well.”

Banks and brokers are trying to sell an estimated $330 billion of securities to finance leveraged buyouts in the face of dwindling investor demand for high-risk, high-yield loans and bonds. Firms that previously bought about 70 percent of those types of securities to repackage them into collateralized debt obligations have stopped buying, Citigroup’s Mr. Bhatia said.

“We estimate that the brokers in aggregate have about $75 billion in exposure related to the $330 billion of total financings in the pipeline,” he said. “The bottom line of our analysis is that the mark-to-market hits the brokers will take related to the leveraged loans are very manageable.”

Investors are cutting back on riskier assets such as the loans and bonds that fund leveraged buyouts after being burned by losses on subprime mortgages. Late payments on loans to U.S. home buyers with poor credit histories are at the highest since 2002, driving down the value of bonds backed by the debts and roiling credit markets.

Mr. Bhatia estimated that Goldman, the world’s biggest securities firm, has $20 billion of leverage-buyout loans that it needs to fund, while Morgan Stanley has $19 billion. Lehman has $16 billion, Merrill has $12 billion and Bear Stearns has $9 billion. All five firms are based in New York.

“Some of the pipeline may evaporate to the extent that deals are canceled,” he added.

Shares of companies that are being taken over usually trade at a discount to the purchase price until the sale is complete. The so-called spread on pending deals is now two to three times wider than normal, “pointing to a higher probability of cancellation,” Mr. Bhatia said.

As risk-averse investors push down the price of leveraged loans and notes, banks may be reluctant to finance additional deals, Mr. Bhatia said.

A 50 percent decline in loan volumes in 2008 would cut the year’s earnings at the top five Wall Street firms by 4 percent to 6 percent, he added.

Citigroup, the biggest U.S. bank, has $26 billion of leveraged-loan commitments, second only to Bank of America Corp., Mr. Bhatia’s note shows. Bank of America, the second-biggest U.S. lender, has the highest funding commitment with $31 billion, he estimated.