Fight For Survival

By Stephen Koepp

Behind the sedate granite facades and oak-paneled boardroom doors of Wall Street, a bitter power struggle is under way that could well decide the fate of the $2.7 trillion U.S. banking industry. The battle pits behemoth against behemoth, commercial banks against investment-banking houses, prestigious names like Citicorp, Bankers Trust and BankAmerica against equally blue-chip concerns like First Boston, Salomon Brothers and Goldman, Sachs. But fundamentally, the struggle matches traditional U.S. bank-lending practices against computer-driven techniques that are drastically changing the way that more than $6 trillion worth of nongovernment credit is channeled through the U.S. economy.

Old-fashioned bank methods are losing that contest. Increasingly, a chorus of experts, including Federal Reserve Board Chairman Paul Volcker, seem to agree that without changes in banking rules that go back half a century, more and more of those institutions will be pressed to the financial wall. Many, indeed, are already there. In general, banking profitability has been deteriorating for the past 15 years, and an estimated 25% of the country's 14,000 banks are losing money this year. U.S. banks, says Paul Baastad, an analyst at the San Francisco brokerage of S.G. Warburg & Co., are under "tremendous pressure. The quality of their assets most likely will ( continue to show significant deterioration, as it has over the past decade."

The challenge facing the banks is summed up in an arcane and inelegant word: securitization. The term describes a sophisticated method of using powerful computers to package traditional loans into securities. The new instruments are then bought and sold like conventional bonds in the credit marketplace. Securitization is double edged: in only a few years, the technique has given an enormous boon to consumers in the form of lower interest rates and fresh infusions of money for mortgages and car loans. Banks have also gained from securitization, observes Lowell Bryan, a director at the McKinsey consulting firm. They have, he says, been able to sell many of their own loans to securitizers and thus free scarce capital for more lending activity.

The loans that remain in banking hands, however, are of steadily decreasing quality in areas like oil-related activity, farming, real estate and Third World debt. The drag of those deteriorating assets has put the banking system at increasing long-term risk. In 1984 and 1985 U.S. banks had to write off between $15 billion and $16 billion worth of bad debts. In 1986 the figure is estimated at $21 billion. Last week, when many big banks reported their first-quarter earnings, the results were broadly depressed. Manufacturers Hanover's profits, for example, fell 21%, to $81 million, while Chase Manhattan's dropped 28%, to $104.1 million. "Compared to making loans, investment banking is a low-risk field," says William Haraf, a visiting scholar on financial deregulation at the American Enterprise Institute, a Washington think tank.

By law, the banks cannot join in the rapidly growing and profitable business of underwriting and dealing in the newly created loan securities. That kind of service, along with virtually all securities activity, is reserved by the 1933 Glass-Steagall Act for investment houses only. Says George Salem, who follows the banking industry for the Manhattan-based investment firm of Donaldson, Lufkin & Jenrette: "Without loan selling and investment-banking products, the big banks will go the way of the dinosaur."

Changing the Glass-Steagall Act is the focus of the current power struggle between the country's financial giants. The battle is as much psychological as political. The legislation, which also created the Federal Deposit Insurance Corporation, was enacted to protect the public from irresponsible banks like those that invested depositors' savings in highly speculative securities prior to the Great Crash of 1929. As a result, the separation of commercial and investment-banking functions by Glass-Steagall still has tremendous populist appeal. But in official Washington, as Fed Chairman Volcker put it in Senate testimony last January, opposition to giving commercial banks access to the investment-banking area "is almost entirely limited to investment houses now with the field to themselves."

This week a significant chink may open in the Glass-Steagall wall. The Fed is expected to rule on the application of three major New York banks -- Citicorp, Bankers Trust and J.P. Morgan -- to begin securities underwriting. Their application depends on an interpretation of Glass-Steagall that would allow a modest amount of such activity within a bank holding company. The five Fed governors are believed to favor their bank petition. But those worthies were warned last February by Robert Downey, a partner in prestigious Goldman, Sachs, that such a decision could "change the financial world forever."

Securitization has already done that, largely in the investment houses' favor. Glass-Steagall has not proved to be much of a barrier for investment firms that wish to engage in banking activity, even if it has worked well the other way around. Over the past two decades, firms like Merrill Lynch (assets: $53 billion) and American Express (assets: $99 billion) have eaten deeply into traditional commercial-banking turf, first through near banking activities like interest-bearing money-market accounts, then through home-equity loans.

The first important loan customers to kiss the banks goodbye were blue- chip corporate borrowers; in the mid-1960s they began issuing short-term debt securities called commercial paper. While corporations have always relied on securities like bonds for long-term debt, commercial paper took the place of short-term bank borrowing. Commercial paper, which is sold by investment banks to big investors, has become a $190 billion industry.

Now the hot securitization field is mortgages. Investment firms buy multimilliondollar chunks of mortgage portfolios from banks and thrifts, and repackage them in bond-size units of $1,000 to $100,000. Then, after the securities are issued, the bank that originated the mortgage typically continues to service it, which includes collecting payments and hounding delinquent debtors. The new process has spread like a Wall Street rumor: in the past two or three years, about $600 billion, or roughly a third of all outstanding mortgages in the U.S., have been securitized. Last year alone the total reached $314.1 billion. The huge volume of the securitized loans renders them cheap to the investment banker. Operating and underwriting cost only a fraction of the 1.3% to 2% of a loan's value that commercial banks need to earn to cover their own costs.

Auto loans too are now securitized. The financing divisions of Detroit's major automakers have increasingly been able to offer below-market interest rates to prospective auto buyers, sometimes as low as 2.9%, thanks in part to investment-bank packaging of car loans as securities. The amount of securitized auto financing has zoomed incredibly, from just $140 million in 1984, to $8.6 billion last year.

Relatively simple in conceptual terms, securitized loans are fiendishly complex to construct. For the investment bank, the tricky part of the process is setting a uniform, profitable interest rate based on many different underlying mortgages with terms, interest rates and payment schedules that may vary enormously. Only with mainframe computers and lengthy software programs can the calculations be done. Even then, the number crunching for a single securities issue can use an investment house's entire computer capacity for as much as a day, after weeks of preliminary coding.

One side effect of securitization is that it can make mortgage rates react much more quickly to volatile changes in the credit markets, where securitized consumer loans are traded. That effect has been highly visible in the past month, as inflation fears roiled the bond markets and helped send mortgage rates jolting upward from below 9% to nearly 11%.

Banks, of course, are also vulnerable to such changes in interest rates. Credit volatility only adds to their urgent desire to get into the business of underwriting the growing securitized credit market as a steady source of income. Indeed, among economists, regulators and other financial thinkers, there is general agreement that the time has finally come to free banks, at least in some ways, to compete with their Wall Street rivals. Says Comptroller of the Currency Robert Clarke: "It is ironic that many of the prohibitions that are supported in the name of bank safety and soundness have contributed to an increase in the level of risk in the banking system."

Another powerful argument for reform of Glass-Steagall is that many of U.S. , banking's most important foreign competitors do not suffer from similar strictures. British and West German banks in particular are able to trade in securities, thus obtaining additional resources for dealing with burdens like bad Latin American debt.

For U.S. bankers, gaining a similar advantage will take time, no matter what happens this week. In March the U.S. Senate passed a banking bill that if adopted by the House would place a one-year moratorium on any regulatory expansion of bank powers. Such legislation would be likely to void any relaxation of Glass-Steagall by the Federal Reserve Board this week. But major banks fully intend to test the limits of how far they can move toward investment services. Last month, for example, Chase Manhattan introduced a deposit account with a yield tied to the stock market's performance. That measure provoked the mutual-fund industry to file a lawsuit alleging violation of Glass-Steagall. In short, the battle between investment bankers and their commercial rivals will continue to intensify, and the pressure on the beleaguered U.S. banking system will continue to grow.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Chart by Cynthia Davis. [TMFONT 1 d #666666 d {Source: McKinsey & Co.}]CAPTION: OLD-FASHIONED LENDING DOWN . . .

DESCRIPTION: Traditional loans as a share of outstanding corporate and consumer debt 1980: 60%, 1986: 53%, 1995 (Projected): 20-30%. Stacks of dollars in three safes.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Chart by Cynthia Davis. [TMFONT 1 d #666666 d {Source: McKinsey & Co.}]CAPTION: . . . NEWFANGLED BORROWING UP

DESCRIPTION: "Securitized" mortgages and "Securitized" car loans in 1984 and 1986. Illustration of house, car.

With reporting by Jay Branegan/Washington and Frederick Ungeheuer/New York