Not even the world's largest commercial banks were immune from the telecom investment craze. As the mania peaked in the late 1990s and early 2000, the gray-flannel crowd at Citigroup (C
), J.P. Morgan Chase (JPM
), Bank of America (BAC
), and elsewhere behaved with all the abandon of day traders. Banks issued more than $320 billion in loans to the telecom industry between 1999 and 2001.
Now, the banking system faces billions in losses. On Jan. 28, Global Crossing Ltd. (GX
) became the latest in a series of once-promising start-ups to take refuge in bankruptcy court, joining the likes of 360networks (TSIXQ
), Teligent (TGNTQ
), and Winstar (WCIIQ
). When they filed, those four carriers owed at least $5.25 billion to the likes of J.P. Morgan, Citi, and Bank of America, which in turn sold the debt to dozens of other banks. "You assume bankers have this great font of wisdom, but they're human like anyone else," says Hugh Ray, partner and head of bankruptcy practice at Houston law firm Andrews & Kurth LLP. "They got really caught up."
In hindsight, it was a disaster waiting to happen. By the time the banks arrived on the scene, bondholders had beaten them to the punch and struck agreements ensuring they'd get paid first if a telecom company failed. The banks often failed to obtain any meaningful collateral on their loans, which were sometimes secured by shares that are now nearly worthless.
These days, pretty much the entire emerging telecom sector is either in bankruptcy or beset by critical financial problems. XO Communications Inc. (XOXO
), which has $4.5 billion of debt, including a $1 billion credit facility, is negotiating to restructure its liabilities. If that fails, one insider says, the company probably will have to file for bankruptcy. In the worst case, the banks' losses could rival the $150 billion hit that they took during the savings and loan crisis of a decade ago. At least this time around, the banks have bigger reserves than then--and their lending is more diversified. But there's no question that telecom losses will force banks to take multibillion-dollar write-offs and lower their future earnings.
The outlook for Global's creditors isn't good. No one knows how much bondholders or banks will receive after investors Hutchison Whampoa Ltd. and Singapore Telecom take control. "They have only offered $750 million, [and] that does not leave a lot of cash for creditors," says Aryeh Bourkoff, a debt analyst at UBS Warburg. Global's chief financial officer, Dan J. Cohrs, says he fully expects that creditors will demand changes to the proposed restructuring. But, already, Global's filing has spooked investors who have rushed to dump shares of other telecom carriers. On Jan. 29, Williams Companies (WMB
) and Tyco International (TYC
), a conglomerate that operates undersea telecom networks, both plummeted about 20% while WorldCom (WCOM
) fell 13%.
The trouble began after the Telecommunications Act of 1996, which started a $1.3 trillion avalanche of lending by investors and bankers eager to finance a host of upstarts that would supposedly take on Verizon Communications (VZ
), AT&T (T
), and other established carriers. Among the upstarts, Global got an extra boost because founder Gary Winnick was one of Wall Street's own. Having risen through the ranks of junk-bond pioneer Michael Milken's shop, Drexel Burnham Lambert Group Inc., he could open doors. "Only a year ago, I could just pick up the phone, have a conference call, and borrow a billion dollars. Times have totally changed," says Global's Cohrs.
The dream was shattered by a series of forces. Internet traffic was expected to grow 75% a year, supporting dozens and dozens of new carriers. But those projections didn't foresee the sudden collapse of hundreds of Internet companies or an approaching downturn. Today, the growth rate for Net traffic is about 30% to 40% a year. The overoptimistic assumptions wreaked havoc with many a start-up's business plans, says Cohrs.
Mounting debt finally forced carriers into bankruptcy. Faced with insufficient revenue growth, they had to borrow money to build new networks or update old ones. Global, with $3.4 billion in revenue, owed a crushing $7.5 billion, on which it had to pay $600 million in interest and $200 million in preferred dividends a year. It wasn't unique. Lots of companies were borrowing money to cover losses incurred in building massive networks. "Telecom had $60 billion in negative free cash flow in 2000, by far the largest amount of any industry in modern times," says Lehman Brothers Inc. analyst Blake Bath. He expects the industry to turn cash flow positive this year. Meanwhile, dozens of companies like Global have declared bankruptcy because investors stopped funding their losses.
Most upstarts got their initial funding from venture capitalists, and then rushed to an initial public offering even before they had steady cash flows or profits. Then, they tapped the junk-bond markets for additional funding. Only after the companies had large market capitalizations and well-known names did the banks decide it was safe to finance them. But the high-yield bond underwriters, led by Salomon Smith Barney, had already staked out their position--and structured their deals so that they would be the first in line to be repaid if a telecom company went under.
The banks and bondholders will fight among themselves, too. Traditionally, banks are entitled to foreclose on a physical asset, such as a factory or a piece of equipment, if a loan goes bad. But in Global's case, lenders such as J.P. Morgan and Citi have no lien on the company's 100,000-mile network, which spans 27 countries and the world's major oceans. Their only claim is on the battered shares of the 100 or so subsidiaries that own the network. Bondholders, meanwhile, own a piece of Global Crossing assets, including its subsidiaries. Look for a "giant pissing match between bank lenders and bondholders," says one telecom banker. Right now, market players are betting the banks will prevail in the end despite their lack of formal claims. That's why Global's bonds are currently trading at 9 cents on the dollar, while its bank loans fetch 40 cents.
Creditors will fare just as badly in other telecom bankruptcies. For example, 360networks' $1.2 billion in bank debt was lent with the understanding that it would be backed by whatever asset the company bought with the money. Those assets--mostly fiber-optic communications systems--are worth just pennies on the dollar, leaving hardly enough to pay back even one creditor. The banks seem to be in a better position with Winstar Communications Inc. because they were able to secure first claim on the carriers' assets. The problem? On Jan. 24, IDT Corp. said it would buy Winstar out of bankruptcy for $24 million. That's equivalent to less than a penny on the dollar for Winstar's $8 billion of outstanding loans, bonds, and equity--so its bank creditors are first in line to get next to nothing.
The Winstar case should be a wake-up call. Some creditors fear that the worst is yet to come for Global Crossing because there's no guarantee that its restructuring will be approved by creditors or the courts. Indeed, Global and other failed telecom carriers such as 360networks could be lucky just to avoid liquidation.
By Steve Rosenbush and Heather Timmons in New York
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