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Commentary: To Snare IPOs, Wall Street May Be Risking Too Much


When Morgan Stanley Dean Witter & Co. underwrote Lucent Technologies Inc.'s (LU) spin-off of its optical-networking subsidiary Agere Systems Inc. (AGR/A) on Mar. 27, the investment bank took a severe beating. Its stock price plunged 22% over six trading days to a 52-week low of $44.10 after investors learned from filings with the Securities & Exchange Commission that Morgan Stanley had bought $2.3 billion of Lucent's debt in January--just before a meltdown in telecom stocks. The idea was to swap the Lucent debt for Agere equity at the time of the initial public offering. But it took Morgan Stanley days to convince analysts and credit agencies that the deal wasn't as risky as it appeared.

What freaked out the market was that Morgan Stanley was potentially vulnerable to big losses on several fronts. It had to put the Lucent debt on its own balance sheet, however briefly, to qualify fully as a creditor and thus harvest an estimated $200 million tax break for Lucent. Plus, the bank faced the risk that once it had agreed to exchange a certain number of shares for the debt it bought from Lucent, the shares could have ended up being worth a lot less. And in the unlikely event of Lucent suddenly going bankrupt in mid-deal, it could have been left completely in the lurch. "At the end of the day, the bank is really on the hook," says Robert Willens, tax and accounting analyst at Lehman Brothers Inc.

THIN LINE. Now, Credit Suisse First Boston and Goldman Sachs Group Inc. are planning a similar deal. Together, they have bought $1 billion of AT&T's (T) debt to swap for shares in AT&T Wireless Group (AWE) on July 9 as part of the subsidiary's eventual spin-off. Analysts say Verizon Communications (VZ) and Nortel Networks Corp. (GRAT) could be mulling using debt-for-equity swaps for spin-offs later this year.

The rush to emulate Morgan Stanley shows what hoops Wall Street firms must jump through to win the handful of IPOs and spin-offs still taking place today: just 53 raising $22 billion since the start of the year, vs. 197 raising $35.7 billion at the same point last year, according to Thomson Financial Securities Data Corp. Once virtually guaranteed to make a mint from oversubscribed equity offerings, investment banks are now being forced to go way beyond the call of duty as advisers and put their own balance sheets on the line.

Bankers could easily end up wrestling with a lot more risk than they have bargained for. Already, credit ratings of top-drawer telecom companies have tumbled as their debt mountains have grown. The pressure to take on even lesser-rated companies is sure to grow. "As they go down to more risky players, someone may get caught holding the bag," warns James F. Mitchell, securities industry analyst for Putnam Lovell Securities Inc.

In the complicated deals, bankers must walk a very thin line to emerge unscathed. In the end, the Agere deal went through without a hitch because Morgan Stanley protected itself by only accepting commercial paper that rolled over on a daily basis, enabling it to reduce the Lucent debt on its books to $520 million by the time of the IPO. It also postponed a decision on how many shares to swap for the debt until after the IPO was priced.

Sources close to AT&T's expected debt-for-equity swap say they believe it will go smoothly partly because AT&T Corp. has a strong credit rating. Bankers also intend to place the shares with mutual funds that track indexes such as the Standard & Poor's 500-stock index, according to filings with the SEC. On June 27, S&P--like BusinessWeek part of The McGraw-Hill Companies--agreed to include the Wireless shares in its indexes less than two weeks before the swap. If it hadn't, the entire deal could have died.

Of course, investment banks earn their keep by taking calculated risks. And Morgan Stanley did manage to pocket an estimated $75 million for Agere's spin-off. But banks could end up paying a steep price for such fees if any of the complex deals start to unravel--a higher risk in the middle of an economic downturn. By Emily Thornton

With Steve Rosenbush in New York


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