As the barriers between commercial and investment banking erode, one of banks' most traditional lines of business, loans to blue-chip American companies, finds itself at a crossroads.

Once the staple of bank balance sheets, loans to venerable U.S. corporations such as Phillips Petroleum Co., McDonald's Corp., and General Motors Corp. are becoming an increasingly tough sell for syndicators.

This development is the culmination of a period of years in which competition and a strong economy eroded the prices corporate clients had to pay for bank loans. And competition is thinning the prospects that companies will return for more-profitable business.

The upshot: Portfolio managers at banks are no longer eager to accept the single-digit returns and nominal fees that come with such loans. Those managers are giving considerably more scrutiny to whether making the loans will lead to more-profitable business.

Bruce Ling, managing director and head of syndicated finance for Credit Suisse First Boston, calls investment-grade loans "loss-leaders that used to lead somewhere but don't anymore."

Relationship banking, he said, is suffering from heightened competition. Also, banks can build relationships through other capital markets products: merger and acquisition advice, as well as bond and equity underwriting.

"As commercial banks get into nontraditional banking business the returns from investment-grade loans are no longer worthwhile," Mr. Ling said. "Why invest in a bank loan when you can invest in equities or bonds?"

Underscoring the market sentiment, PNC Bank Corp. announced last week it would stop lending to large corporations outside its regional market. Instead, the bank will focus on its fee-based corporate banking and capital markets business.

"It's an issue everyone is addressing in some way," said Maurice H. Hardigan, executive vice president and deputy manager of corporate banking at PNC.

"We did a cold, hard litmus test" in deciding whether to stay in the market. "We're not able to see an environment which will improve the returns on that business."

Much is at stake as bankers consider the future of this market.

Of the $1.01 trillion in loans syndicated in 1998, 69%, or $696 billion, was priced at investment-grade levels, according to Thomson Financial Securities Data. Of the 2,988 loans tracked by the firm last year, 1,566 were priced at investment grade.

Nowhere have the low returns of investment-grade loans become more of a problem than at money-center banks. Banks such as BankAmerica Corp., Citigroup Inc., Chase Manhattan Corp., and J.P. Morgan & Co. not only syndicate the bulk of these loans but carry them on their balance sheets.

Michael C. Mauer, managing director and head of loan syndication at J.P. Morgan, said money-center banks have absorbed an unusually large volume of investment-grade loans in recent months.

He said the imbalance continues to be fueled by the exit of Japanese banks from the U.S. loan market in late 1997 and early 1998 and the rapid consolidation of domestic banks.

For instance, when BankAmerica Corp. merged with NationsBank Corp. in October, a major participant in the market disappeared.

That loss was exacerbated when the new bank, BankAmerica, overhauled its portfolio. Loans to companies and sectors to which the bank was overexposed were sold off, mainly through collateralized loan obligations.

Banks have gradually taken action to improve the returns and marketability of investment-grade loans. Most of the changes have come in recent months, in response to the global financial crisis at the end of last year.

Late in the third quarter, the capital markets were stalled. New bond issues suddenly became expensive, if possible at all. U.S. companies, needing financing, quickly turned to their bank credit lines for cash instead.

It was then that portfolio managers began to realize the extent of the problem. The generous terms of the loans kicked in, diminishing returns and tying up capital that the Federal Reserve requires to offset default risk.

As J.P. Morgan's Mr. Mauer explained, three trends developed in response to the crisis:

Instead of issuing long-term credit lines, which require capital set- asides, banks issued short-term credit lines of 364 days or less that were made extendable at the whim of the borrower. The change allows banks to keep credit lines open without requiring that capital be set aside.

For example, a record $30 billion loan to AT&T is being marketed by Chase and Goldman Sachs & Co. as a 364-day facility. One banker familiar with the loan said, "It's just what you have to do to get these things syndicated these days."

Companies began reducing the credit lines they had built up in recent years. With rates at an all-time low from 1995 to 1997, companies "stocked up" on credit, Mr. Mauer said. Now, companies are shrinking those lines to more "reasonable" levels, he said.

And prices for new investment-grade loans increased. For instance, an A-rated company that had paid single-digit up-front fees was suddenly paying in the double digits.

A report by BankAmerica on investment-grade loans said Tyco International Ltd. saw fees on its $1.75 billion, 364-day credit line jump 33% when it refinanced in February 1998, compared with what it had paid just six months earlier. Should Tyco not use the credit line, fees would increase 50%.

Likewise, fees on a $500 million long-term loan to the company jumped 20%, regardless of whether the credit line was used or not.

"They're still nowhere near an acceptable standard as a stand-alone return," Mr. Mauer said, "and it's dramatically below pricing terms in 1990 and 1991" at the height of a credit crunch.

This development is seen as the most lasting and effective method of aiding the investment-grade loan market. Though higher prices mean a greater cost to borrowers, the fatter returns are the only sure way investors will accept such loans.

"Banks are becoming more dependent on return-on-equity models" and risk- adjusted return on capital, said Gary Kearns, head of Fleet Financial Group's large corporate group. "Banks are simply getting more demanding."

For now, those measures have acted as a stopgap against the proliferation of cheap credit, but bankers agree longer-term solutions are needed.

One market-driven solution may be increased relationship-based pricing.

In essence, bankers would charge more to companies that are not likely to return for more-profitable banking products-regardless of sparkling credit ratings.

Mr. Mauer said those distinctions are already being made. He estimates that what was once a 10% to 15% discount for good customers has ballooned to as much as a 40% discount.

Peter Nightingale, head of loan syndication for Fleet, said, "I don't think there's any question that there's increased focus on the relationship."

Like many banks during the last year, Fleet has developed criteria that loan executives use when deciding about making a loan or committing to another bank's loan.

The assessment first measures whether returns meet the risk. Then officers must establish how much business the borrower may be able to bring Fleet.

"We remain a very relationship-focused bank and the relationship has to work for us," Fleet's Mr. Kearns said. "We're taking steps to get additional business and that means either we'll continue the relationship or exit. If the deal clears our hurdles, we'll do it."

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