An effort to speed the development of a secondary market for syndicated loans is increasing tensions between Wall Street firms and commercial banks.
Through the Loan Syndications and Trading Association Inc., investment banks are drafting guidelines and taking other measures designed to make it easier to trade syndicated loans. Thanks to their trading prowess, Wall Street firms see the developing market as a potential source of income and a means to maximize the value of their loan portfolios.
But many commercial banks-especially smaller ones-fear a strong secondary market for loans. They say they would need to build costly and sophisticated trading desks to compete. And they are concerned that the market will make it easier to make daily valuations of loans, which banks typically hold at face value.
"There's a real fear banks will be required to price their loans to market," said one former commercial banker.
To be sure, secondary trading of syndicated loans still has far to go. Though trading volume has increased threefold since 1994, it remains a tiny percentage of the $1 trillion worth of loans originated each year.
But it is growing rapidly. This year, $52.9 billion of loans changed hands through the third quarter, setting a pace that would beat last year's volume of $62 billion by 11%, according to Loan Pricing Corp. of New York.
"Only a small fraction of the universe of nonbank investors have discovered loans as an asset class," said Peter Gleysteen, head of global syndicated finance for Chase Manhattan Corp. "So the growth potential is not only enormous but escalating rapidly."
Just last week, officials from Standard & Poor's and the Loan Syndications Trading Association confirmed that they have a verbal agreement to compile an index that would measure the value of leveraged loans in the secondary market. The index, which will be compiled by Portfolio Management Data LLC, New York, is expected to be unveiled in late 1999.
"Many portfolio managers really need something to measure their own performance with," said Allison Taylor, executive director of the LSTA. "The other indexes out there haven't reflected the full market."
The association is also revamping its mark-to-market program, which provides portfolio managers with the latest bids and offers on 750 secondary market loans as reported by association members. The retooling is scheduled to be finished by spring 1999.
Banking experts say the coming indexes reflect not only the growing interest of institutional investors in the loan market but the influence investment banks are having on what was once seen as the province of commercial banks.
Though the LSTA comprises both commercial and investment banks, representatives from Wall Street firms such as Goldman, Sachs & Co. and Donaldson Lufkin & Jenrette hold many key committee posts.
Alden L. Toevs, executive vice president of First Manhattan Consulting Group in New York, said that as investment banks gobble up a larger share of the bank loan underwriting market, they have brought along their trading mentality.
"Here's a market that has been long the domain of commercial banks, but includes a product that is similar to junk bonds," Mr. Toevs said.
The investment bank influence may help the secondary loan market grow as large as the markets for collateralized mortgage obligations and asset- backed securities. Like the secondary loan market, those markets did not exist 20 years ago.
Some large commercial banks say they welcome the development of a secondary loan market insofar as it would enable them to trade for clients and build relationships. But some banks are resistant to the idea.
As many bankers see it, loans traded in the secondary market are often undesirable. The market is like "one of those discount outlets outside of New London where they sell seconds," one commercial banker said. "It's where investment banks and the Japanese have gone to dump."
One reason the market has yet to explode is the nature of corporate loans. Unlike bonds, a loan's value is tied to interest rates, which makes them less volatile than other instruments.
That stability has been attractive to banks that have historically practiced buy-and-hold strategies-making a secondary market for loans unnecessary. Because banks hold loans at their face value, there is little incentive to trade or mark them to the market price.
Investment banks and fund managers, however, price the value of their investments against the market at end of each day. If a loan's value falls or rises, they can buy or sell to balance their portfolios.
As loans on the secondary market become more liquid, prices become more accurate and trades more frequent. That makes it easier to judge the value of a loan as determined by the market.
As recently as three years ago, syndicated lenders' concern about valuing loans in the secondary market "was huge," a former banker said.
"There was a practical fear about being able to manage the portfolio, and a fear about how volatile the business could become," this former banker added.
Steven M. Bavaria, director of bank loan ratings for Standard & Poor's, agreed that a shift to daily pricing would mark a fundamental change for commercial banks .
"It was never part of a banker's model for thinking about those kinds of market conditions," Mr. Bavaria said. "A banker never cared if he could sell those loans for 100 cents on the dollar."
But Ms. Taylor of the LSTA said she does not see a secondary market as a threat to banks. She said trading volume is nowhere near the level necessary to mark loans to market.
"Loans aren't securities," she said, "and at this stage of the game the Federal Reserve doesn't require marking loans to market; they require adequate reserves against bad loans."
Nevertheless, to shield against the possibility of making bad loans, many large commercial banks now hold loans outside their investment portfolios, for secondary trading.
Smaller banks, which do little or no secondary trading, might be more at risk, according to First Manhattan's Mr. Toevs. That's because larger banks will be able to sell more loans to investors without holding significant portions.
Large banks will then originate for volume, driving down returns for the small banks, he said.
A volume business "turns loan income into fee income," Mr. Toevs said. A secondary market would "eliminate pricing efficiencies, and spreads will decline for new loans."
To make up for those losses, small banks would need to become active players in the secondary market-a move that would require a costly investment in building a sophisticated trading desk, Mr. Toevs said.
But Chase's Mr. Gleysteen said that small banks will probably not see a bottom-line crunch as the secondary market broadens. Borrowers will still want banks to hold significant parts of their loans for relationship purposes, and loan returns will have to compete with securities such as corporate bonds.
As a result, smaller banks can continue to use a buy-and-hold approach without worrying about participating in the secondary market, Mr. Gleysteen said.
"There's no business reason for market participants to be dealers in the secondary loan market," he said.
Likewise, Robert Morris Associates, the credit-risk trade group that includes a majority of community and regional banks among its membership, is in favor of a strong secondary loan market.
"On a conceptual basis we support a secondary market to bring liquidity," said Robert Morris president Allen W. Sanborn. "The more options banks have, the better."