Junk bond crash takes toll on Wall St.

When Credit Suisse Group announced two months ago that it was buying Donaldson Lufkin & Jenrette for a princely $12 billion, experts said the U.S. investment bank’s hugely lucrative junk bond operation was the real prize.

Oops.

Junk bonds have lost so much luster since then that August’s prize asset has become October’s kewpie doll.

The pending DLJ acquisition is now weighing so heavily on Credit Suisse’s stock price that James Hyde, an analyst with Fox-Pitt Kelton in London, simply concludes, “They would not have bought DLJ at this price.” But, he notes, Credit Suisse is now bound to the deal.

Little time

In fact, plummeting junk bond prices are forcing a major reassessment of investment banks like DLJ, which have earned huge fees by taking issues to market, and casting a pall over the holders of high-yield debt.

This month, for example, the share price of Morgan Stanley Dean Witter dropped by more than 10% in one day on rumors that the investment bank had suffered large losses in high-yield telecom bonds.

Rumors aside, many analysts are predicting a mounting wave of defaults.

Over the four quarters through next September, the default rate of junk bonds is expected to soar to 8.4%, from 5.1%, according to Moody’s Investors Service.

The credit rating agency forecasts that by the end of the year the rate will hit 6% – a level not seen since 1989 when defaults hit a disastrous peak.

Analysts, in hindsight, are blaming the problem on bad credit judgment. Too many issuers with iffy business prospects got bundles of cash nonetheless.

Edward Altman, a high-yield-bond market expert and finance professor at New York University, says the problem hit its high-water mark in 1996-1998.

That crop includes many telecommunications and some new media issues that now make up 40% of the $508 billion U.S. junk bond market.

“The concern of the market is that these [telecom] companies are running out of time,” says David Negri, senior vice president at OppenheimerFunds Inc. in New York, which has four high-yield-bond funds.

With telecom firms stumbling badly and investors racing to dump their junk holdings, Wall Street firms are left with two serious problems: a potential drop in their big junk-bond-underwriting revenues and mounting losses from their junk holdings.

One firm particularly hard hit is Morgan Stanley.

In a research report issued this month, Salomon Smith Barney listed the 20 worst-performing high-yield telecom issues of the last three years. Several were managed by the New York firm.

As the damage to both the company’s reputation and bottom line mounted early this month, Dwight Sipprelle, Morgan Stanley’s co-head of global high-yield-bond trading, underwriting and sales, departed after 16 years with the firm. A week later, the firm announced that its losses from high-yield-bond trades in the third and fourth quarters of this year will total $88.7 million.

Morgan Stanley has plenty of company in the high-yield doghouse. Goldman Sachs, Merrill Lynch and Lehman Brothers also manage several of the worst-performing junk issues.

In the meantime, some of the largest holders of high-yield bonds in New York also are suffering.

They include OppenheimerFunds Inc., which has more than $7 billion in high-yield bonds; Alliance Capital Management LP, which holds $4.5 billion and Smith Barney Asset Management, with $3.5 billion, according to Capital Access International.

The junk bond debacle also has broader implications for the industry. Although junk bond pros remain in demand, thousands of jobs could be on the line if the market continues to tank, according to headhunters.