(FORTUNE Magazine) – HOW DID A BIG DOG like Westinghouse end up getting wagged by its tail? The Pittsburgh electrical equipment giant managed despite the recession to post modest third-quarter operating profits in all its major businesses -- except one. And trouble in that one, the company's financial subsidiary, led to a $1.6 billion quarterly loss.

The short answer is that during the late 1980s, Westinghouse Credit Corp., known in the company simply as Credit Corp., shoveled loans out the door with the speed and abandon of a go-go S&L. It poured money into high-risk, high- return ventures like hotels, shopping centers, junk bonds, and leveraged buyouts. Now it's paying the price. Those high-interest loans constitute over 85% of the asset portfolio, and many are failing or underperforming. In two write-downs in the past nine months, Credit Corp. stunned Wall Street by paring $2.7 billion from what was once a $10 billion portfolio. Westinghouse Electric Chairman Paul E. Lego, 61, a dapper, gray-haired electrical engineer with no operating experience in finance, is scrambling to contain the financial meltdown. If Credit Corp. collapses, it could drag down big chunks of the parent company as well. Lego has lured out of retirement Leo Yochum, 64, a former chief financial officer with a reputation for integrity. Yochum retired early in 1988 when he was passed over for chairman in favor of John Marous, Lego's immediate predecessor. Now Yochum replaces William Powe, 54, who left his job as chairman of Credit Corp. on the day Lego announced the quarterly loss. Yochum won't be lonely. Teams of financial experts from investment banks Lazard Freres and Shearson Lehman Brothers and from the Price Waterhouse auditing firm will help him pore over accounts. Lego says the experts are telling him that more write-downs are possible if the economy or real estate markets worsen. Interviews with present and former employees, most of whom requested anonymity, suggest that cleaning up the mess will be a slow process. This disaster was not built in a day, nor by one person. During the 1980s, Westinghouse sold some 70 enterprises and bought over 50 in search of the perfect, and probably mythical, countercyclical mix. While Lego's two predecessors, Marous and Douglas Danforth, were shuffling assets, they depended on Credit Corp. to generate growth, which it did. Between 1981 and 1990 the subsidiary's assets shot from $2 billion to $10 billion, and its earnings contributed mightily to corporate profits. THE STRATEGY to focus on high-interest loans began under John McClester, chairman of Credit Corp. for 17 years. It was approved by the man McClester reported to at corporate headquarters, Leo Yochum, now riding to the rescue. As McClester approached retirement in 1988, a race to succeed him developed between Powe, who as head of real estate lending was running his portfolio as if it were a herd of bulls, and Robert Barbour, head of commercial services. Powe (rhymes with wow) is a driven dealmaker, former Marine, and native of Louisiana. He won in part because he was a proven growth wizard. In the decade before becoming chairman, he expanded Credit Corp.'s real estate portfolio from $300 million to $2 billion. Once he got in the corner office he was forceful and persuasive, pushing the subsidiary's assets from $6 billion to $10 billion in just three years. ''Powe does only one thing really well,'' says someone who worked with him. ''He can sell anything. Anything.'' Sure, he could sell deals, but could he collect? The record says no. The drive to lend was not accompanied by rigorous oversight. According to one manager: ''The thing about Credit Corp. is that nearly every deal that went to a loan committee got approved. The committees were dominated by other dealmakers.'' The pace was so frantic that some auditors say they were often left in the dust. One company accountant, Vallerey Stylianoudis, a CPA who worked at Credit Corp. in 1987 and 1988, said the numbers she was given frequently didn't add up, and it wasn't just pennies. She alleges no illegality, just appalling sloppiness. Once she couldn't find an ''audit trail'' for $100 million, which means she couldn't find out how the figure was derived and therefore couldn't verify it. When she complained, she says, she was told to ''plug it,'' in-house jargon for ''forget it.'' It should be pointed out, though, that she has something of an ax to grind against Westinghouse. In 1988, Stylianoudis, a tense, stubborn woman whose grandfather, Alexander Vandegrift, was commandant of the Marine Corps in the 1940s, filed a complaint that a supervisor had sexually harassed her. He denied it and the Equal Employment Opportunity Commission ruled against her. Since then she has sued the company. When the economy -- and real estate markets -- weakened, Credit Corp. began paying for its overzealous growth and lack of controls. With accounts falling delinquent, dealmakers began renegotiating like mad, usually lowering interest payments in return for equity in the projects. In August, Credit Corp. filed a 10-Q form with the SEC that paints a particularly dismal picture of the slide. The renegotiated terms and late payments have squeezed the margin between what Credit Corp. pays for funds and what it gets in interest from borrowers. The margin dropped from 3.4% in the first half of 1990 to 2.7% in the first half of this year, and income was $94 million less than it would have been if the original contracts were being honored. The carnage continued in the third quarter. Lego says that real estate assets listed as nonperforming or underperforming grew from $2.5 billion at the end of June to $3 billion at the end of September. SITTING in their massive black headquarters in downtown Pittsburgh, the engineers who run Westinghouse apparently misjudged the approaching peril at Credit Corp., eight blocks away in a sleek, blue-green glass tower. Some critics blame Lego, even though the high-risk strategy was adopted long before he became chairman. They believe he was inattentive as the crisis built. Says a former corporate executive: ''Lego was an original and challenging engineer on his way up. When he got to the place where there was no one to challenge him, he began to withdraw.'' According to this view, Lego spends a lot of time with two close friends in the company: Anthony Massaro, whom Lego made president of the environmental systems group and who is a contender as Lego's heir, and Eileen Massaro, who is Anthony's wife and vice president of corporate relations. Eileen Massaro is Lego's imagemaker and frequent aide-de-camp. Adds the executive: ''When Lego finishes a speech he runs straight to her in the front row to ask, 'How'd I do?' '' Lego, who is a wine fancier, is part owner of a small winery in Italy, along with Anthony Massaro and John Barsotti, who also owns the Common Plea restaurant in downtown Pittsburgh across from the Allegheny County jail. Lego counters that he has spent a third of his time on Credit Corp. since the middle of last year. Initially Lego bought Powe's argument that the best strategy was to hang on in hopes that an economic recovery would turn bad loans into good ones. In September 1990 he called in Lazard Freres to help him figure out how to ride out the storm. Then he put on an everything-is-all-right mask that has since created a credibility gap for him on Wall Street. Shortly after Lazard came in, Lego told nervous security analysts in New York that he understood what was in the Credit Corp. portfolio and that there would be no write-downs. Powe promised more growth in the 1990s. In December, at a company dinner where employees roasted the top brass, one comic-for-a-day said Powe was on the operating table having his foot removed from his mouth. Then, in February, Lego and Powe faced the increasingly anxious analysts again. When one asked for a breakdown of the real estate portfolio by property type, Powe could recall only about half of it. Lego tried to fill in by reading from a list. That prompted an exasperated analyst to ask: ''Do any of you guys know what the f--- is going on?'' -- a rather extreme breach of manners at such occasions. Another hip fake came when top executives got their annual bonuses. In mid- January, Westinghouse reported unaudited profits for 1990 of $1 billion, including $128 million for Credit Corp. Although the board was told at the time that a major write-down could be pending, it approved performance bonuses for top officers. Lego's total cash compensation, including his annual bonus, increased from $1.4 million to $1.7 million. Barely a month later Westinghouse corrected 1990's results to reflect a $975 million fourth-quarter write-down of Credit Corp.'s assets. That put Credit Corp. $474 million in the red and cut Westinghouse Electric's net to $268 million. Bonuses for the brass were not corrected. Lego says the board can waive ''extraordinary items'' when evaluating performance. Asked if that doesn't make the performance bonus all carrot and no stick, he replied sharply: ''If you look at compensation for 1991, there will be a heck of a big stick. The penalties will be severe.'' That sounds like a promise to take a big cut. Board members, take notice. Shareholders, watch for the proxy statement. NEXT YEAR'S BONUS may be the least of Lego's worries, because Credit Corp. is a long way from being out of the woods. Since the write-downs represent a huge loss in equity in Credit Corp., the parent must put roughly $1.5 billion in cash into its shrinking subsidiary this year to maintain a debt-to-equity ratio of 6.5 to 1 and to shore up its reputation in the financial community. (Moody's recently downgraded Credit Corp. from a P1 to a P2 credit rating, and Lego says that Standard & Poor's may lower its rating as well if the situation worsens.) But spare cash is hard to find in the present weak recovery. The company's operating profits (excluding Credit Corp.) are down 30% so far in 1991. Lego announced that he will cut 4,000 of the company's 116,000 employees, saving $200 million a year, though that won't help much in the short run. So Lego is trying to raise the money by selling stock, which may raise some eyebrows as well. Last February the company finished buying in five million shares for $32 on grounds that the stock was undervalued. In May, Lego sold 21 million shares for $26.50 each, reaping $550 million, which he put into Credit Corp. Now he plans to issue $400 million of stock to the employee pension fund. The company will also attempt a $500 million private placement of shares. In all, the dilution of company shares may equal 16%. And if investors don't snap up the new Westinghouse shares, dividends (roughly $400 million a year) might be cut or parts of other divisions sold off. Much of Credit Corp.'s asset portfolio is on the block. Most of the junk bonds have been sold for $436 million, $50 million more than their restated value. But before the write-downs began, those bonds had been valued at $500 million. About $1 billion of the latest $1.6 billion write-down applies to real estate so it can be put on the market at reduced prices. With the market so flat, however, the reductions might not be enough. Nicholas P. Heymann, an analyst in New York for County NatWest Securities, estimates that at least one more write-down of between $500 million and $1 billion will be necessary by the end of this year. Even if Credit Corp. does manage to sell some real estate, its sick portfolio may actually grow over the coming year because it has lots of off- the-books loan commitments. In many deals, borrowers are unable to get bank loans unless a third party guarantees them. If a project fails, the guarantor has to pay the bank. Credit Corp. piled up more than $3 billion of these guarantees, collecting a fee for each. Heymann estimates that it may have to assume as much as $2.5 billion worth in the next few years, leaving Credit Corp. holding a new bag of bad loans almost as big as the one it has now. So Paul Lego's career is on the line, and Leo Yochum faces a long and painful chore. Says Heymann: ''The crisis at Westinghouse began as a hangnail and turned into gangrene.'' The question is, can Westinghouse just take it off at the ankle? Or at the knee? Or will a whole Lego?

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