| Year 2007 No. 57, September 29, 2007 | ARCHIVE | HOME | JBBOOKS | SUBSCRIBE |
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In a period of just weeks, the subprime time-bomb that had been ticking unnoticed for half a decade suddenly exploded into a systemwide liquidity crisis that then escalated into a credit crisis in the entire money market dominated by the non-bank financial system that threatens to do permanent damage to the global economy.
As an economist, Ben Bernanke no doubt understands that the credit market through debt securitisation has in recent years escaped from the funding monopoly of the banking system into the non-bank financial system. As chairman of the US Federal Reserve, however, he must also be aware that the monetary tools at his disposal limit his ability to deal with the fast-emerging marketwide credit crisis in the non-bank financial system. The Fed can only intervene in the money market through the shrinking intermediary role of the banking system, which has been left merely as a market participant in the overblown credit market.
Thus the Fed is forced to fight a raging forest fire with a garden hose. One of the reasons the Fed shows reluctance in cutting the Fed Funds rate target may be the fear of exposing its incapacity in dealing with the credit crisis in the non-bank financial system at hand. What if the Fed fires its heavy artillery but the credit crisis persists, or even gets worse?
Banks worldwide now reportedly face risk exposure of US$891 billion in asset-backed commercial paper facilities (ABCP) due to callable bank credit agreements with borrowers designed to ensure ABCP investors are paid back when the short-term debt matures, even if banks cannot sell new ABCP on behalf of the issuing companies to roll over the matured debt because the market views the assets behind the paper as of uncertain market value.
This signifies that the crisis is no longer one of liquidity, but of deteriorating creditworthiness systemwide that restoring liquidity alone cannot cure. The liquidity crunch is a symptom, not the disease. The disease is a decade of permissive tolerance for credit abuse in which the banks, regulators and rating agencies were willing accomplices.
Investment vehicles in the form of commercial paper that mature in one to 270 days, which normally carry top credit ratings, allow issuing companies to sell debt in credit markets to institutions such as money-market funds and pension funds at rates lower than bank borrowing or standby bank credit lines. Unlike non-financial companies, which use the short-term debt proceeds to finance inventories, financial-company debtors invest the proceeds in longer-term securities with higher yields for speculative profit from interest-rate arbitrage.
Many of these higher-yield securities are in the form of collateralised debt obligations (CDOs) backed by "synthetic" high-rated tranches of securitised subprime mortgages, which have been losing market value as the US market seizes from subprime-mortgage default rates that have risen to the highest levels in a decade and are expected to get worse - perhaps much worse than currently admitted publicly by parties who are in a position to know the ugly facts.
At what level such wilful withholding of material information crosses over from serving the public interest by benign calming of market fear to criminal security fraud in disseminating false information is for the US Securities and Exchange Commission (SEC), and eventually the courts, to decide.
The professed mission of the SEC is to protect investors and maintain fair, orderly and efficient markets while facilitating capital formation.
Claiming to be an advocate for investors, the SEC proclaims on its website: "As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor-protection mission is more compelling than ever. As our nation's securities exchanges mature into global for-profit competitors, there is even greater need for sound market regulation."
The SEC declares:
"The laws and rules that govern the securities industry in the US derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.
"Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions. The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation's economy. To ensure that this objective is always being met, the SEC continually works with all major market participants, including especially the investors in our securities markets, to listen to their concerns and to learn from their experience.
"The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud."
It is now clear that material information about the true condition of the financial system along with material information of the financial health of major US banks and their financial-company clients has been systemically withheld, over long periods and even after the crisis broke, from the investing public who were encouraged to buy and hold even at a time when they should have really been advised to sell to preserve their hard-earned wealth. The aim of this charade has not been to enhance the return on the public's investment, but to exploit the public trust to shore up a declining market and postpone the inevitable demise of wayward institutions.
For example, Larry Kudlow, a self-proclaimed "renowned free-market, supply-side economist armed with knowledge, vision, and integrity acquired over a storied career spanning three decades", and host of the Kudlow & Company TV show on CNBC, is an intrepid cheerleader for the debt economy in an evangelistic manner, while the logo for his programme is "Putting Capital Back into Capitalism".
As an evangelist for free-market capitalism who celebrates debt and voices loud calls for central-bank intervention to reinflate the burst debt bubble, Kudlow sounds amazingly similar to the campaign of Christian evangelist Pat Robertson of the 700 Club to put God back into people's lives while advocating assassination of Venezuelan President Hugo Chavez and proclaiming Israeli prime minister Ariel Sharon's stroke as divine retribution for the Israeli pullout from the Gaza Strip.
The problem of both evangelistic programmes is that the declarations of faith are frequently countered by faithless calls for sinful response to developing events. One is grateful that evangelists are not yelling fire in a theatre crowded with believers, but to tell the audience to sit and finish watching the movie when fire has broken out is not exactly doing God's work.
There is indeed need to put capital back into debt-infested finance capitalism. Until then, Kudlow's evangelistic message that "capitalism works" is just empty words. While market capitalisation of US equity reached US$20.6 trillion at the end of 2006, the US debt market grew to more than $25 trillion in trading volume. There is $5 trillion of negative capital in US capitalism, about 45% of gross domestic product.
Hedge funds, which number some 10,000, commanding assets in excess of $2 trillion funded with debt, have become dominant players in the runaway debt market, particularly in complex market segments, trading about 30% of the US fixed-income market, 55% of US derivative transaction, 80% of high-yield/high-risk derivatives, 80% of distressed debts and 55% of the emerging-market bonds.
Investors in hedge funds include mutual funds, insurance companies, pension funds, banks, brokerage house proprietary trading desks, endowment funds, even central banks.
When private-equity firms acquire public companies to take them private, the acquisition is done mostly with debt. Most corporate mergers and acquisition are funded with debt. Foreign wars and domestic tax cuts are funded with sovereign debt. Debt instruments are routinely traded as if they were equity.
Since bank clients such as hedge funds and private-equity firms are private entities that cater to supposedly "sophisticated" investors, neither the banks nor their private clients are required by US regulation to make full disclosures of their financial situations. Yet mutual funds and pension funds get the money they manage from members of the general public who do not qualify individually as "sophisticated" investors. They should be entitled to better disclosure requirements.
As banks only set up and run investment "conduits" as independent entities to help their risk-prone clients monetise their securitised assets, such as receivables from credit cards, automobile loans or home mortgages, by selling ABCP, such conduits are kept off the balance sheet of banks.
When dealing in the arcane derivatives market in particular, collateral management is an indispensable risk-reduction strategy.
The Enron implosion was caused by "special-purpose vehicles", which were early incarnations of "conduits" backed by phantom collaterals. Enron's collapse was a high-profile event that briefly brought credit risk to the forefront of concern in the financial-services industry. Collateral management rose briefly from the Enron ashes as a critical mechanism to mitigate credit risk and to protect against counter-party default.
Yet in the recent liquidity boom, collateral management has again been thrown out the window and rendered dysfunctional by faulty ratings based on values "marked to theoretical models" that fall apart in disorderly markets.
Kenneth Lay, once the high-flying chairman of Enron, before his untimely death faced securities-fraud as well as bank-fraud charges after Enron's bankruptcy. The bank-fraud issue revolved around an obscure Federal Reserve banking regulation from the Depression era, called Regulation U, which sets out certain requirements for lenders, other than securities brokers and dealers, who extend credit secured by margin stock.
Margin stock includes any equity security registered on a national securities exchange; any debt security convertible into a margin stock; and most mutual funds. The regulation covers entities that are not brokers or dealers, including commercial banks, savings-and-loan associations, federal savings banks, credit unions, production credit associations, insurance companies, and companies that have employee stock-option plans. This limits the amount of credit a bank can extend to customers for buying on margin. The purpose of the law is to prevent banks from taking on unwarranted or excessive risk.
Prosecutors alleged that Lay signed documents at Bank of America, Chase Bank of Texas and Compass Bank in which he agreed that he would not use the $75 million in personal credit lines to buy or maintain stock on margin but then proceeded to do exactly that. Had he been convicted, Lay would have faced up to 30 years in jail for each count.
On Lay's official website, the Houston community leader, free-enterprise icon and superstar in the energy business denounced the charges as "based on arcane laws" and added that "my legal team can find no record during this law's 70-year existence of these provisions ever being used against a bank customer [like me] until now".
When speculation grew about the role Citibank played in the collapse of Enron, shares of Citigroup fell 12%.
The US Senate heard testimony from Senate investigators about the role US banks and their investment-bank subsidiaries might have played in backing the specious accounting at Enron in a complex scheme known as "pre-pays", under which Enron booked loans as energy trades and thus as profits to make the firm look far more profitable than it really was.
The investigators contended that Enron could not have shown such profitability but for the shady help of large commercial banks, such as Citigroup and JPMorgan Chase, and their investment-banking arms. Under General Accepted Accounting Principles (GAAP), loans issued to Enron should have been booked as debt rather than revenue.
Both Citigroup and JPMorgan claimed that "pre-pay" transactions are entirely lawful.
Each bank engaged in about a dozen deals that involved questionable transactions with the failed energy trader. Enron then illegally hid the loans by cloaking them in transactions that were booked as energy trades to show it was earning more money than it really was. This in turned boosted not only Enron's share price but also its credit rating, permitting it to continue to secure loans at preferential rates. The convoluted transactions involved the leveraged purchase of natural gas and other commodities over long periods with credit to look like sales and booked as revenue to increase profits.
Outrageously, while Enron booked the transactions as profits from phantom revenue, it did not report them on its tax returns, electing instead to log them as loans to deduct interest payments. About $5 billion of such loan amounts remained outstanding when Enron filed for protection under Chapter 11 of the US Bankruptcy Code, which allowed the company to operate as a debtor-in-possession to try to minimise loss to creditors. According to the Senate report, the transactions, which took place from 1992 to 2001, in effect hid part of Enron's mounting debt, which eventually bankrupted the doomed energy giant.
The University of California, whose pension fund invested in Enron stocks, led a shareholder class-action suit against Enron and its banks, alleging that internal Enron documents and testimony of bank employees detailed how the banks engineered sham transactions to keep billions of dollars of debt off Enron's balance sheet and create the illusion of increased earnings and operating cash flow.
The suit listed specifically that Merrill Lynch purchased Nigerian barges from Enron on the last day of 1999 only because Enron secretly promised to buy the barges back within six months, guaranteeing Merrill Lynch a profit of more than 20%. As a result of this fraud, Merrill Lynch ultimately paid $80 million to settle with the SEC.
Also listed as evidence was the fact that Barclays Bank entered several sham transactions with Enron, including creating a "special-purpose entity" called Colonnade, a shell company to hide Enron's debt, named after the street in London where the bank is headquartered. Also on the list was investment bank Credit Suisse First Boston, which engaged in "pre-pay" transactions with Enron, including serving as one of the stop-offs for a series of round-trip, risk-free commodities deals in which commodities were never actually transferred or delivered.
Although the three lead banks and others settled with the Enron fraud victims for $7.2 billion, several huge banks named in this suit still have not paid a penny to the victims of the fraud. After years of trial preparation and just a few weeks before the scheduled trial, a 2-1 Fifth Circuit Court of Appeals decision on March 19 let the banks off the hook and destroyed the hope of Enron victims for any further recovery.
The appeals court acknowledged that the conduct of the banks was "hardly praiseworthy", but ruled that because the banks themselves did not make any false "statements" about their conduct, they could not be liable to the Enron victims even if they knowingly participated in the scheme to defraud Enron shareholders. The court ruled that Enron Corp shareholders could not proceed as a class against three investment banks for allegedly participating in fraudulent behaviour that led to Enron's collapse.
The University of California asserts that the appeals court decision absolving the banks from liability was wrong because the banks were uniquely positioned to create contrived financial transactions to distort a public company's financial statements.
The ruling awards the banks "get out of jail free" cards to commit fraud without being held accountable, lawyers representing the university argued. The ruling, in essence, declares that the mastermind of the bank robbery who planned the heist, recruited the other robbers, provided the weapons, drove the getaway car and went back to the hideout to split up the loot is not legally responsible, just because he did not show his face inside the bank.
As the sole dissenting judge summarised, the ruling "immunises a broad array of undeniably fraudulent conduct from civil liability ... effectively giving secondary actors license to scheme with impunity, as long as they keep quiet".
The appeals court split decision is inconsistent with the express language of the broad anti-fraud prohibition of 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5, which makes it unlawful for "any person, directly or indirectly", to "employ any device, scheme, or artifice to defraud" or "to engage in any act, practice, or course of business which operates ... as a fraud or deceit upon any investor".
In an extraordinary admission, the appeals court's two-member majority acknowledged: "We recognise, however, that our ruling ... may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they allege was aided and abetted by the defendants at bar, with notions of justice and fair play."
Units of Citigroup Inc arranged an unusual financing technique for Enron that enabled the energy trader to appear rich in cash from trading rather than saddled with debt. In a series of deals known as Yosemite, Citigroup's multifarious scheme helped Enron borrow money over a period of three years that was booked as proceeds from trades instead of loans. The deals involved bond offerings and trades with an offshore entity to help manipulate the company's weak cash flow upward to match its growth in paper profits, at a time when the gap had grown to as much as $1 billion a year.
Enron would not have been able to defraud investors but for the willing participation of Wall Street banks. Evidence supports the allegation that Citigroup, the nation's largest financial institution, which also owned commercial-bank and investment-bank units, helped Enron disguise debt on its balance sheet through complex financial accounting arrangements at the company.
Although Citigroup actions technically might have been in accordance with then-lax accounting principles, they raised questions over whether Citigroup helped shield important material information from Enron investors. Citigroup denied wrongdoing, noting that lenders should not be held responsible for how a client such as Enron accounted for the financing arranged by its bankers.
In a statement, Citibank said: "The transactions we entered into with Enron were entirely appropriate at the time based on what we knew and what we were told by Enron. We were assured that Enron's auditors had approved them, and we believed they were consistent with accounting rules in place at the time."
Citibank was saying that the problem was with the rules of the game and that it had only been a clever player. Pathetically, it was the only true statement in the whole sordid affair.
Citigroup rival JPMorgan Chase and Co also faced after-the-fact SEC scrutiny for similar deals through a vehicle known as Mahonia, which was the subject of a page 1 story in the Wall Street Journal in January 2003.
Mahonia drew wide scrutiny after a lawsuit with insurers who had guaranteed the transactions through surety bonds. The insurers refused to pay Morgan, arguing that prepaid transactions in effect generated loans, not trades. Their view was confirmed by presiding US District Judge Jed S Rakoff, who wrote in an opinion that the Mahonia transactions "appear to be nothing but a disguised loan".
The SEC investigated both Citigroup and JPMorgan on whether the banks helped Enron hide debt and artificially boost cash flow for regulatory violations, and the office of Manhattan District Attorney Robert Morgenthau also examined the deals for criminal offences. Enron, which had a reputation of browbeating its bankers, was accused of putting pressure on Citigroup to carry out elements of the deals.
As with the Mahonia arrangement, Citigroup's Yosemite transactions involved commodity "pre-pay" transactions, in which money is paid up front for commodities such as natural gas or oil to be delivered at a future date, a practice common in the energy market. But Senate hearings documents showed that the Yosemite transactions were manipulated to make debt appear on Enron's public disclosures as trades through a series of "round trip" prepaid transactions.
In each of the four Yosemite deals, Citigroup set up a trust that raised money from investors in Europe and the US. Then the money moved to a Citigroup-sponsored special-purpose vehicle in the Cayman Islands known as Delta, which then sent the money in a circle through a series of oil trades, first to Enron then to Citigroup, and then back to Delta, each time moving the money through oil pre-pay contracts. Oil never actually changed hands, and the trades in effect cancelled one another out in what amounted to financial manipulation.
Cash settlement is common in commodity transactions, but the round-trip nature of the trades is one uncommon aspect that drew the scrutiny of US congressional investigators. So did the accounting effect of the circular trades, which allowed Enron to borrow money from the Yosemite investors but record it as cash generated from its operations - because that pre-pay contracts were booked as trades rather than loans. The distinction was central because the company's burgeoning debt levels were starting to raise red flags among shareholders well in advance of Enron's final collapse.
The use of pre-pays as a monetisation tool is a sensitive topic for both ratings agencies and institutional investors. Documents show that Enron routinely kept Yosemite transaction details in a "black box". Only two participating parties would know the precise details: Enron and Citigroup. This type of "black box" opaqueness is present in many over-the-counter derivate products, "conduits" and "special investment vehicles" that are causing the current ABCP credit crisis.
Enron would put into Yosemite an extra payment called a "magic note" that ensured that Yosemite's investors received promised interest on their investments. Those investors were led to believe they were buying assets from Enron that had revenue streams. In fact, Enron simply was paying - out of its other revenues - interest on its magic note, a bond with a yield of as much as 49% in one instance. The return was spread out among Yosemite investors to make sure they were paid the promised interest on their investment in the trust. All of this became a belated concern to regulators because the debt did not appear as such in Enron's public filings.
Citigroup put the blame squarely on Enron and its then-auditors at Arthur Andersen LLP. "I wish I'd never heard of Enron," Citigroup chairman and chief executive officer Sanford I Weill said in an interview. He might have added that he wished he had never heard of Jack Grubman.
Grubman, star telecom analyst of Citigroup investment-banking firm Salomon, entered a quid pro quo with Weill to upgrade his "independent" rating of AT&T to help Solomon land a huge deal AT&T was preparing to finance a spin-off of its wireless-telephone unit. Grubman, in a two-page memo to Weill titled "AT&T and the 92nd Street Y", offered that if Weill, a member of the AT&T board and a close associate of AT&T CEO C Michael Armstrong, would help Grubman's twin children get into a much-sought-after New York nursery school, Grubman would take on a more positive view of AT&T's business model as Weill had suggested. Weill proposed a donation of $1 million to the school if the Grubman kids were admitted.
The exposure of the Grubman-AT&T deal revealed an embarrassing picture of how Wall Street firms put their own interests well ahead of those of the small investors they were supposed to be helping with independent research during the years of the information-technology bubble. The tale eventually led to the departure of both Grubman and Weill from Citigroup, with Grubman barred from the security industry for life. Weill personally survived the multibillion-dollar Enron fraud unscathed, only to fall over the questionable donation of $1 million to help an employee put his children in a nursery school in return for a biased stock analysis. Immunity mounts in proportion to the scale of malfeasance.
On July 28, 2003, the SEC instituted and settled enforcement proceedings against JPMorgan Chase and Co and Citigroup Inc for their roles in Enron's manipulation of its financial statements. The SEC accused each institution of helping Enron mislead its investors by characterising what were in essence loan proceeds as cash from operating activities. The proceeding against Citigroup also resolved SEC charges stemming from the assistance Citigroup provided Dynegy Inc in manipulating that company's financial statements through similar conduct.
For JPMorgan Chase, the SEC filed a civil injunctive action in US District Court in Texas. Without admitting or denying the SEC allegations, JPMorgan Chase consented to the entry of a final judgment in that action that would (1) permanently enjoin JPMorgan Chase from violating the anti-fraud provisions of US federal securities laws, and (2) order JPMorgan Chase to pay $135 million as disgorgement, penalty, and interest. The settlement suggested that JPMorgan Chase had not been enjoined from violating the anti-fraud provisions of the federal securities laws before the Enron collapse.
For Citigroup, the SEC instituted an administrative proceeding and issued an order making findings and imposing sanctions. Without admitting or denying the SEC findings, Citigroup consented to the issuance of the SEC Order whereby Citigroup (1) was ordered to cease and desist from committing or causing any violation of the anti-fraud provisions of the federal securities laws, and (2) agreed to pay $120 million as disgorgement, interest, and penalty. Of that amount, $101 million pertained to Citigroup's Enron-related conduct and $19 million to the Dynegy conduct.
The SEC enjoinment against the two errant banks is like using the disallowance of further bank robberies as punishment for a previous bank robbery.
The SEC intended to direct the money paid by JPMorgan Chase and Citigroup to fraud victims ($236 million to Enron fraud victims and $19 million to Dynegy fraud victims) pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002. That amounted to a mere pittance of the billions in losses suffered by the victims.
On May 10, 2004, Citigroup under new CEO Charles Prince said that it would pay $2.65 billion to investors who bought securities of WorldCom that had been highly recommended by its analyst Jack Grubman before the telecommunications company collapsed. It also said it would put aside several billions of dollars more in reserves for other legal claims, raising the total cost to more than $10 billion to clean up its problems stemming from the failure of WorldCom and Enron, as well as questionable practices in the offering of new issues and the publishing of sham stock research during the high-flying days before the tech stock-market bubble burst.
The after-tax cost to Citibank would total $4.95 billion, or 95 cents a share against its second-quarter earnings. Prince emphasised that that was only about equal to its profit for one quarter, and bond-rating companies said they would not lower their rankings of Citigroup's debt. In other words, it was no big deal.
Before taxes, Citigroup's total cost of settling the WorldCom suit, paying regulatory fines relating to Enron and research analysts, and setting aside reserves for other litigation came to $9.8 billion, with losses on loans to WorldCom and Enron adding another $500 million.
"These are historical matters," Prince said in May 2004. "They arose in a different era." Last month, it appeared that history was repeating itself.
The enforcement division of the SEC commented on the settlement with the two errant banks that "if you know or have reason to know that you are helping a company mislead its investors, you are in violation of the federal securities laws". It went on to say that it intended "to continue to hold counter-parties responsible for helping companies manipulate their reported results. Financial institutions in particular should know better than to enter into structured transactions where the structure is determined solely by accounting and reporting wishes of a public company." It deflected attention from the fact that the disciplinary action was merely a gentle tap on the wrist.
The SEC pointed out that JPMorgan Chase and Citigroup engaged in, and indeed helped their clients design and execute, complex structured finance transactions. The structural complexity of these transactions had no business purpose aside from masking the fact that, in substance, they were loans. As alleged in the charging documents, by engaging in certain structural contortions, these financial institutions helped their clients: (1) inflate reported cash flow from operating activities; (2) underreport cash flow from financing activities; and (3) underreport debt.
As a result, Enron and Dynegy presented false and misleading pictures of their financial health and results of operations. Significantly, with respect to Enron, both financial institutions knew that Enron engaged in these transactions specifically to allay investor, analyst, and rating-agency concerns about its cash flow from operating activities and outstanding debt. Citigroup knew that Dynegy had similar motives for its structured finance transaction.
As alleged by the SEC, these institutions knew that Enron engaged in the structured finance transactions to match its "mark to market" earnings (paper earnings based on daily changes in the market value of certain assets held by Enron) with cash flow from operating activities. As alleged, by matching mark-to-market earnings with cash flow from operating activities, Enron sought to convince analysts and credit rating agencies that its reported mark-to-market earnings were real, i.e., that the value of the underlying assets would ultimately be convertible to cash in full.
The SEC further alleged that these institutions also knew that these structured finance transactions yielded another substantial benefit to Enron: they allowed Enron to hide the true extent of its borrowings from investors and rating agencies because sums borrowed in these structured finance transactions did not appear as "debt" on Enron's balance sheet. Instead they appeared as "price risk management liabilities", "minority interest", or otherwise. In addition, Enron's obligation to repay those sums was not otherwise disclosed.
Acting like a Marshal Wyatt Earp who had just cleaned up Dodge City, the SEC congratulated itself for cleaning up the Wild, Wild West of structured finance by gracefully acknowledged the assistance of the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the New York State Banking Department in connection with its Enron-related actions. These agreements, between the institutions and their primary banking regulators, obligated them to enhance their risk-management programmes and internal controls so as to reduce the risk of similar misconduct. The regulator focused only on bank obligation to "reduce the risk of similar misconduct", not to eliminate the misconduct entirely. Zero tolerance was not the message.
With these actions, the SEC raised to six the total number of separate actions it brought in connection with the Enron fraud in 20 months since Enron declared bankruptcy in December 2003. The various defendants and respondents include three major financial institutions, Enron's former chief financial officer, and eight other former senior Enron executives. The SEC garnered a pathetic $324 million for the "benefit" of the victims of the Enron fraud.
Despite the banks' denials of any wrongdoing, many investors say the banks had or should have had knowledge about the true state of Enron's finances.
Enron's use of pre-pays arranged by banks was so extensive that accounting firm Arthur Andersen created guidelines that it gave to banks about what was needed for these structures to appear on Enron's books as trades rather than debt. "For pre-pays to be treated as trading contracts, the following attributes must exist," the brochure said, citing, among other things, that "the purchaser of the gas must have an ordinary reason for purchasing the gas". A Houston federal jury convicted Arthur Andersen in June 2003 of obstructing justice after the government accused the firm of destroying documents related to Enron.
An array of executives, lawyers, bankers and institutions were formally named in an amended class-action complaint for their alleged role in the Enron scandal. Lawyers for the Regents of the University of California, the court-appointed lead plaintiff in the case, said the defendants "pocketed billions of dollars" while Enron investors were being defrauded. Among those on the list were: Andersen, Enron auditor; Enron's banks, including JPMorgan Chase and Citigroup; and Enron's lawyers, including Vinson & Elkins. Enron board members such as Wendy Gramm, wife of the influential Republican senator Phil Gramm, were also named.
Wendy Gramm, an economist who had called for deregulation of the energy industry, headed the Commodity Futures Trading Commission (CFTC) from 1988 to 1993. After a heavy lobbying campaign from Enron, the CFTC exempted it from regulation in trading of energy derivatives. Subsequently, Gramm resigned from the CFTC and took a seat on the Enron board of directors, where she was paid $1.85 million.
This lack of CFTC oversight contributed to Enron's accounting irregularities, and the failure of the hedge fund Amaranth Advisors from losses resulting from betting on the wrong side of natural-gas prices last September.
Arthur Andersen, Enron's auditor, with 2001 revenue of $9.4 billion, offered to settle its part in the case for $300 million, reduced from its initial $750 million offer and indicative of its dire financial circumstances brought on by deserting clients and disintegrating worldwide structure. But it failed to cut a deal in time to be removed from the suit.
Joseph Berardino, Andersen's chief executive, who resigned over the issues, was named a defendant. Andersen was convicted on June 15, 2002, of obstruction of justice for shredding documents related to its audit of Enron. Since the SEC does not allow convicted felons to audit public companies, the firm agreed to surrender its licenses and its right to practice before the SEC on August 31, 2002. This in effect ended the company's operations.
The Andersen indictment also put a spotlight on its faulty audits of other companies, most notably Sunbeam, Waste Management and WorldCom.
Sunbeam, a household-appliances manufacturer, acquired three other companies: Coleman, Signature Brands and First Alert with $1.7 billion of debt, which it cited in a court filing as leading to the bankruptcy.
In the late 1990s, Sunbeam CEO Al Dunlap used accounting tricks to paint a picture of a turnaround in earnings that didn't exist. With a pay package that included more than 7 million shares and options, Dunlap stood to make more than $200 million personally if he could keep Sunbeam's stock price flying. In the spring of 1998, when Dunlap and his team ran out of tricks, Sunbeam corrected its books, it declared bankruptcy on February 6, 2001, and the stock price plunged from $53 at its peak to just pennies.
In an ominous harbinger of the Enron scandal, the SEC discovered that Andersen accounting documents had been destroyed. In 2001, Andersen paid $110 million to settle (without admitting legal responsibility) a class-action suit by shareholders of Sunbeam over wildly "mis-stated" corporate financial statements in the 1990s.
In the case of Waste Management - which in 1998 issued the largest corporate restatement before Enron - the company had exaggerated its earnings by $1.7 billion. The SEC's investigation found a long-running cover-up - not just by Waste Management, but by Andersen as well.
Andersen and Waste Management paid a steep price in stockholder settlements, but no one went to jail. The SEC fined Andersen $7 million in June 2001, and Andersen promised to shore up its internal oversight - but by then it was already deeply enmeshed in new trouble at Enron.
The bankruptcy of WorldCom on July 22, 2002, came one month after it revealed that it had improperly booked $3.8 billion in expenses. WorldCom surpassed Enron as the biggest bankruptcy in history, which led to a domino effect of accounting and other corporate scandals that continue to tarnish US business practices.
WorldCom, with $107 billion in assets, collapsed under its $41 billion debt load. Its bankruptcy dwarfed that of Enron, which listed $63.4 billion in assets when it filed a year earlier. Immediately upon filling for bankruptcy protection, WorldCom lined up $2 billion in debtor-in-possession financing from Citigroup, JPMorgan and GE Capital that would allow it to operate while in bankruptcy.
The WorldCom bankruptcy was precipitated by the revelation on June 25, 2002, that it had incorrectly accounted for $3.8 billion in operating expenses. The admission cast WorldCom into the top tier of scandal-ridden companies alongside Tyco International, Global Crossing, Adelphia Communications and Enron.
On May 31, 2005, the US Supreme Court unanimously overturned Andersen's conviction on the ground of serious flaws in jury instructions. In the court's view, the instructions allowed the jury to convict Andersen without proving that the firm knew it had broken the law or that there had been a link to any official proceeding that prohibited the destruction of documents.
The opinion, written by the late chief justice William Rehnquist, was also highly sceptical of the government's concept of "corrupt persuasion" - persuading someone to engage in an act with an improper purpose even without knowing an act is unlawful. The Supreme Court was in effect saying that common-sense unethical business behaviour can be technically legal. The court seemed to view Andersen's destruction of incriminating documents as merely an attempt to manage public relations, in opposition to the lower court's view of criminal obstruction of justice.
The problem for the banks now is exacerbated when asset-backed commercial paper conduits are no longer issued by one issuer and sold to one investor. ABCP now combine a variety of debt categories from different issuers and are sold to a large number of investors, making full disclosure difficult to understand even by "sophisticated" investors. Notes from conduits now account for half of the $3 trillion global commercial paper market.
High public officials who are in the position to know, ranging from the chairman of the Federal Reserve to the secretary of the US Treasury, repeatedly gave assurances to the investing public that were not only at variance with discernible trends but turned out to be materially false within weeks. The "basic facts" about the market that the SEC claims as its mission to make available to all investors were systemically distorted and withheld from the investing public with denials by officials of distress firms and their regulators up to days before the adverse information surfaced as undeniable facts.
These officials can now rest at ease for misleading investors because the high court of the United States of America has declared "corrupt persuasion" to be legal, that persuading someone to engage in an act with an improper purpose even without knowing an act is unlawful is not criminal behaviour.
US Federal Reserve data show that the outstanding stock of US commercial paper has fallen by US$255 billion or 11% over the past three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial-paper (CP) market, tumbled $59.4 billion to $998 billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest-rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.
Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash, when large trusts did not have access to a lender of last resort, as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash, when the Fed delayed needed intervention.
Today, key market participants who dominate the credit market with unprecedented high levels of securitised debt operate beyond the purview of the Fed in the non-bank financial system, and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.
US banks are now unhappy about capital and debt markets, where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks' share of net credit markets, according to Fed data on flow of funds, dropped from a peak of more than 62% in 1975 to 26% in 1995 and was still falling rapidly, while securitisation's share rose from negligible in 1975 to more than 20% in 1995 and more than 30% in 2006 and was still rising rapidly, with insurers and pension funds taking the rest.
Debt securitisation in the first half of 2007 stood at more than $3 trillion, up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972. About $1.2 trillion is asset-backed securities. The biggest issuers are: Countrywide, $55 billion; Washington Mutual, $43 billion; and General Motors Acceptance Corp (GMAC), $40 billion. Big bank issuers are: JPMorgan Chase, $38 billion; Citibank, $29 billion; Barclays Bank, $29 billion. Big brokerage issuers are: Lehman Brothers, $37 billion; Merrill Lynch, $31 billion, Bear Sterns, $31 billion; and Morgan Stanley, $26 billion.
Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt-securitisation market.
In February 2000, the Dow Jones Industrial Average (DJIA) closed below 10,000 - a psychological benchmark from a peak of 11,723 just four weeks earlier, and 10,000 was only a transitional barrier. Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%.
On September 17, 2000, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27. The market had declined 4,436.71 points, or 38%, from January 14, 2000, when it rose 140.55 to close at all time high of 11,722.98, the first close above both 11,600.00 and 11,700.00.
On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001, and did so again 12 more times to 1% on June 25, 2003, and held it there - below inflation rate - for a full year, unleashing the debt bubble.
On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all-time high. The DJIA had risen 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in four years and 10 months. The US gross domestic product rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, an increase of 30%. Asset prices outpaced economic growth by a multiple of three during that period.
This extraordinary divergence shows more than the different economic fundamentals of the old and new economies. It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets in which, with the advent of structured finance, the line between equity and debt has in effect been blurred.
Nasdaq companies rely less on banks for funds and were thus less affected by then Fed chairman Alan Greenspan's threats of interest-rate hikes. Greenspan had been vocal in explaining that his monetary-policy moves of rising Fed Funds rate targets were not specifically targeted toward "irrational exuberance" in the stock markets, but toward the unsustainable expansion of the US economy as a whole. But data show that the economy did not expand at the same rate as the rise of equity prices. Economic growth would be more sustainable with irrational exuberance in the stock market.
In the same breath, Greenspan decried the dangers of the wealth effect if it ever ended up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspan's positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation. He continued to restrain demand in favour of supply in an already overcapacity economy.
The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing whether housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home-equity loans enabled homeowners to monetise their housing investment gains to support their non-housing consumption.
It is hard to see how home prices rising higher than homebuyers can afford to pay can be good for any economy. Yet the Fed celebrates asset-price appreciation for shares and real estate, but treats wage rises like a dreaded plague.
The so-called "bifurcated" market indices of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon was the Fed Funds rate, lost control of the new economy, which appears impervious to short-term interest-rate moves.
Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest-rate target to rein in an impervious Nasdaq at the peril of the whole economy. Interest-sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced the Fed to keep Fed Funds rate at 1% for a whole year, from June 2003 to June 2004, to create the housing bubble. With the inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.
Financial-services companies, including commercial banks, brokerage firms and mortgage lenders, investment-bank and non-bank financial companies such as GE and GMAC, had since produced some of the biggest profits in the recent bull market fuelled by a liquidity boom.
The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favour return on capital rather than through rising wages, it exacerbates the supply-demand imbalance, which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over-investment except by taking on consumer debt and home-equity debt.
In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money-centre banks and broker dealers, along with their hedge-fund customers, are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest-rate swaps, default swaps and securitised mortgages. But this was just an early symptom, like an initial wave of high fever.
Lipper TASS reports that institutional and wealth private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate hedge-fund performance of 5.19% by June 30 did not surpass market indices' rise for the period. The S&P 500 returned 6.28%, while the MSCI World TR returned 6.71%. The biggest inflows were for market-neutral long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period. Strategies that posted net outflows included global macro-funds, which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million. Losses of this scale are bound to have structural effects.
The most popular of all derivative products is the interest-rate swap, which in essence allows participants to make bets on the direction interest rates will take.
According to the US Office of the Comptroller of the Currency (OCC), interest-rate swaps accounted for three out of four derivative contracts held by US commercial banks at the end of 1999. The notional value of these swaps totalled almost $25 trillion; 2-3% of that reflected the banks' true credit risk in these products, or between $500 billion to $700 billion. The notional amount outstanding as of December 2006 in OTC (over the counter) interest-rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. A 1% move in the interest rate would alter interest payments in the amount of $4 trillion, albeit much the payment would be mutually cancelling, unless in the case of counter-party default.
The Comptroller of the Currency Quarterly Report on Bank Derivatives Activities shows that US commercial banks generated a record $7 billion in revenues trading cash and derivative instruments in first quarter of 2007, up 24% from the first quarter of 2006, which at $5.7 billion had been the previous record. Revenues in the first quarter were 82% higher than in the fourth quarter. Net current credit exposure, the net amount owed to banks if all contracts were immediately liquidated, decreased $5.3 billion from the fourth quarter to $179.2 billion. The data for the third quarter of 2007 are expected to be very negative to reflect market turmoil since July.
The notional amount of derivatives held by US commercial banks increased $13.3 trillion to $144.8 trillion in the first quarter of 2007, 10% higher than in the fourth quarter and 31% higher than a year ago. Bank derivative contracts remain concentrated in interest rate products, which represent 82% of total notional value. The notional amount of credit derivatives, the fastest-growing product of the global derivatives market, increased 13% from the fourth quarter of 2006 to $10.2 trillion in first quarter in 2007. Credit default swaps represent 98% of the total amount of credit derivatives. Credit derivatives contracts are 86% higher than at the end of the first quarter of 2006. The largest derivatives dealers continue to strengthen the operational infrastructure for over-the-counter derivatives through a collaborative effort with financial supervisors, the OCC reports. Still, counter-party risk remains problematic.
Derivatives of all kinds weigh heavily on banks' capital structures. But interest-rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began - in fact, yields have risen 25% - these institutions now find themselves on the wrong side of an interest-rate gamble. Moreover, as interest rates rise, bank income diminishes from interest-rate-related businesses such as mortgage lending. Interest-sensitive sources of income will be the revenue disappointments in 2008, as in 2000, and as trading was in 1999.
The impact of the demise of the Nasdaq index on the wealth effect was not total. Investment banks pitched to high-tech/Internet founders and early shareholders to hedge capital gains by signing away future upsides. For those high-tech swimmers who took advantage of the offers, this amounted to two-layer swimming trunks that allowed them to lose the top layer without risking being caught naked when the tide receded suddenly. It was the financial version of a flat-proof tubeless tire that can get you to the next service station or 50 kilometres (whichever is closer) in the event of a puncture. It does not, however, guarantee the driver the existence of a service station that has not been forced to close from operational losses within 50km.
Meanwhile, pension funds are forced to jettison their old-fashioned balanced portfolios in favour of structured finance strategies to seek higher returns. What the Greenspan Fed did was to penalise the general public by devaluing their future pension cash flow for the sins of the aggressively investing rich, who continued to add to their wealth with Greenspan's blessing as long as the risks of high returns were passed on to the system as a whole. This is what US economic democracy has come to.
Investors worldwide are unconvinced that the US Federal Reserve can succeed in stabilising the US commercial-paper market, the latest and so far biggest shoe to drop in the spreading contagion from US subprime mortgages. Banks are suddenly exposed to unexpected risks as US asset-backed CP shrank by its biggest weekly percentage since November 2000 as investors shunned debt linked to mortgages and opted for the safety of Treasuries.
This means that investors prefer to lend money to the US government, despite historically high levels of fiscal deficit and national debt, than to financial institutions that seek profit from interest-rate arbitrage. Market preference for speculative investment has vanished. Banks are suddenly holding the bad end of a massive amount of speculative debt instruments. When new commercial paper is not sold to roll over the maturing debt, borrowers must draw on bank credit at a higher interest cost to prevent default, leaving banks with riskier debts that the market has rejected.
In the week to August 22, after the Fed lower the discount rate by 50 basis points to 5.75% on August 17, banks borrowed a daily average of only $1.2 billion from the Fed discount window, suggesting that banks were still unsure how to use the facility to lend to distressed clients. Officials at the New York Fed, the central bank's liaison with Wall Street, received inquiries from commercial banks on whether their clients' asset-backed commercial paper could be pledged as collateral at the discount window.
The New York Fed issued a statement "in response to specific inquiries" from money-centre banks on Friday, August 24, that it "has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper" for discount-window loans to ease the liquidity crisis faced by the banks to try to calm an essential part of the money market, the orderly functioning of which is critically needed to lubricate financial markets. But the statement only trimmed slightly the abnormally high average ABCP yield to 6.04%, still roughly 80 basis points higher than normal, even for those borrowers who could sell commercial paper at all, which normally would be at rates close to the Fed funds rate of 5.25%.
On the same day, the Fed eased regulations governing the relationship between Citibank NA, the US bank subsidiary of Citigroup Inc, and its broker-dealer subsidiary, Citigroup Global Markets Inc. The regulatory exemption allows Citibank to lend up to $25 billion to customers of the broker-dealer. Bank of America Corp received a similar easing.
Section 23A of the Federal Reserve Act and the Fed board's Regulation W limit the amount of "covered transactions" between a bank and any single affiliate to 10% of the bank's capital stock and surplus and the amount between a bank and all its affiliates to 20%. The banks have agreed to limit their lending under the exemption to $25 billion, which will constitute less than 30% of each bank's total regulatory capital.
The two banks, along with JPMorgan Chase & Co and Wachovia Corp, borrowed a total of $2 billion two days earlier in a symbolic show of support for the Fed's anaemic actions, while noting that they still had access to cheaper funding than the new discount rate of 5.75%.
Until the repeal of the Glass-Steagall Act, banking regulation prohibited banks with federally insured deposits from operating brokerage subsidiaries. In the early part of the last century, individual investors had been repeatedly damaged by banks whose overriding interest was to profit from promoting stocks held by banks, rather than to enhance the interest of individual investors or protect the security of its depositors.
After the 1929 market crash, regulators sought to limit the conflicts of interest created when commercial banks underwrote stocks or bonds, which contributed to abuses that caused market crashes. A new law, known as the Glass-Steagall Act, banned commercial banks from underwriting securities, forcing banks to choose between being a regulated lender of high prudence or an underwriter-broker with high risk appetite. The law also established the Federal Deposit Insurance Corp (FDIC), insuring bank deposits, and strengthened the Federal Reserve's control over credit.
The 1933 Glass-Steagall Act became a key pillar of banking law by erecting a regulatory wall between commercial banking and investment banking. The law kept banks from participating in the equity markets, and equity market participants from being banks. The relevant measure of the Glass-Steagall Act is actually the Banking Act of 1933, containing the provision erecting a wall separating the banking and securities businesses. It also left a small loophole to allow the Federal Reserve to let banks get involved in the securities business in a limited way to relieve otherwise cumbersome operation.
Glass-Steagall (actually two acts arising from bills sponsored by Democratic senator Carter Glass and Democratic congressman Henry B Steagall) was born during the Great Depression. The US banking system was in shambles, with more than 11,000 banks having failed or had to merge, reducing the number of surviving banks by 40%, from 25,000 to 14,000. The governors of several states closed their state banks and in March 1933, president Franklin Roosevelt briefly closed all the banks in the United States. Congressional hearings conducted in early 1933 concluded that the trusted professionals of the financial markets - the bankers and brokers - were guilty of disreputable and dishonest dealings and gross misuse of the public trust.
Historians, while acknowledging the role of malfeasance, now understand that the chief culprit of bank failures was structural, with inadequate regulations that permitted market abuse to become regular practice. Unethical practices were legal, and competition was conducted under the law of the financial jungle.
The Banking Act of 1933 was the newly elected Roosevelt administration's response to the perceived shambles of the nation's financial and economic system. But the act did not address the structural weakness of the US banking system: unit banking within states and the prohibition of nationwide banking. This structure is a key reason for the failure of many US banks, some 90% of which were unit banks with less than $2 million in assets. The act instituted deposit insurance and the legal separation of most aspects of commercial and investment banking, the principal exception being allowing commercial banks to underwrite most government-issued bonds.
Carter Glass was then a 75-year-old senator who physically stood only 163 centimetres tall but was historically a towering figure. A former Treasury secretary, he was a founder of the Federal Reserve System and a vocal critic of banks that engaged in the risky business of investing in stocks. He wanted banks to stick to conservative commercial lending, and he exploited traditional anti-bank sentiments to push through changes. Henry Steagall, a rural populist from Ozark, Alabama, the Democratic chairman of the House Banking and Currency Committee, signed on to the bill to attach an amendment that authorised bank deposit insurance.
Senator Glass was convinced that banks should not be involved with securities underwriting or investment, as such activities violated basic rules of good banking. As intermediary custodians of money, banks' involvement in equity markets would lead to destructive speculation, as evidenced by the crash of 1929 with its bank failures and the subsequent Great Depression.
Curbing the natural monopolistic tendency of banks has been a common legislative theme throughout US history until the recent onslaught of economic neo-liberalism. During the 1930s and 1940s, US banks were regulated to stay within the basics of taking deposits and making secured loans funded by deposits.
Congress did not intervene until 1956, when it enacted the Bank Holding Company Act to keep financial-services conglomerates from amassing excessive financial power. That law created a barrier between banking and insurance in response to aggressive acquisitions and expansion by TransAmerica Corp, an insurance company that owned Bank of America and an array of other financial services businesses. Congress thought it improper for banks to risk possible losses from underwriting insurance. While many banks today can sell insurance products provided by insurers, banks are not permitted to take on the risk of underwriting.
TransAmerica began when a young entrepreneur named A P Giannini started a small bank known as the Bank of Italy, later to be known as Bank of America. Giannini acquired Occidental Life Insurance Co through TransAmerica Corp in 1930. The 1956 Bank Holding Company Act prohibited a company from owning both banking and non-banking entities. The company decided to divest itself of its bank holdings and keep its core life-insurance businesses and related services under the TransAmerica name. As a financial conglomerate, it acquired motion-picture studio and distributor United Artists, Trans International Airlines, and Budget Rent-A-Car.
As private equity is the rage today, conglomerates were the new trend in the 1960s, exploiting a combination of low interest rates and recurring alternative cycles of bear/bull markets, which allowed the conglomerates to acquire companies in leveraged buyouts at temporarily deflated values with loans at negative real interest rates.
As long as the acquired companies had profits greater than the interest on the loans used to buy them, the overall leveraged return on investment (ROI) of the conglomerate grew spectacularly, causing the conglomerate's stock price to rise sharply within short periods. High stock prices allowed the conglomerate to borrow more money without altering its debt-to-equity ratio, with which to acquire even more companies. This led to a chain reaction that allowed conglomerates to grow very rapidly.
But when interest rates finally rose to catch up with inflation, conglomerate ROI fell when anticipated "synergies" from owning diversified businesses failed to live up to expectation and conglomerate shares fell in market value, forcing them sell off recently acquired companies to pay off loans to maintain the required debt-to-equity ratio.
By the mid-1970s, most conglomerates had been dismantled, as many private-equity deals are expected to be in coming months.
Repeated unsuccessful attempts were made after 1933 by commercial bankers and sympathetic regulators to repeal or draft exceptions to those sections of Glass-Steagall Act that mandate separation of commercial and investment banking. As a result, the United States and Japan - which was forced to adopt laws similar to the US banking statues after World War II - alone among the world's major financial nations, legally require this separation. Japanese banks can engage in many securities activities, however, including underwriting and dealing in commercial paper and ownership of up to 5% of non-bank enterprises.
Beginning in the 1960s, US banks began lobbying Congress to allow them to enter the municipal-bond market. In the 1970s, deregulation allowed brokerage firms to encroach on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterpreted Section 20 of the Glass-Steagall Act, which bars commercial banks from being "engaged principally" in securities business, deciding that banks can only have up to 5% of gross revenues from investment banking business. The Fed board then permitted Bankers Trust, a commercial bank, to engage in certain CP transactions. In the Bankers Trust decision, the board concluded that the phrase "engaged principally" in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue.
In the spring of 1987, the Federal Reserve Board voted 3-2 in favour of easing regulations under Glass-Steagall Act, overriding the opposition of then-chairman Paul Volcker. The vote legalised as policy proposals from Citicorp, JPMorgan and Bankers Trust to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, vice chairman of Citicorp, had argued that three "outside checks" on corporate misbehaviour had emerged since 1933 - a very effective Securities and Exchange Commission (SEC), knowledgeable investors, and very sophisticated rating agencies - to render the tight regulations unnecessary.
Yet in the current liquidity crisis, it has become clear that all three of these "outside checks" failed in recent years to protect both the public interest and the orderly function of markets. The SEC has largely been ineffective in preventing corporate fraud and market abuse, investors have been unable to understand fully the risk of complex financial instruments pushed on them by confused if not unprincipled brokers, and rating agencies fell far short in accurately rating the true risk embedded in debt instruments they rate.
Paul Volcker (Fed chairman 1979-87) feared that if the easing were approved, banks would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. It was the financial equivalent of letting the camel's foot into the tent. But he was outvoted and since then, the history of finance capitalism has been the triumph of the security industry's aggressive culture of risk over the banking industry's prudent culture of security.
In March 1987, the Fed approved an application by Chase Manhattan to engage in underwriting commercial paper. While the board remained sensitive to concerns about mixing commercial banking and underwriting, it reinterpreted the original congressional intent by focusing on the words "principally engaged" to allow for some securities activities for banks. The Fed also indicated that it would raise the limit from 5% to 10% of gross revenues at some point in the future to increase competition and market efficiency.
In August 1987, Alan Greenspan, a director of JPMorgan and a proponent of banking deregulation, was appointed chairman of the Federal Reserve board. Greenspan put the full power of his new position toward advocating bank deregulation by asserting its necessity to help US banks become global financial powers in the context of the US push for financial globalisation.
In January 1989, the Fed board approved a joint application by JPMorgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marked a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business was still at 5%. Later in 1989, the board issued an order raising the limit to 10% of revenues, referring to the April 1987 order for its rationale.
In 1990, JPMorgan became the first bank to receive permission from the US Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% revenue limit. In 1984 and 1988, the Senate passed legislation that would ease major restrictions under Glass-Steagall, but in each case the more populist House of Representatives blocked passage.
In 1991, the administration of president George H W Bush put forward a proposal for repeal of Glass-Steagall, winning support of both the House and Senate banking committees, but the House again defeated the bill in a full vote. Again in 1995, the House and Senate banking committees approved separate versions of legislation to repeal Glass-Steagall, but conference negotiations on a compromise fell apart.
Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.
In December 1996, with the vocal public support of chairman Alan Greenspan, the Federal Reserve board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25% of their business in securities underwriting, up from 10%. This expansion of the loophole initially created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall in effect rendered the act obsolete, in view of explosive growth of banking. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25% limit on revenue, since banks are much larger institutions as compared with security firms. However, the law remained on the books and, along with the Bank Holding Company Act, continued to impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.
In August 1997, the Fed further eliminated many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The board stated that the risks of underwriting had proved to be "manageable" and allowed banks the right to acquire securities firms outright. In 1997, Bankers Trust, now owned by Deutsche Bank, bought the investment bank Alex Brown & Co, becoming the first US bank to acquire a securities firm.
In February 1998, Sandy Weill of Travelers Insurance approached Citicorp's John Reed on a merger. The transaction had to work around remaining regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent a merger of insurance underwriting, securities underwriting, and commercial banking. The pending merger in effect gave regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.
The Fed gave its approval to the Citicorp-Travelers merger on September 23. The Fed's press release indicated that "the board's approval is subject to the conditions that Travelers and the combined organisation, Citigroup Inc, take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal ... The Board's approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act."
After the merger announcement on April 6, 1998, Weill immediately launched a lobbying and public relations campaign for the repeal of Glass-Steagall and passage of new financial services legislation known as the Financial Services Modernisation Act of 1999. "Modernisation" was a euphemism for total deregulation for the brave new world of financial globalisation.
The House Republican leadership wanted to enact the measure in the current session of Congress. While the administration of then president Bill Clinton generally supported Glass-Steagall "modernisation", there were concerns that mid-term elections in November could bring in new Democrats less sympathetic to changing the populist laws. In May 1998, the House passed legislation by a narrow vote of 214-213 that allowed the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee voted 16-2 to approve a compromise bank-overhaul bill. Despite this new momentum, Congress was still not certain to pass final legislation before the end of its session.
As the final push for new legislation heated up around election time, lobbyists raised the issue of financial modernisation with a fresh round of political fundraising. Indeed, in the 1998 mid-term election, the finance, insurance, and real-estate industries, known as the FIRE sector, built a bonfire of more than $200 million on lobbying and more than $150 million in political donations. Campaign contributions were targeted to members of congressional banking committees and other committees with direct jurisdiction over financial-services legislation.
After 12 attempts in 25 years, Congress finally repealed Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic. Opponents saw it as the root of a future depression.
What nobody expected, not even the most fervent opponents to bank deregulation, was that the repeal of Glass-Steagall would pave the way to the emergence of the non-bank financial system, which took off like a fighter jet off the deck of an aircraft carrier with the advent of deregulated global financial markets, which eventually rendered both banks and their central-bank lenders of last resort irrelevant in a brave new world of finance.
Just days after the US Treasury Department signed on to support the repeal of Glass-Steagall, treasury secretary Robert Rubin, a former co-chairman of Goldman Sachs, accepted a top position at Citigroup as vice chairman. The previous year, Weill had called Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, "You're buying the government?" Rubin could have added: "With debt?" The answer, while never reported, could have been: "No, the whole world."
The world that Weill bought with debt from the non-bank financial system is now in a severe credit crisis with an irrelevant banking system that needs to have $1.3 trillion put back into the banks' balance sheets. Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades.
Cash may be king in a liquidity crisis, but in a credit crisis, a king may echo William Shakespeare's Richard III: "A horse, a horse, my kingdom for a horse."
* Henry C K Liu is chairman of a New York-based private investment group. His website is at www.henryckliu.com.