Liquidity Bust Bypasses the Banking System

Henry C.K. Liu

Part I: The Rise of the Non-bank Financial system

This article appeared in AToL on September 6, 2007

In a short period of weeks, the subprime time bomb that had been ticking unnoticed for half a decade suddenly exploded into a system-wide liquidity crisis which 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, the new Chairman of the US Federal Reserve, no doubt understands that the credit market through debt securitization has in recent years escaped from the funding monopoly of the banking system into the non-bank financial system. As Fed Chairman, however, he must also be aware that the monetary tools at his disposal limit his ability to deal with the fast emerging market-wide 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 at hand in the non-bank financial system. What if after the Fed fires its heavy artillery and the credit crisis persists or even further deteriorates?

Liquidity Crunch only a Symptom

Banks worldwide now reportedly face hitherto known risk exposure of $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 credit worthiness system wide 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.

Commercial Paper Crisis

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.

Much of these higher yield securities are in the form of collateralized debt obligations (CDOs) backed by “synthetic” high-rated tranches of securitized subprime mortgages, which have been losing market value as the 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 would such willful 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.

SEC as Advocate for Investors

The professed mission of the SEC is to protect investors, 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 that “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 insure 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.”

The Issue of Systemic 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 banks and their financial company clients have 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, self-proclaimed “renowned free market, supply-side economist armed with knowledge, vision, and integrity acquired over a storied career spanning three decades”, host of the “Kudlow & Company” TV show on CNBC weeknights at 5pm EST with live broadcast on Sirius Radio and XM Radio, and on Saturday mornings WABC radio, is an intrepid evangelistic cheer leader for the debt economy. The logo for his program 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 re-inflate the burst debt bubble, having never called for central bank intervention to stop the bubble from forming, 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 Israeli pullout from the Gaza Strip.

The problem of both evangelistic programs is that the declarations of faith are frequently countered by faithless calls for sinful responses to developing events. One is grateful that evangelists are not yelling fire in a theater 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” are just empty utterances.
While market capitalization of US equity reached $20.6 trillion at the end of 2006, the US debt market grew to over $25 trillion in trading volume. There is $5 trillion of negative capital in US capitalism, about 45% of GDP.

Debt Drives the Market

Hedge funds, which number some 10,000, commanding assets in excess of $2 trillion funded with debt, have become dominant players in the run-away 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 firm acquire public companies to take them private, the acquisition is done mostly with debt. Much of 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. With structured finance, debt can be lent out repatedly without reserve in the debt market. The lack of reserve allow the slight market turmoil to lead inevitably to an insurmoutable credit crisis.

Banks and Off-Balance-Sheet “Conduits”

Since bank clients such as hedge funds and private equity firms are private entities that cater to supposedly “sophisticated” investors, neither the banks or their private clients are required by 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, these funds 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 monetize their securitized assets, such as receivables from credit cards, auto loans or home mortgages, by selling ABCP, such conduits are kept off the balance sheet of banks.

The Rise and Decline of Collateral Management

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 present-day “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.

Banks and SEC Regulation U

Kenneth Lay, the once high-flying chairman of collapsed Enron, before his untimely death faced securities fraud as well as bank fraud charges after Enron’s bankruptcy. The bank fraud issue revolves 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. which 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. Lay would have to face up to 30 years in jail for each count if convicted had he lived.

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."

The Role of Banks in the Enron Fraud

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 “prepays” 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 Enron could not have shown such profitability but for the shady help of large commercial banks, such as Citigroup and JP Morgan 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 JP Morgan 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 Enron was earning more money than it actually was. This in turned boosted not only Enron 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 present 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 in order to deduct interest payments. About $5 billion of such loan amounts remained outstanding when Enron filed for Chapter 11 bankruptcy protection in December, 2003, which allowed the company to operate as a debtor-in-possession to try to minimize loss to creditors. According to the Senate report, the transactions, which took place from 1992 to 2001, effectively hid part of Enron's mounting debt, which eventually bankrupted the doomed the 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 into 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 had settled with the Enron fraud victims for $7.2 billion, several huge banks named in this suit still had 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-to-1 Fifth Circuit Court of Appeals decision on March 19, 2007 let the banks off the hook and destroyed the hope of Enron victims for any further recovery.

Court of Appeals Let Banks Off the Hook

The US Court of Appeals for the Fifth Circuit acknowledged that the conduct of the banks was “hardly praiseworthy,” but they 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 Corporation shareholders cannot proceed as a class against three investment banks for allegedly participating in fraudulent behavior that led to Enron’s collapse.

The University of California asserts that the Fifth Circuit Appeals Court decision absolving the banks from liability is 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 get-away 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 summarized, the ruling “immunizes 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 2-to-1 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 that “We recognize, 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 that 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 wrong-doing, 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.” What Citibank was saying was 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.

SEC Scrutiny of Banks

Citigroup rival J.P. Morgan Chase & Co. also faced after-the-fact SEC scrutiny for similar deals through a vehicle known as Mahonia, which was the subject of a page one story in The Wall Street Journal in January 2003. Mahonia drew wide scrutiny following a lawsuit with insurers who had guaranteed the transactions through surety bonds. The insurers refuse to pay Morgan, arguing that prepaid transactions effectively 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 J.P. Morgan 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 offenses. Enron, which had a reputation of brow-beating 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 also involved commodity “prepay” transactions, in which money is paid up front for commodities such as natural gas or oil to be delivered at a future date, a practrice 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 prepay contracts. Oil never actually changed hands, and the trades effectively canceled each other 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 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 prepay 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 prepays as a monetization 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 is many over-the-counter derivate products, “conduits” and “special investment vehicles” (SIVs) that are causing the current ABCP credit crisis.

Enron would put into Yosemite an extra payment called a “magic note” that assured that Yosemite’s investors received promised interest on their investments. Those investors were led to believe they were buying assets from Enron that has 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.

Banks Blame Auditors

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 CEO Sanford I. Weill said in an interview. He might have added that he wished he had never heard of Jack Grubman.

Jack Grubman, star telecom analyst of Citigoup investment banking firm, Salomon, entered into a quid pro quo with Citigroup CEO Weill to upgrade his “independent” rating of AT&T to help Solomon land a huge deal AT&T was preparing in order 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 on 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 that  of the small investors they were supposed to be helping with independent research during the IT bubble years and eventually led the departure of both Grubman and Weill from Citigroup, with Grubman barred from the security industry for life. Weill personally survived the multi-billion 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 J.P. Morgan Chase & 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 characterizing what were essentially 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 J.P. Morgan Chase, the SEC filed a civil injunctive action in US District Court in Texas. Without admitting or denying the SEC allegations, J.P. Morgan Chase consented to the entry of a final judgment in that action that would (i) permanently enjoin J.P. Morgan Chase from violating the antifraud provisions of the federal securities laws, and (ii) order J.P. Morgan Chase to pay $135 million as disgorgement, penalty, and interest. The settlement suggested that J.P. Morgan Chase had not been enjoined from violating the antifraud 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 (i) was ordered to cease and desist from committing or causing any violation of the antifraud provisions of the federal securities laws, and (ii) agreed to pay $120 million as disgorgement, interest, and penalty. Of that amount, $101 million pertains to Citigroup's Enron-related conduct and $19 million pertains 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 J.P. Morgan 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.

History Repeats Itself in 2007

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 over $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 highflying 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 emphasized 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.” It appears that history is repeating itself in August 2007.

SEC Tolerance

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 “intend 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 risk.

The SEC pointed out that J.P. Morgan 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.

Specifically as to J.P. Morgan Chase, the SEC allegations stem from J.P. Morgan Chase’s participation in so-called prepay transactions with Enron which were loans disguised as commodity trades to achieve Enron’s reporting and accounting objectives. These prepays were in substance loans because their structure eliminated all commodity price risk that would normally exist in commodity trades. This was accomplished through a series of trades whereby Enron passed the commodity price risk to a J.P. Morgan Chase-sponsored special purpose vehicle, which passed the risk to J.P. Morgan Chase, which, in turn, passed the risk back to Enron. While each step of this structure appeared to be a commodity trade, with all elements of the structure taken together, Enron received cash upfront and agreed to future repayment of that cash with negotiated interest. The interest amount was set at the time of the contract, was calculated with reference to LIBOR, and was independent of any changes in the price of the underlying commodity. The only risk in the transactions was J.P. Morgan Chase’s risk that Enron would not make its payments when due, i.e., credit risk.

Citigroup prepay transactions with Enron, while structured somewhat differently than the Chase transactions, had the same overall purpose and effect. Like the J.P. Morgan Chase prepays, the Citigroup prepays passed the commodity price risk from Enron to a Citigroup-sponsored special purpose vehicle to Citigroup and back to Enron. As in the J.P. Morgan Chase prepays, Enron's future obligations under the Citigroup prepays consisted of repayments of principal and interest that were independent of any changes in the price of the underlying commodity.

Additionally, two other Citibank transactions with Enron, Project Nahanni and Project Bacchus, each of which was also a structure that transformed cash from financing into cash from operations. In project Nahanni, Citigroup knowingly helped Enron structure a transaction that allowed Enron to generate cash from operating activities by selling Treasury bills bought with the proceeds of a loan. Project Bacchus was structured by Enron as a sale of an interest in certain of its pulp and paper businesses to a special purpose entity capitalized by Citigroup with a $194 million loan and $6 million in equity. However, in substance, Project Bacchus was a $200 million financing from Citigroup, because Citigroup was not at risk for its equity investment in the project.

Citigroup structured a transaction with Dynegy, known as Project Alpha, which was a complex financing that Dynegy used to borrow $300 million. Citigroup knew that Dynegy implemented Alpha to address the mismatch between its mark-to-market earnings and operating cash flow, and that it characterized as cash from operations what was essentially a loan transaction. As Citigroup knew, Dynegy, too, was concerned that the mismatch between earnings and cash flow from operations would raise questions about the quality of Dynegy’s earnings and its ability to sustain those earnings.

Acting like a Marshal Wyatt Earp who had just cleaned up Dodge City, the SEC congratulated itself for cleaning up the Wild Wide 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. The Federal Reserve Bank of New York and the Office of the Comptroller of the Currency entered into separate written agreements with Citigroup. The Federal Reserve Bank of New York and the New York State Banking Department entered into a written agreement with J.P. Morgan Chase. These agreements, between the institutions and their primary banking regulators, obligate them to enhance their risk management programs 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 misconducts entirely. Zero tolerance was not the message.

With these two actions, the SEC raised to six the total number of separate actions it brought in connection with the Enron fraud in twenty 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.

FleetBoston Financial Corp. and Credit Suisse First Boston arranged Enron “prepay” transactions totaling a little more than $1 billion in a decade. J.P. Morgan alone during roughly the same period arranged $3.7 billion. Citigroup provided Enron with $4.8 billion in 14 separate transactions through prepays in just the last three years before Enron filed for bankruptcy protection.

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. The two banks, as well as other Wall Street firms involved in Enron, face lawsuits accusing them of pushing Enron securities on the public, when, as lenders, they should have had insights that Enron's finances were dodgy.

Enron’s use of prepays arranged by banks was so extensive that Arthur Andersen created guidelines it gave to banks about what was needed for these structures to appear on Enron's books as trades rather than debt. “For prepays 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 Andersen in June 2003 of obstructing justice after the government accused the accounting 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 auditors; Enron’s banks, including JP Morgan 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. Gramm, an economist who had called for deregulation of the energy industry, headed the Commodity Futures Trading Commission 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 in September 2006.

The Fall of Andersen

Arthur Andersen, Enron’s auditor, with 2001 revenue of $9.4 billion, offered to settle its part in the case for $300m, reduced from its initial $750m 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 effectively 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 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 seven 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, 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 "misstated" 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 longrunning 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 they were already deeply enmeshed in new trouble at Enron. Andersen paid $7 million last June to settle fraud allegations arising from an audit it conducted of the huge Waste Management Inc., based in Houston. Andersen agreed to pay $7 million to settle federal charges it filed false and misleading audits of Waste Management in which the Houston-based waste services company overstated income by more than $1 billion.

Andersen examined Waste Management's books from 1993 through 1996, and issued audit reports that falsely claimed that the statements had been prepared using generally accepted standards, the SEC said.

The agency said that the Waste Management financial statements that Arthur Andersen blessed had overstated the Houston-based waste services company's pretax income by more than $1 billion.

The bankruptcy of WorldCom on July 22, 2002, one month after it revealed that it had improperly booked $3.8 billion in expenses. WorldCom surpassed Enron as the biggest bankruptcy in history 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, J.P. Morgan and G.E. Capital that would allow it to operate while in bankruptcy.

The WroldCom bankruptcy was precipitated by the revelation on June 25 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. WorldCom was one of the success stories of finance capitalism in the 1990s. In 1998, WorldCom under CEO Bernie Ebbers bought MCI, the nation's No. 2 long-distance provider behind for $37 billion. The company was struggling with its $41 billion debt, $24 billion of which was in corporate bonds. When its problems came to light in June, 2002, its banks refused to provide the company with any credit unless it was secured with WorldCom assets. Within 30 day, after missing three interest payments totaling $79 million on July 14, the company filed for bankruptcy protection a week later. Andersen for 15 months had signed off on the telecommunications company’s overstated profit reports.

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 Chief Justice William Rehnquist, was also highly skeptical 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 behavior can be technically legal. The Court seems 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 Enron Corporation on September 23, 2003 in turn sued a variety of banks, brokerage firms and their subsidiaries that financed its deals and partnerships, accusing them of participating in deliberately murky transactions for millions of dollars in fees and helping to create the failed energy company’s facade of success. Defendants in the suit filed in Federal Bankruptcy Court in New York include J. P. Morgan Chase & Company and Citigroup Inc., two of Enron's largest creditors. Others include Merrill Lynch & Company, the Canadian Imperial Bank of Commerce, Deutsche Bank and Barclays Bank. The suit contends that Enron executives conspired with the banks to inflate profits and hide debt.

Conduits Dispersed

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 “sophisticate” 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 Treasury repeatedly gave assurances to the investing public that were not only at variance with discernable 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 land 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 behavior.

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