Capitalism's bad apples: It's the barrel
Henry C K Liu
This article appeared in AToL
on August 1, 2002
There is a general rule about the way society treats criminals: place
responsibility for antisocial acts on the individual, thus absolving
society from blame.
The mismatch between society's attitude toward heroes and criminals
rests in society's claim of credit on heroes and rejection of
responsibility for criminals. A criminal is one who has betrayed
societal values by violating a prescribed code of conduct, who is
deranged but not legally insane, a deviant, an anomaly, a manifestation
of social disease, a virus against the system, a unit malfunction and a
Adolf Hitler was labeled a madman to protect German culture and
fascism, notwithstanding the curious fact that Hitler rose to power in
Germany in a discernible sociocultural context. Even organized warfare
must be conducted within the limits of regulated behavior. War crimes
and crimes against humanity are not tolerated.
Yet market fundamentalism argues for wholesale deregulation to allow
economic crimes against humanity. Charles Ponzi was deemed an
unprincipled conman to insulate unregulated capitalism itself from
being revealed as a systemic Ponzi scheme.
In the December 18 US Senate Commerce Committee hearing on the Enron
collapse, the verbal barrage that committee members unleashed on
Kenneth Lay, the resigned chairman of Enron, once the United States'
seventh-largest company and now bankrupt, amounted to wholesale
trampling of Lay's constitutional rights. The irony of Fifth Amendment
capitalists was not lost on those who remember the McCarthy hearings on
communists under the Smith Act, which outlawed a targeted political
party in the democratic United States. The issue of Lay's guilt or
innocence is of course a matter for the judiciary branch and Lay's
right under the constitution's Fifth Amendment to avoid
self-incrimination is fundamental to US justice.
The same senators had not been skittish about having their pictures
taken with Kenneth Lay the hero capitalist, or accepting vast sums in
political contributions from him, his company, his consultants and
lobbyists. Up to the sudden collapse of Enron, Lay was regarded by all
as the star of deregulated markets, close friend of the president, a
political mover and shaker who played key roles in putting George W
Bush in the White House, a shining example of the high level of human
potential that can be achieved with free enterprise.
Senator Peter Fitzgerald, a Republican from Illinois, comparing Lay to
Charles Ponzi, now labeled him worse than a carnival barker, for a
carnie will at least "tell you up front that he's running a shell
game". Was Fitzgerald telling the nation that deregulated market
fundamentalism with structured finance is a shell game?
The evidence is undeniable that the Enron scandal exposed critical
flaws in the entire financial system and the ineffective policing of US
capital markets and corporate governance. Arthur Levitt, former
Democratic head of the Securities and Exchange Commission (SEC),
characterizes corporate financial statements as "a Potemkin village of
deceit". Senator Ernest Hollings, a Democrat from South Carolina,
characterized Lay's political prowess as "cash and carry government".
The New York Times reported the following day that Hollings had
received campaign contributions from Enron and Arthur Andersen dating
Until Enron filed for bankruptcy, the system's top law firms and
accounting firms were providing professional opinion that what went on
in Enron was "technically" legal. The international dealings of Enron
received unfailing support from the US government. Many of the schemes
undertaken by Enron and other companies were devised by investment
bankers who collected fat fees advising their clients and who profited
handsomely from providing financing for schemes they knew were towers
of mirage. It was known in the industry as "finance engineering" and
the vehicle was structured finance or derivatives.
The prevailing view in the legal profession is that the beleaguered
Enron executives will most likely not be convicted of economic crimes
under existing laws, only criminal liabilities arising from perjury,
conspiracy, obstruction of justice and mail fraud. Anderson, the
disgraced accounting/consulting firm, was found guilty of obstruction
of justice, but not of economic malfeasance.
Coincidentally, the New York Times carried on the same day of the
Senate Enron hearing an obituary on Victor Posner, whose financial
dealings landed himself, Ivan Boskey and Michael Milkin, the junk-bond
king, in jail over technical criminality for insider trading, but not
for the violent damage their good work at Drexel did to the system and
the millions of innocent victims in it.
On February 26, Jeffrey K Skilling, former president and chief
executive of Enron, who was the sole top company official willing to
testify without claiming Fifth Amendment protection, managed to engage
accusing senators in a veiled debate about the system's responsibility.
Skilling, named in April 2001 by Worth magazine as No 2 of the 50 top
CEOs in the US, behind only Steve Ballmer of Microsoft, maintained that
while what Enron management did might have been unethical, it was most
definitely not illegal within then applicable laws. Yes, the company's
management did cause a great deal of financial casualties and
destruction, but it is not at all clear that it committed financial war
crimes in the eyes of the law. At most, it was collateral damage. At
any rate, Enron management did no more than what was common practice
Unlike Skilling and his less forthcoming colleagues who can place their
financial future under the protection of existing security laws, the
lawmakers must subject their political future to the test of public
opinion. Thus lawmakers were lining up for the microphone to make
indignant grandstanding statements. Yet Skilling was quite effective in
laying the blame for the financial mess at the door of unregulated
structured finance (derivatives), which Congress, under pressure from
the finance industry, had repeatedly refused to regulate, albeit also
at the urging of the both the Federal Reserve Board and the Treasury,
and even the SEC, which only faintly warned against accounting
manipulation of corporate balance sheets.
It is ironic that the head of a company that had vigorously championed
deregulation and market discipline, a company whose spectacular recent
growth was financed by wholesale theft from the future if not directly
the public, by booking future revenue as current income, deferring
associated liabilities as off-balance-sheet future capital expenditure,
by disguising loans as income with hedges in derivative transactions
that produce spectacular instant profit, is now calling for Congress to
regulate the widespread use of the "material adverse change" clause in
derivative contracts and related financing that allows investors to
pull their funds abruptly and completely on practically no notice. Not
only was the barn manager allowed to play with fire, he is now asking
for the authority to keep the barn doors closed to prevent the horses
from fleeing for their lives. To deflect the embarrassing subject, one
senator ridiculed the suggestion as a version of the old movie It's
a Wonderful Life, notwithstanding that it was a rather good film.
There is another systemic fault that surfaced briefly in the exchanges
when Senator Barbara Boxer of California accused Skilling of
"unloading" stocks while encouraging unsuspecting Enron employees to
buy. When Skilling responded that he too had been hurt by the Enron
collapse, being one of the major shareholders as a result of the
dubious practice of lucrative stock options granted to management,
albeit that his selling of a small portion of his holdings amounted to
a proceed of US$60 million, no senator challenged him on what justified
that astronomical level of executive compensation. The chairman of
Citigroup was reported to have received compensation, including stock
options, in excess of $1 billion over the past decade. All accepted it
as the American way.
Obscene disparity of income is accepted as the heart rather than the
cancer of finance capitalism. Yes, a lot of people connected with Enron
at all levels lost 95 percent of their holdings, but the remaining 5
percent of residual asset could range from tens of millions to a mere
thousands of dollars. Even if the average employee were exempt from the
"lockup" provision in his or her pension plan, and was allowed to bail
out his or her pension holdings at $4.50 a share, down from its peak of
$90, many would still have walked away with merely a few thousand
dollars, putting their retirement dreams in ruins. Risking one's
pension with a downside of $60 million is very different from a
downside of $6,000, hardly an egalitarian game of a receding tide
lowering all boats.
Skilling even ventured to propose introducing deposit insurance for
derivative investors, though he fell short of suggesting that the
insurance be financed by taxing the peak profits. It is another example
of socializing the risk and privatizing the profits. Is Enron the
opening shot of the return of New Deal populism? Skilling was probably
telling the truth that when he resigned from his post a year ago, he
did not expect Enron to go under, or he would have sold out his
holdings completely. If Federal Reserve Board chairman Alan Greenspan
could not resist denial of the inevitable outcome of a debt bubble, why
should a mere mortal like Skilling?
General Electric was dragged into the hearing when the committee staff
inaccurately listed GE offshore subsidiaries as numbering only 24 as
compared with Enron's 3,000, presumably to show GE as the model of good
corporate behavior. Aghast, Skilling responded that most who are in the
slightest way familiar with structured finance know that GE has been
every bit as aggressive as Enron, and GE in fact is engaged as
counterparty in many Enron trades. GE's dominance in the commercial
paper market is what gives it the financial advantage over many
competitors, including commercial banks, in structured finance. Bankers
feared Jack Welch and Gary Wendt (leaders of non-bank financial
institutions) more than they fear Saddam Hussein or Osama bin Laden.
When Wendt ran GE Capital, he had a reputation of taking no prisoners.
GE of course is now facing its own credit rating and share value
With the exception of cases of contempt of Congress, the US legislature
is powerless to put any of the Enron officials behind bars, or to force
them to disgorge their ill gains. That is the courts' responsibility.
Even the SEC can only impose civil fines. The rule of law often allows
the unethical but legal to happen with impunity. Already, Greenspan,
who steadfastly opposed regulating the structured finance markets, has
told Congress that independent boards in corporate governance are
harmful to economic growth. Karl Marx left out a big slice when he
surmised that surplus value would lead to capitalism's structural
demise, in assuming that the financial system was inherently honest. To
preserve the mirage of an honest system, Congress needs to find crooked
Seven months later, the July 24 Senate Subcommittee on Investigation
hearing, chaired by Senator Carl M Levin, a Democrat from Michigan, on
the role of financial institutions in the Enron scandal fingered JP
Morgan Chase and Citigroup, two of the world's largest banks, as
culprits in helping Enron Corp arrange billions of dollars in loans
that disguised as income to mask its deteriorating financial condition,
and to hide the material details of some deals from unsuspecting
investors. The subcommittee alleged that JP Morgan Chase and Citigroup
were knowing participants in Enron's efforts to disguise billions of
dollars of debt as income from energy trades, by using the now
notorious "prepay forward commodities transactions" (PFCT). Chase and
Citigroup also sold the prepay structures to at least 10 other clients.
The PFCTs brought Enron more than $8.5 billion of misreported income in
the six years before it collapsed last fall. Had Enron properly
accounted for the loans, its debt obligations would have increased by
more than 40 percent, to $14 billion in 2000. That would have led to
drastically lower credit ratings for the company. Prepays are
arrangements in which companies are paid to deliver a product - in
Enron's case, oil and natural gas - at a later date. But Enron and
several large banks structured the deals in ways that compromised the
independence of the transactions, making them loans rather than sales
for accounting purposes. Senate investigators alleged that Enron did
not reveal that fact to its shareholders, and instead booked the deals
as cash from operations, making its finances look better than they
were, thus inflating its share prices.
Chase and Citigroup engaged in the deals by using secretive offshore
entities called Mahonia, Delta and Yosemite. Senate investigators
alleged that while the entities, based on the Isle of Jersey in the
English Channel and in the Cayman Islands, are not legally tied to the
banks, they are, in essence, controlled by them through lawyers and
charitable trusts. Investors might have been purposefully given
misleading information about Enron's health in the sale of notes via
the Yosemite investment trust formed by Citigroup. Citigroup raised
more than $2.4 billion for Enron in six Yosemite bond offerings between
1999 and 2001.
The prepay deals are also under scrutiny by the Manhattan district
attorney's office and the SEC. JP Morgan Chase and Citigroup are also
being sued by Enron shareholders. Separately, JP Morgan Chase is
fighting in court a group of insurance companies that refuse to pay for
the failed prepay deals because they claim to have been deceived about
the nature of the transactions.
Senator Levin had the smoking gun in an internal e-mail dated November
1998 within Chase stating that Enron "loves these PFCT deals as they
allow Enron to hide funded debts from equity analysts ..." The internal
e-mails and recorded phone conversations showed that Chase knew Enron
was using prepay deals deceptively, using them to hide what were in
effect loans. According to criteria set out by the since disgraced
Andersen, Enron's auditor, one of the conditions that must be in place
for a prepay to be considered a legitimate transaction is that the
third party involved had to be independent.
Mahonia, the offshore vehicle known as a Special Purpose Entity through
which JP Morgan funneled hundreds of millions of dollars to Enron, was
set up in the Channel Islands at the behest of JP Morgan. The bank
executives claimed that Mahonia was independent, to the visible
dissatisfaction of Levin, who called Enron's use of the prepays to
disguise debt "an accounting sham" and said the company had "the help
and knowing assistance of some of the biggest financial institutions in
our country". The senator referred to a recording of a telephone
conversation last September between Morgan and Enron executives in
which they discussed ways to make Mahonia appear more independent, such
as getting it a separate fax number.
Senate investigators alleged that the banks collected large fees and
earned consideration for more deals with Enron, in addition to interest
payments, for structuring the PFCT deals. Both banks are
counterattacking, arguing that their actions were consistent with years
of widespread industry practice and had been vetted by lawyers and
auditors. PFCT is a common and widely used form of structured finance.
As the biggest trader of derivatives, JP Morgan Chase also dismissed
speculation that it may have to put up more money to satisfy
counterparty credit requirements should its stock price fall below a
certain level. Derivatives are contracts whose value is derived from
underlying securities or commodities. Marc Shapiro, vice chairman for
finance, risk management and administration at JP Morgan Chase and Co,
told the press that prepays are routine structured finance plays that
enable corporations to get funds from new sources that have fueled the
boom of the past decade, and that it is "gross injustice" to the people
involved suddenly to label it fraud now. Shapiro, co-chairman of the
merger integration team within JP Morgan and Chase and a member of the
merged firm's executive and management committees, outlined six tenets
of success in financial risk management in a recent speech:
diversification, independence, transparency, alignment, active
management and the importance of stress tests. The Enron case
apparently fell short on all six tenets. There was structural
misalignment of incentives that led to deviant behavior by executives.
JP Morgan Chase issued a press release on Monday together with a letter
signed by chief executive officer William B Harrison in response to the
United States Senate's Permanent Subcommittee on Investigations'
request last Thursday for additional information about Mahonia, which
states: "The capital markets system in the United States has been a key
contributor to the most powerful economy in the world. Structured
finance and Special Purpose Entities are important components in that
system and contribute significantly to our economy. They are designed
to help clients meet their financing needs, including reducing their
borrowing costs, improving liquidity and diversifying their funding
sources. Special Purpose Entities are used in transactions that range
from the commonplace, including mortgage-backed securities and credit
card securitizations, to highly structured transactions. The fact that
structured finance transactions may be complex or that Special Purpose
Entities may be organized offshore does not make them improper or
The thrust of the subcommittee hearing was that more disclosure of
off-balance-sheet debts or liabilities is needed to prevent abuse. Yet
the focus on disclosure is obviously misdirected. With more disclosure,
these deals would not have been done because their whole purpose was to
evade existing disclosure requirements on financial manipulations to
provide corporations with funds which they otherwise could not raise.
Several witnesses from the finance industry and regulating agencies
testified that there was nothing wrong with these structured finance
deals if full disclosure was made. It is the same as saying that murder
is all right if no killing is involved.
Derivatives can be used to restructure transactions so that liability
positions are legally moved off balance sheet, floating rates turned
into fixed rates (and vice versa), currency denominations changed,
interest or dividend income can become capital gains (and vice versa),
liability turned into assets or revenue, payments moved into different
periods in order to manipulate tax liabilities and earnings reports,
and high-yield securities made to look like conventional AAA
investments (See The
dangers of derivatives , May 23.)
So what is full disclosure? To tell the investing public that
structured finance is an elaborate arrangement to mask the real
financial condition of corporations? That, by the way, before you
invest in this company, the management would like to tell you that the
income reported in the balance sheet is not real?
The dilemma for Congress is that while Enron's bankers are in the hot
seat for alleged corporate and bank fraud, structured finance is on
trial for systemic fraud. But structured finance is so widely used that
if it should be stalled by new requirements of full disclosure, the
financial system as it currently exists might well end.
WorldCom has overshadowed Enron as the largest bankruptcy in history.
Federal prosecutors have let it be known that fired top executives of
WorldCom will be indicted for fraud within days. The company admitted
it inflated earnings by nearly $4 billion. WorldCom also could be
indicted as a corporation by the US Justice Department. The SEC, citing
"accounting improprieties of unprecedented magnitude", filed civil
fraud charges last month against WorldCom. Yet it is not clear that
these executives can be found guilty independent of systemic fraud,
given that what they did was not separable from industry practice
The accounting of IRU (Indefeasible Right of Use) of communication
network capacity, particularly "dark trades" of unused fiber-optics
capacity widely employed in the telecommunication sector, has inflated
revenue for the entire sector, by booking future revenue as current
income and related future liabilities as off-balance-sheet future
capital expenditure. Global Crossing also has massive IRU problems.
Qwest and Sprint are also on the watch list.
Finance capitalism is operating with less and less reliance on capital.
Capital has become a notional value in structured finance. Credit is no
longer anchored by equity but by circular hedges. Debt-to-equity ratio
is no longer a relevant consideration. Practically all US major
businesses nowadays, with their high debt leverage based on an
unprecedented asset bubble, would have negative real equity if the
price/earning (P/E) ratio were to return to historical norms. Blue-chip
corporations are being shut out of the unsecured short-term commercial
paper market as their credit ratings are downgraded. Corporate credit
ratings have been inflated by exorbitant market capitalization value,
which in turn reflects irrational P/E ratios. Even now, during what
many on Wall Street contend to be a savage bear market, the Standard
& Poor's 500 Index yields 25 times earnings. It would have to fall
by another 41 percent to reach the median valuation prevailing since
1957. When that happens, the derivative defaults will hit the financial
system like a tsunami.
Federal securities regulators investigating the collapse of Enron are
turning their eyes toward Wall Street. The SEC, as part of its Enron
probe, is reviewing the financing lines that banks such as JP Morgan
Chase and Citigroup provided to Enron and other energy-trading
companies. Regulators are examining whether the banks helped to create
the intricate and misleading financial structure that eventually led to
Enron's bankruptcy filing.
Separately, the SEC is reviewing the adequacy of JP Morgan Chase's
disclosures about its exposure to Enron and in particular whether these
disclosures were made in a timely fashion. The Federal Reserve Bank of
New York, which has supervisory responsibility of New York banks, is
also looking into civil liabilities. The Wall Street Journal criticized
both banks by pointing out that "what is legal isn't always ethical".
Both New York banks confirm they have significant exposure to Enron.
The role of commercial banks in the Enron saga throws the spotlight on
the 1999 Financial Modernization Act, which in effect repealed the
Depression-era Glass-Steagall Act. Glass-Steagall was meant to separate
the business of lending from underwriting to prevent a repeat of the
financial turmoil of 1929, and the Depression that ensued.
The SEC review underscores that Wall Street firms could ultimately face
potential liability in the collapse of Enron, and now the
second-largest US bankruptcy after WorldCom. At the very least, the
review highlights the close ties and varied trading positions Wall
Street firms had with Enron. Some of the world's leading banks and
brokerage firms provided Enron with crucial help in creating the
intricate financial structure that fueled Enron's impressive rise.
Enron had billions of dollars of derivatives contracts outstanding with
Wall Street, and until these contracts are unwound, the ultimate
exposure of securities firms and commercial banks won't be clear. But
by now it is clear that Enron was not a unique case.
The Financial Times just revealed that US and European banks and
bondholders lent an estimated $500 billion to the crippled US gas and
power sector. US energy companies borrowed heavily in the late 1990s to
take advantage of deregulation, investing in infrastructure and
building up trading operations. The debt of the top eight energy
traders soared by 200 percent to $115 billion in the three years to May
Asia is not immune to corporate fraud and creative accounting. While
security laws in Asia are generally less sophisticated with regard to
aggressively creative accounting, it does not follow that Asian
corporations are less prone to dubious lessons on ingenious structured
finance schemes from enveloping-pushing global investment banks.
The ripple effect has surfaced with press reports of Merrill Lynch
downgrading four major Hong Kong corporations for potential accounting
problems. One of these is deeply involved in telecommunication
investment and finance and it would be highly unusual for it to be free
of the financial problems facing the debt ridden global sector as a
whole. A prominent Hong Kong property tycoon, a US citizen, was an
outside director of the Enron board and a member of the board's
JP Morgan Chase and Citigroup are both major players in Asia. It is
only natural that what these banks did for Enron, WorldCom and Global
Crossing, they would also do for their Asian corporate clients.