In The Suites
Are More Enrons Out There; The Rot Is Systemic
scandal has reached a ripeness that now calls for a...radical
solution, the creation of public auditors, hired by government,
paid by insurance fees levied on industry and completely
insulated from private interests or politics."
collapse of Enron has swiftly morphed into a go-to-jail
financial scandal, laden with the heavy breathing of political
fixers, but Enron makes visible a more profound scandal,
the failure of market orthodoxy itself. Enron, accompanied
by a supporting cast from banking, accounting and Washington
politics, is a virtual piÒata of corrupt practices
and betrayed obligations to investors, taxpayers and voters.
But these matters ought not to surprise anyone, because
they have been familiar, recurring outrages during the
recent reign of high-flying Wall Street. This time, the
distinctive scale may make it harder to brush them aside.
"There are many more Enrons out there," a well-placed
Washington lawyer confided. He knows because he has represented
a couple of them.
rot in America's financial system is structural and systemic.
It consists of lying, cheating and stealing on a grand
scale, but most offenses seem depersonalized because the
transactions are so complex and remote from ordinary human
criminality. The various cops-and-robbers investigations
now under way will provide the story line for coming months,
but the heart of the matter lies deeper than individual
venality. In this era of deregulation and laissez-faire
ideology, the essential premise has been that market forces
discipline and punish the errant players more effectively
than government does. To produce greater efficiency and
innovation, government was told to back off, and it largely
has. "Transparency" became the exalted buzzword.
The market discipline would be exercised by investors
acting on honest information supplied by the banks and
brokerages holding their money, "independent"
corporate directors and outside auditors, and regular
disclosure reports required by the Securities and Exchange
Commission and other regulatory agencies. The Enron story
makes a sick joke of all these safeguards.
the rot consists of more than greed and ignorance. The
evolving new forms of finance and banking, joined with
the permissive culture in Washington, produced an exotic
structural nightmare in which some firms are regulated
and supervised while others are not. They converge, however,
with kereitzu-style back-scratching in the business of
lending and investing other people's money. The results
are profoundly conflicted loyalties in banks and financial
firms, who have fiduciary obligations to the citizens
who give them money to invest. Banks and brokerages often
cannot tell the truth to retail customers, depositors
or investors without potentially injuring the corporate
clients that provide huge commissions and profits from
investment deals. Sometimes bankers cannot even tell the
truth to themselves because they have put their own capital
(or government-insured deposits) at risk in the deals.
and other deformities will not be cleaned up overnight
(if at all, given the
political subservience to Wall Street interests). But
Enron ought to be seen as the casebook for fundamental
reform. The people bilked in Enron's sudden implosion
were not only the 12,000 employees whose 401(k) savings
disappeared while Enron insiders were smartly cashing
out more than $1 billion of their own shares. The other
losers are working people across America. Enron was effectively
owned by them. On June 30, before the CEO abruptly resigned
and the stock price began its terminal decline, 64 percent
of Enron's 744 million shares were owned by institutional
investors, mainly pension funds but also mutual funds
in which families have individual accounts. At midyear,
the company was valued at $36.5 billion, having fallen
from $70 billion in less than six months. The share price
is now close to zero. Either way you figure it, ordinary
Americans, the beneficial owners of pension funds, lost
$25-$50 billion because they were told lies by the people
and firms they trusted to protect their interests.
is a shocking but not a new development. Global Crossing
went from $60 a share to pennies (as with Enron, the market
had said it was worth more than General Motors). CEO Gary
Winnick cashed out early for $600 million, but the insiders
did not share the bad news with other shareholders. Workers
at telephone companies bought by Global Crossing had been
compelled to accept its stock in their retirement plans.
(Winnick bought a $60 million home in Bel Air, said to
be the highest-priced single-family dwelling in America.)
Lucent's stock price tanked with similar consequences
for employees and shareholders, while executives sold
$12 million in shares back to the failing company. (After
running Lucent into the ground, CEO Richard McGinn left
with an $11.3 million severance package.) There are many
Enrons, as the lawyer said.
disorder writ large by the Enron story is this regular
plundering of ordinary Americans, who are saving on their
own or who have accepted deferred wages in the form of
future retirement benefits. Major pension funds can and
do sue for damages when they are defrauded, but this is
obviously an impotent form of discipline. Labor Department
officials have known the vulnerable spots in pension-fund
protection for many years and regularly sent corrective
amendments to Congress, ignored under both parties. In
the financial world, the larceny is effectively decriminalized,
culprits typically settle in cash with fines or settlements,
without admitting guilt but promising not to do it again!
. If jailtime deters garden-variety crime, maybe it would
be useful therapy for corporate and financial behavior.
most important reform that could flow from these disasters
is legislation that gives employees, union and nonunion,
a voice and role in supervising their own pension funds
as well as the growing 401(k) plans. In Enron's case,
the employees who were not wiped out were sheet-metal
workers at subsidiaries acquired by Enron whose union
locals insisted on keeping their own separately managed
pension funds. Labor-managed pension funds, with holdings
of about $400 billion, are dwarfed by corporate-controlled
funds, in which the future beneficiaries are frequently
manipulated to enhance the company's bottom line. Yet
pension funds supervised jointly by unions and management
give better average benefits and broader coverage (despite
a few scandals of their own). If pension boards included
people whose own money is at stake, it could be a powerful
enforcer of responsible behavior.
corporate transgressions could not have occurred if the
supposedly independent watchdogs in the system had not
failed to execute their obligations. Wendy Gramm, wife
of Senator Phil, the leading Congressional patron of banking's
privileges, is an "independent" director of
Enron and supposedly speaks for the broader interests
of other stakeholders, from the employees to outside shareholders.
Instead, she sold early too. With notable exceptions,
the "independent" directors on most corporate
boards are a well-known shamt, ypically handpicked by
the CEO and loyal to him, even while serving on the executive
compensation committees that ratify bloated CEO pay packages.
The poster boy for this charade is Michael Eisner of Disney.
As CEO, he must answer to a board of directors that includes
the principal of his kids' elementary school, actor Sidney
Poitier, the architect who designed Eisner's Aspen home
and a universi! ty president whose school got a $1 million
donation from Eisner. As Robert A.G. Monks and Nell Minow,
leading critics of corporate governance, asked in one
of their books: "Who is watching the watchers?"
not count on "independent" auditors, as Arthur
Andersen vividly demonstrated at Enron. While previous
scandals did not involve massive document-shredding, Andersen's
behavior is actually typical among the Big Five accounting
firms that monopolize commercial/financial auditing worldwide.
Andersen already faces SEC investigation for its role
in "Chainsaw Al" Dunlap's butchery of Sunbeam
and has paid $110 million to settle Sunbeam investors'
damage suits. A decade ago Andersen fronted for Charles
Keating's notorious Lincoln Savings & Loan, which
bilked the elderly and then collapsed at taxpayer expense,
despite a prestigious seal of approval from Alan Greenspan
(Keating went to prison; Greenspan became Federal Reserve
Chairman). But why pick on Arthur Andersen? Ernst &
Young paid out even more for "recklessly misrepresenting"
the profit claims of Cendant Corporation--$335 million
to the New York and California public-employee pension
funds. Cendant itself has paid out $2.8 billion to injured
investors, but hopes to recover some money by suing Ernst
& Young. PriceWaterhouseCoopers handled the books
at Lucent, accused of inflating profits by $679 million
in 2000 and prompting yet another SEC investigation.
corruption of customary auditing, and the fact that an
industry-sponsored board sets the arcane accounting tricks
for determining whether profits are real or fictitious,
is driven partly by the Big Five's dual role as consultants
and auditors. First they help a company set its business
strategy, then they examine the books to see if management
is telling the truth. This egregious conflict of interest
should have been prohibited long ago, but the scandal
has reached a ripeness that now calls for a more radical
solution, the creation of public auditors, hired by government,
paid by insurance fees levied on industry and completely
insulated from private interests or politics. Actually,
this isn't a very radical idea, since the government already
exercises the same close scrutiny and supervision over
commercial banks. Because that banking sector lost its
primary role in lending during the past two decades, the
same public auditing and supervisory protections should
be extended to cover the unregulated money-market firms
and funds that have displaced the bankers.
is unregulated, though it functioned like a giant financial
house. So is GE Capital, a money pool much larger than
all but a few commercial banks. Mutual funds and hedge
funds are essentially free of government scrutiny. So
are the exotic financial derivatives that Enron sold and
that led to shocking breakdowns like the bankruptcy of
Orange County, California. The government failed too,
mainly by going limp in its due diligence but also by
withdrawing responsibility through legislative deregulation.
The one brave exception was Arthur Levitt, Clinton's SEC
commissioner, who gamely raised some of these questions,
but without much effect because he was hammered by the
industry and its Congressional cheerleaders. Corrupt accountants
and investment bankers now have a friendlier commissioner
at the SEClawyer Harvey Pitt, whose firm has represented
Arthur Andersen, each of the Big Five and Ivan Boesky,
whose fraud case was settled for $100 million. Pitt blames
Arthur Levitt's inquiries for upsetting the accounting
industry's self-regulation. Given his connections, Pitt
should not just recuse himself from the Enron case, a
crisis of legitimacy for the SEC, he should be compelled
to resign. Similarly sympathetic cops are scattered throughout
the regulatory agencies. At the Federal Reserve, a new
governor, Mark Olson, headed "regulatory consulting"
in Ernst & Young's Washington office. Another new
Fed governor, Memphis banker Susan Bies, has been an active
opponent of strengthening derivatives regulation.
the heart of the scandal resides in New York, not Washington.
The major houses of Wall Street play a double game with
their customers, doing investment deals with companies
in their private offices while their stock analysts are
out front whipping up enthusiasm for the same companies'
stocks. Think of Goldman Sachs still advising a "buy"
on Enron shares last fall, even as the company abruptly
revealed a $1.2 billion erasure in shareholder equity.
Goldman earned $69 million from Enron underwriting in
recent years, the leader among the $323 million Enron
paid Wall Street firms. Think of the young Henry Blodget,
now famous as Merrill Lynch's never-say-sell tout for
the same Nasdaq clients whose fees helped fuel Blodget's
$5-million-a-year income (Merrill has begun settling investor
lawsuits in cash). Think of Mary Meeker at Morgan Stanley
Dean Witter, dubbed the "Queen of the Net" for
pumping up Internet firms while Morgan Stanley was taking
in $480 million in fees on Internet IPOs.
conflict is not exactly new but has reached staggering
dimensions. The brokers whose stock tips you can trust
are the ones who don't offer any.
larger and far more dangerous conflict of interest lies
in the convergence of government-insured commercial banks
and the investment banks, because this marriage has the
potential not only to burn investors but to shake the
financial system and entire economy. If the newly created
and top-heavy mega-banks get in trouble, their friends
in power may arrange another cozy government bailout for
those it deems "too big to fail." The banking
convergence, slyly under way for years, was formally legalized
in the 1999 repeal of Glass-Steagall, the New Deal law
that separated the two sectors to eliminate the very kind
of self-dealing that the Enron case suggests may be threatening
again. We don't yet know how much damage has been done
to the banking system, but its losses seem to grow with
each new revelation. JP Morgan Chase and Citigroup provided
billions to Enron while also stage-managing its huge investment
deals around the world and arranging a fire-sale buyout
by Dynegy that failed (Morgan also played financial backstop
for Enron's various kinds of trading transactions). Instead
of backing off and demanding more prudent management,
these two banks lent additional billions during Enron's
final days, perhaps trying to save their own positions
(we don't yet know). Instead of warning other banks of
the rising dangers, Chase and Citi led the happy talk.
Both have syndicated many billions in bank loans to other
commercial banks, a rich fee-generating business that
allows them to pass the risks on to others (federal regulators
report that the volume of "adversely classified"
syndicated loans has risen to 8 percent, tripling the
problem loans since 1998).
facts may help explain why former Treasury Secretary Robert
Rubin, now of Citigroup, called an old friend at Treasury
and suggested federal intervention. Rubin's bank has a
large and growing hole in its own loan portfolio. Could
Treasury please pressure the credit-rating agencies, Rubin
asked, not to downgrade Enron? Though he styles himself
as a high-minded public servant, Rubin was trying to save
his own ass. Indeed, he called the very Treasury official
who, as an officer of the New York Federal Reserve back
in 1998, had engineered the cozy bailout of Long Term
Capital Management, the failing hedge fund that Citigroup,
Merrill and other major financial houses had financed.
Gentlemanly solicitude for big boys who get in trouble
connects Washington with Wall Street and spans both political
this new world of laissez-faire,when things go blooey,
the government itself is exposed to risk alongside hapless
investors, if the commercial banks are lending federally
insured deposits along with their own investment plays
or are exercising what amounts to an equity position in
the failed management. This is allegedly forbidden by
"firewalls" within the mega-banks, but when
a banker gets in deep enough trouble, he may be tempted
to use the creative accounting needed to slip around firewalls.
"A bank that has equity shares in a company that
goes south can no longer make neutral, objective judgments
about when to cut off credit," said Tom Schlesinger,
executive director of the Financial Markets Center. "The
rationale for repealing Glass-Steagall was that it would
create more diversified banks and therefore more stability.
What I see in these mega-banks is not diversification
but more concentration of risk, which puts the taxpayers
on the hook. It also creates a financial sector much less
responsive to the real needs of the economy."
fallacies of our era are on the table now, visible for
all to see, but the follies are unlikely to be challenged
promptly, not without great political agitation. The other
obvious deformity exposed by Enron is the insidious corruption
of democracy by political money. The routine buying of
politicians, federal regulators and laws does not constitute
a go-to-jail scandal since it all appears to be legal.
But we do have a strong new brief for enacting campaign
finance reform that is real. The market ideology has produced
the best government that money can buy. The looting is
unlikely to end so long as democracy is for sale.