Infectious Greed (69 page)

Thus, American Express joined the long list of supposedly sophisticated financial experts that had been unable to assess the risk and value
of their own investments in derivatives: Bankers Trust, Salomon Brothers, Askin Capital Management, Barings, Kidder Peabody, Enron, and so on. Like many of these institutions, American Express's investments in CDOs had not appeared on its balance sheet. The consequences for American Express were awful, even if the publicity was not: Chenault dismissed several senior financial officers, and the company laid off hundreds of lower-level employees in Minneapolis, Minnesota, where American Express was the largest private employer.

The problems at American Express led some experts to question complex financial dealings at other companies. While the securities analysts at major banks continued to recommend companies involved in off-balance-sheet dealings and credit derivatives, a few independent analysts and investors began asking hard questions of other companies. What were their derivatives risks? Did they have substantial off-balance-sheet liabilities? Were there any suspicious transactions alluded to only in the footnotes to a company's financial statements? How did they use CDOs? Or SPEs? Or any other dangerous acronym they could think of?

These questions about American Express led directly to Enron, which announced significant losses a few months later. Enron was a major participant in the credit-derivatives market, and had done several CDOs. In fact, Enron boasted of its CDO deals in its most recent annual report, a fact few investors had noticed. Those deals, like those of American Express, were incurring substantial losses, hidden from view.

In addition, Enron—along with Global Crossing and WorldCom—was prominently featured in the portfolios of debt and credit default swaps that made up the underlying investments of CDOs. For example, more than three-fourths of the CDOs Standard & Poor's rated in the United States contained WorldCom bonds.
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Moody's said fifty-eight of the Synthetic CDOs it rated had exposure to WorldCom.
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Although the junior pieces of CDOs absorbed the first losses, those pieces were not very large, relative to the entire CDO. In a typical Synthetic CDO, the junior piece represented just two to three percent of the overall portfolio. Once that cushion was gone, the senior pieces would bear any additional losses. A typical CDO had at most 100 companies; and, with so many companies defaulting, the hundreds of billions of dollars of supposedly safe, highly rated senior pieces were at risk of loss. WorldCom alone made up an average of 1.2 percent of Synthetic CDOs.
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With Enron and Global Crossing also in default—plus new
bankruptcies such as United Airlines and US Airways—the $500+ billion CDO market was hanging by a thread.

The rating agencies scrambled to downgrade their CDOs in 2002, in a last-minute effort to maintain credibility. But members of Congress were not impressed. They held hearings on the role of credit-rating agencies, and included in the corporate reform legislation passed in July 2002 a requirement that securities regulators undertake a major study of how credit-rating agencies fit within the framework of financial market regulation. In late 2002, the SEC lined up dozens of experts to testify about this issue. But the SEC still couldn't decide what to do about credit ratings agencies.

 

 

A
lthough the waves of financial scandals continued, for every company that was destroyed, there were many others continuing the same risky and/or deceitful practices unabated.

Consider a few: In January 2002, during the heat of the debate about Enron, Merrill Lynch and Citigroup did a $1 billion FELINE PRIDES deal for Williams Companies. (Recall that FELINE PRIDES were the complex, three-stage, mandatory-convertible securities Merrill Lynch had invented to take advantage of favorable regulatory treatment by tax authorities and credit-rating agencies.) Fifteen days later, Williams postponed the release of its fourth-quarter earnings and announced that it might have discovered an additional $2.4 billion in liabilities. The company's stock price fell 25 percent in one day.
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Merrill and Citigroup apparently hadn't spotted the errors during their due-diligence investigation.

During the first quarter of 2002, half of El Paso Corporation's profit was from a network of partnership deals similar to Enron's—called “Project Electron.”
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El Paso had purchased the right to sell electricity at above-market rates; but, instead of recognizing the profit from these high rates over time, it restructured its agreements to recognize all of the profit up front. El Paso claimed it had disclosed these practices, but it was hard to disagree with Carol Loomis of
Fortune
magazine, who called the firm's disclosure—in a footnote to its financial filings—“convoluted” and “impenetrable.”
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El Paso's stock price also fell 25 percent, the day the news about Project Electron was reported.

Dynegy reportedly manipulated its forward curves—the various rates at which commodities were trading for delivery at specified future dates—
in precisely the same way Enron had.
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Dynegy's stock price plummeted when these manipulations became public.

Dell Computer announced it had sold put options on its own stock in over-the-counter deals with Morgan Stanley and Goldman Sachs. When Dell's stock price fell by half, the company had been forced to spend $3 billion buying back 68 million shares to fulfill the put options.
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AOL Time Warner disclosed an investigation by the SEC into how it accounted for advertising sales at America Online. AOL's stock price plunged 15 percent, to a four-year low. Standard & Poor's and Moody's rated AOL's $24 billion of bonds investment grade, even though the cost of AOL's credit swaps doubled in early July 2002.
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John M. Rusnak, a 36-year-old trader at the Baltimore branch of Allfirst Financial, desperately sold “deep-in-the-money” currency options—options he almost certainly would have to pay money to satisfy at maturity—to Citibank, Bank of America, Deutsche Bank, and Bank of New York, losing a total of $750 million.
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Rusnak pleaded guilty to bank fraud in late 2002 and was expected to begin serving a multiyear prison term in 2003.

PNC Financial was a virtual clone of Enron, in that it had bizarrely named Special Purpose Entities (PAGIC I, PAGIC II, and PAGIC III), huge off-balance-sheet liabilities, and hundreds of millions of dollars of losses. PNC Financial entered into a settlement with the SEC related to these SPEs, but did not even pay a fine. The financial press, tired from news of Enron, did not even have the energy to report on the PAGIC deals.

Five officials from Adelphia Communications were arrested, based on charges the company hadn't disclosed extensive Related Party dealings. Adelphia had at least $2.7 billion in off-balance-sheet debt tied to closely held partnerships, and its controlling shareholders—the Rigas family—had used an off-balance-sheet entity, called Highland Holdings, to guarantee loans to themselves, which they then used to buy Adelphia shares.
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Xerox admitted to overstating its revenues by almost $2 billion. L. Dennis Kozlowski, CEO of Tyco International, resigned just before he was charged with evading more than $1 million in sales taxes on art. Qwest Communications disclosed it was under criminal investigation. Even Martha Stewart, the popular CEO, was connected to an insider-trading scheme.

Bernie Ebbers and Scott Sullivan were among the lucky few who had
received early allocations of Initial Public Offerings, virtually guaranteeing them a huge profit. They received shares of several hot IPOs, including Rhythms NetConnections, the Internet firm that linked WorldCom to Enron, and sent both firms on a billion-dollar Internet roller-coaster ride during 1999 and 2000. Ebbers allegedly made $16 million from shares of Rhythms NetConnections he was allocated before the IPO; four other CEOs allegedly made similar amounts. Ebbers also allegedly received a half-million-dollar check after the Rhythms NetConnections IPO, which he decided to split with Sullivan, even endorsing the check over to Sullivan so he could deposit it.
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There was a reference to Rhythms NetConnections on the check, a reference that linked Sullivan and Ebbers to Rhythms NetConnections, which was linked to Salomon and Enron, which were linked to innumerable parties in ways that would sicken individual investors when they learned about it.

The list went on.

As the stock market plunged, Warren Buffett—the multibillionaire investor—began selectively buying companies that appeared to be clean. His advice summed up the changes in financial markets during recent years: “When I take a look at a company's annual report, if I don't understand it, they don't want me to understand it.”
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By 2002, financial practices at many companies were so complex that even senior managers did not understand the details. If Buffett wouldn't touch those companies, and managers couldn't explain the risks, why would individual investors want to buy the stocks?

The only good news was that banks appeared to be immunized from the banking panics that had plagued the U.S. markets during the nineteenth and twentieth centuries. Individuals could feel safe about their bank deposits, even if they were only earning one percent interest. The related bad news was that banks were no longer the major source of risk, and because banks didn't bear the risk associated with loans, they had stepped up their lending. The risks previously associated with the banking system were now buried somewhere deep in the books of insurance companies, industrial companies, pension funds, and perhaps even a municipality or two. Individuals depended on those institutions for their livelihoods.

By 2003, there were worries about the banking system, too, from an unlikely source. The financial markets shuddered in June, but not for the reasons most investors might have expected. The financial pages were filled with news about budget and trade deficits, the plummeting dollar,
and especially the indictment of Martha Stewart for insider trading. But Wall Street, Congress, and regulators were jolted by Freddie Mac, the government-sponsored mortgage company that finances one in six U.S. homes and is the forth largest U.S. financial institution.

Freddie Mac announced it was firing its president, David Glenn, “because of serious questions as to the timeliness and completeness of his cooperation and candor with the Board's Audit Committee counsel.” Lawyers investigating Freddie Mac's accounting practices had asked Mr. Glenn for notes from meetings, and he had admitted that some pages were altered or missing. That cost him his job.

But Freddie Mac's shares didn't fall 16 percent—more than $6 billion—that day because of worries about Mr. Glenn's notes. The concerns were deeper, and replacing an executive didn't make them go away.

Experts had been nervous about Freddie Mac since March 2002, when the company replaced its auditor, Arthur Andersen, which had been implicated in Enron's collapse. Like Enron, Freddie Mac was a major player in the derivatives market. And like Enron, Freddie Mac had been unable to produce audited financial statements for more than a year because its derivatives trading was so complex.

The fears about Freddie Mac stem from its unusual role in the markets. Congress chartered the Federal Home Loan Mortgage Corporation in 1970 to stabilize mortgage markets and expand opportunities for homeownership. Since then, the company has purchased millions of home mortgages from lenders and repackaged them into securities to be sold to investors. After lenders sell one mortgage, they are free to issue another, which also can be repackaged and sold. Homebuyers, lenders, and investors have benefited from the liquid markets resulting from these practices.

More recently, though, the company now known as “Freddie” has been exploiting its federal charter. Although Freddie Mac has private shareholders, Congress has implicitly guaranteed investors in repackaged mortgages that the government will pay if Freddie Mac cannot. Investors believe this guarantee is credible, and credit rating agencies give Freddie Mac their highest ratings. Over time, the company has used its quasi-public status to borrow hundreds of billions of dollars at very low rates, investing the money to earn positive returns. Regulators, including Alan Greenspan, have been complaining about these practices for years. Meanwhile, Freddie Mac's officials have benefited greatly; Mr. Glenn made $5.3 million last year.

Freddie Mac increasingly played in the unregulated derivatives markets, where its implicit government guarantee gave it an advantage over less creditworthy parties. Freddie Mac's trades might not have been of much concern if it disclosed more details about them. But because of its preferred status as a federally chartered institution, it was not required to file the same statements as virtually every other U.S. financial institution. Whereas a leading bank such as JP Morgan had to tell shareholders about its eye-popping $25.8 trillion derivatives portfolio, Freddie Mac could disclose less information.

In this way, too, Freddie Mac echoed Enron. Freddie Mac ran a sophisticated derivatives trading operation that was virtually indistinguishable from that of a Wall Street investment bank, except that Freddie Mac was not regulated as a financial institution; similarly, Enron traded derivatives, but was a deregulated energy firm. Freddie Mac's derivatives assets grew by more than 600 percent during 2002; Enron's grew by roughly the same amount during 2000, the year before its bankruptcy.

In the previous election cycle, Freddie Mac had been the largest corporate contributor of unlimited “soft money” donations to the political parties, just as Enron and its chairman, Kenneth Lay, were major donors. As members of Congress abandoned some of their scandalized donors, they also called for hearings on the regulation of Freddie Mac. But the calls for reform died out after Freddie disclosed “correct” numbers, indicating that the company had earned
more
income than it originally reported.