CHAPTER 6

The Tech Bubble to Subprime Meltdown

The key factor sustaining Enron’s ability to secure a low cost of capital was an investment grade credit rating … derivatives enabled Enron to exploit inefficiencies in debt and derivatives rules, thereby artificially (if only temporarily) inflating the value of its residual equity claims.

Enron operated in newly deregulated energy and derivatives markets, where participants were constrained only by the morals of the marketplace. Enron’s officers combined the risky strategies of Wall Street bankers with the deceitful practices of corporate CEOs in ways investors previously had not imagined.

—Frank Partnoy

The biggest fear at the dawn of the 21st century was Y2K, the potential for the world’s computers to crash because of using two-digit years. Other than that, things seemed great: the economy was expanding, the federal government in surplus, and Silicon Valley success fueled the stock market. Accountants took credit for sophisticated reporting of derivatives, off-the-books entities, and global integration of accounting systems. What could possibly go wrong?

Crises came but Y2K was a nonevent. The blissful, “this time it’s different” economy, the federal budget, and overheated, overhyped market turned ugly. Silicon Valley growth engines sputtered. The big story after the crash was financial and accounting scandals—particularly in two industries: energy and telecommunications. Deregulation turned stodgy energy companies to high-tech traders and speculators using derivatives and structured-finance. Big risks and complex deals meant big accounting profits or hiding losses in dubious and often fraudulent schemes. Deregulation transformed telecoms from American Telephone and Telegraph’s (AT&T) monopoly to competitive tech giants, trying to dominate with new technologies. Arrogance and incompetence led to overcapacity followed by basic accounting fraud. Corruption did not stop ultimate big losses and bankruptcies. Enron led the way in sophisticated financial fraud, while WorldCom took the low-tech fraud crown.

Following the discovery of widespread scandals and a recession, the economy sputtered along. Regulations expanded, including Sarbanes-Oxley at the federal level, the creation of a new federal audit regulator and a multitude of new FASB standards. Despite regulation, new frauds were uncovered, including the amazing case at HealthSouth plus other problems at financial firms such as American Insurance Group (AIG) and Fannie Mae. But these paled in comparison to the developing mortgage debacle, a massive crisis predicted by virtually no one in power. Once again, accountants made major contributions to the developing scandals. Attempting to solve complex accounting issues for special purpose entities, using fair values and derivatives would plague accounting regulators ever since.

The Tech Bubble Collapses

High-tech stocks dominated NASDAQ, creating an extreme bubble before the new millennium. The NASDAQ composite peaked at 5049 in March of 2000, then collapsed. By October 2002 the index dropped almost 80 to 1,114 percent—once again, euphoria was a painful lesson. Other markets declined less—Dow down 26 percent, S&P, 19 percent. What happened? As explained by Michael Lewis:

In retrospect, it seems obvious that money-losing companies created by twenty-six-year-olds should never have been worth billions. But at the time, these companies appeared to have at least a shot at playing extremely important roles in wildly compelling versions of the future.¹

Plenty of bears predicted doom. Fed Chairman Alan Greenspan introduced “irrational exuberance,” but kept interest rates down (believing productivity would keep inflation down). Tech stocks with no earnings issued stock behaving like money machines. Then insiders bailed out, selling in big block trades:

How did they know? Some high-ranking executives knew that their own companies’ earnings were fictitious. They also realized that they were running out of road: one can only restate earnings so many times. Others were in a position to know that many of the companies that they did business with were not nearly as profitable as they appeared: orders were down, and inventories were building, along with corporate debt.²

The economy went into a mild recession in March 2001, made worse by the September 11 debacle. Greenspan soon pumped in liquidity, part of the “Greenspan put” legacy (by selling Treasury securities, cash is put into the system). Interest rates dropped to 1 percent by the middle of 2003.

Techs Fall Apart

Certain high-tech industries, especially information or computers and communications exploded with Internet savvy and new technologies. Information technologies were mainly free market (“preregulation”) and communications deregulated after a century of AT&T monopoly. Investors saw dollar signs, although “innovation and genius” were not synonyms with super earnings. The airline industry, a tech darling from an earlier age, usually proved to be a long-term money loser. The 1950s’ computer industry saw immense competition, which mostly went bankrupt. IBM became the long-term winner and a perpetual blue chip.

Upstart tech companies had similar stories, many famously started in dad’s garage or a dorm room. Amazon.com had an extraordinary business model and eventually became profitable—after considerable effort and some suspicious accounting. Michael Dell assembled computers in his dorm room and succeeded as a big, low-cost producer of PCs. Most suffered from poor business models, no profitability, and too little capital (the “cash-burn ratio” predicted when the cash ran out). Once the euphoria collapsed and the recession took hold, even modestly successful startups struggled: Egghead.com, drkoop.com, Cybercash, and eToys crashed and exploded; Amazon survived.

Financial Analysts Working on the Dark Side

Historically, brokerage firms used fixed commissions, generating big profits, enough to bundle various services including financial analysis research. The federal government decided this was price fixing and fixed commissions for trading stocks were outlawed by Congress—called “May Day” (the SEC put the ban into effect on May 1, 1975). Commissions dropped quickly and retail brokerage, no longer the cash cows of investment banks, soon competed with discount brokers such as Charles Schwab.

The investment banking model changed, looking for other opportunities, such as mergers and acquisitions (M&A). Financial analysts became deal advocates rather than objective reviewers and the “Chinese Wall” separating stock deals and analysts crumbled.

Analysts no longer offered objective assessments to help investors pick stocks. They were now part of the banking ‘team’ that helped their firms pitch and win deals. … The issuance of ‘positive’ research was part of the deal; companies demanded it as a condition of selecting underwriters.³

Despite the conflicts of interest, “New Economy” superstars included Jack Grubman of Salomon Smith Barney (later part of Citigroup), Mary Meeker of Morgan Stanley, and Henry Blodgett of Merrill Lynch. Blodgett’s call for Amazon.com to reach $400 came true, leading Merrill Lynch to hire him. Internet expert Mary Meeker helped bring Netscape public in 1995 (Netscape jumped over 100 percent from its initial price on day one). Jack Grubman became a telecom analyst, panning AT&T and promoting new entrants after the Federal Telecommunications Act of 1996 deregulated the business.

The three analysts minimized factual analysis and focusing on favorable M&A propaganda; also, CEO-sized salaries—Grubman at about $20 million annually, the others not far behind. Analyst reports for banking clients were virtually guaranteed strong buys, ignoring most real problems.

Morgan Stanley, Goldman Sachs, Merrill Lynch, and Salomon bundled initial public offerings (IPOs), M&A, and other deals. The banks also kept client executives happy by handing out IPO stock of other companies at favorable prices (essentially using the “preferred list” strategy from the 1920s—now called “spinning”). CEO beneficiaries included Bernie Ebbers of WorldCom (at Salomon) and Meg Whitman of eBay (at Goldman Sachs).

Once again the shady practices were discovered with the latest bust, this time after the tech bubble in 2000. Analyst actual feelings were found in their e-mails. Blodgett called client Infospace “a piece of junk” while publicly giving it a “strong buy.” He recommended “sell now”—privately only—on client ICGE. WorldCom, Global Crossing, and Quest failed, with Grubman chief cheerleader to the end. So much for the superstar analysts.

Where were the regulators? The severely underfunded SEC investigated some Wall Street activities like mutual funds and shady IPOs, but not analysts. Honest analysts could be fired; Marvin Roffman, interestingly enough, criticized Donald Trump on junk bond deals, but the SEC showed no interest. It was after the crisis that Congress held hearings and various agencies investigated (including later disgraced New York Attorney General Eliot Spitzer). Both Blodgett and Grubman paid large fines, resigned, and barred from the industry. Spitzer reached a “global settlement” with the banks, fining them a combined total of $1.4 billion. Citigroup paid $2.7 billion to the New York State pension fund, one of many class action suits by outraged investors.

Enron—the Great Scandal

Enron could be the premier scandal in modern corporate history, a “new economy” trading company convincing Wall Street it succeeded at everything it attempted. Enron’s stock price hit over $90 in August 2000—up 700 percent for the decade, a market value close to $70 billion. Based on revenue over $100 billion, it was the 7th largest American corporation. Chairman and CEO Kenneth Lay made $123 million on exercised options, on top of a base salary of $1.3 million and a $7-million bonus. But Enron was based on sophisticated, long-term fraud. Within a year, the company was bankrupt. Executives cashed out their options, but Enron employees and investors lost it all.

As scandal go, Enron was the total package: executive compensation excesses; meeting earnings expectations using masterful manipulation; deceptive derivatives trading; a board of directors without oversight; a particularly crooked chief financial officer (CFO) using hidden side agreements; an accommodating auditor and law firm; investment bankers making one illicit deal after another; analysts always rating Enron a strong buy; and strategic political payoffs and lobbying. People raising red flags were often fired. Enron was a microcosm for an entire corrupt environment.

The Early Years

Stodgy gas transmission companies InterNorth Inc. and Houston Natural Gas merged in 1985, soon run by Kenneth Lay. This 38,000-mile pipeline company with the largest gas transmission system in the United States, became Enron in 1986. Enron started with considerable debt, common for a stodgy transmission company, which proved a perpetual problem with a poor bond rating bouncing around between low investment grade and junk.

Enron’s first scandal hit in 1987 with a small energy-trading subsidiary in New York. Lay and auditor Arthur Andersen hid the problem, showing a lack of ethics and willingness to hide bad news. Arthur Andersen discovered unusual transactions and potent fraud (sham transactions, kickback, offshore accounts), duly reported to Enron’s Audit Committee with little comment. If material, Enron would have to disclose the impropriety to the SEC and restate earnings. Rather than face these sanctions (and possible bankruptcy) Enron declared the problems immaterial, did not report it to the SEC, or restate earnings. Speculation in New York led to a $85-million loss (after tax) in 1987. The SEC and U.S. attorney’s office blamed the local executives and Enron survived. The moral seemed to be the importance of cover-ups and obfuscation. Faulty internal controls and governance policies in place were not corrected.

Gas Trading

Prior to the Reagan Revolution of the 1980s, natural gas retained price controls and stayed regulated. Gas transmission contracts were long term with little risk and low profits. Deregulation made Houston the wild west, with volatile gas prices and high risk. Gas traded in the spot market based on short-term contracts. Prices and supply could rise or fall like a geyser. Out of this chaos, Enron created a brilliant trading strategy and became the market maker in the buying and selling of gas. With rising expertise Enron traders offered long-term contracts, providing forward contracts (at stated future prices), accepting the volatility risks. By matching buyers and sellers, Enron (and the customers) were hedged. The futures contracts were standardized at the New York Mercantile Exchange (NYMEX). Enron moved to options, swaps and other increasingly complex derivatives.

Enron hired Jeffrey Skilling from Kinsey in 1989, to run the new Gas Bank to help smaller wildcatters. The producers contracted to sell their expected future natural gas to Enron. Enron gave them cash upfront, the equivalent of a bank loan, with the promise of selling the expected future gas to Enron. With price and supply more or less guaranteed, the market found relative stability. Skilling also developed an “asset-light” strategy of active trading, although Enron owned substantial pipeline assets and massive debt.

Accounting Scandals

Enron specialized in three accounting areas for manipulation magic, issues that would give accountants fits ever since: derivatives, special purpose entities, and use of market value for financial instruments. These were sophisticated techniques, difficult to distinguish aggressive accounting from illegal acts. Assuming fraud, who was to blame? Nonaccountants could claim ignorance. Manipulation proved relatively easy, regulator solutions difficult. All three would play a part in the 2008 subprime meltdown and threaten future debacles.

Derivative Deals

Enron became a master of derivatives deception. Enron’s profit generator, gas trading, depended on forwards,⁴ futures, and other derivative contracts. Natural gas trading expanded into electricity derivatives, made particularly notorious by taking advantage of California’s inept deregulation. Derivatives trading was not highly valued by the market, with a typical price earnings ratio of 10 for trading companies, while tech firms could be multiples of that. Enron tried to be a tech business through inept acquisitions and Enron’s price earnings ratio (PE) did go up, but net losses on these businesses had to be covered up through increasingly fraudulent accounting.

Typical of 1990s executives, stock options were the compensation of choice. This meant every trick in the book was used to raise stock price, including using Enron stock to create new derivatives—some $4 billion worth. Enron borrowed money using prepaid swaps to treat various deals as off-balance sheet derivatives.

Fudging derivative trading profits became fundamental to Enron’s earnings manipulation. As a market maker, Enron had considerable expertise on future prices and traders’ bonuses depended on individual profit-making. Naturally, they speculated on future prices usually with considerable success. When trading losses happened, traders developed strategies to temporarily hide both profits and losses to show gradually increasing profits each quarter, a practice called income smoothing. Especially for excess profit, “prudency reserves” were set up as dummy accounts in the trader’s records, splitting gains between real profit and reserve. During a period of huge gains, reserves expanded. The trader later dipped into the reserve when trading losses hit. The second manipulation method used “mark-to-model.” The trading on long-term contracts (short-term contracts, less than 6 years, were traded on NYMEX and market prices publicly recorded daily) required modeling of energy rates on various maturities (called the forward curve). These over-the-counter contracts could easily be “mismarked” by the trader, usually when the trader lost money on the trade.

Trading profits increased with market volatility and opportunities expanded when California deregulated energy. Enron used every trading trick to overcharge California buyers; giant electric utilities California Edison and Pacific Gas and Electric were forced into bankruptcy in 2001. Enron traders developed specific strategies such as Fat Boy, Death Star, Get Shorty, and Ricochet specifically to disrupt California power and increase electricity prices. These trading practices were improper and some (based on later litigation) proved to be illegal.

Mark-to-Market

Long-term gas trading contracts, usually valued at historical cost (spreading revenues and income over the contract life roughly matching cash flows), was not acceptable to Skilling who demanded the use of market value to record revenue and income upfront—great for current earnings and executive bonuses, high risk long term. Skilling got approval for mark-to-market from the board and, more surprisingly, the SEC. Enron then expanded mark-to-market to generate greater profits and quarterly earnings manipulation—determining fair value when formal markets did not exist was not an exact science.

Mark-to-market works when a formal market exists (such as a stock market for equities) with specific closing prices. Fair values are recorded on the balance sheet and gains and losses recognized, a holding gain on the income statement or a balance sheet adjustment. Skilling’s recognizing upfront profits (“front-loading”) works on the idea that the trade contract determines profit, not meeting contract terms over time (and generating cash).

The contracts or instruments are revalued at the end of each accounting period, increasing volatility—especially the chance that losses must be recognized. Enron used mark-to-market on long-term trading contracts, although reliable market values on gas prices did not exist. Pricing used math models (“mark-to-model”) allowing big gains by changing model assumptions. The incentives were clear: traders got bonuses based on trades, not gas deliveries. Quarterly manipulation created new income based on “mark-to-model,” or “cookie jar reserves” established for potential future losses.

Separating long-term cash flows from profits created problems, because dividends, bonuses, and operations depended on actual cash. Enron did not think long term and did not hedge its positions. Future downturns meant disaster. In the meantime, Enron used prepayments (prepays) to manipulate “cash from operations,” recording bank loans disguised as gas futures to hide negative cash from operations. No question, Enron traders were experts at gas derivatives. Commodities trading (including electricity, also deregulated, and other commodities) was Enron’s most profitable business, but profits were overstated. Success led to speculation with the potential for losses but camouflaged using what became standard manipulation methods.

Structured Financing and Special Purpose Entities (SPEs)

Securitization converts standardized assets to debt instruments (such as auto loans or mortgages), selling the debt to investors. The liabilities could be transferred to a separate legal entity (SPEs, set up as a trust, corporation, or partnership), cash received, and the whole package priced at market value, usually for a nice gain recorded on the income statement.⁵ The SPE could perform specific tasks while isolating financial risks. Until active markets were developed, pricing used mark-to-model. First Boston began repackaging General Motors Acceptance Corporation auto loans in 1985.

Because SPEs meant off-balance-sheet (not disclosed on the balance sheet) and allowed unique manipulation to hide debt (particularly useful given Enron’s huge debt and junk bond rating) and create bogus income, Enron used thousands of them. Andrew Fastow was hired as a SPE specialist, initially to combine energy-related assets to resell to big investors such as General Electric, beginning with “Cactus,” in 1991—long-term gas contracts from the Gas Bank to fund long-term contracts with oil and gas producers. The point as summarized by McLean and Elking: “keep fresh debt off the books, camouflage existing debt, book earnings, or create operating cash flow.”⁶ SPEs got bigger, more complicated, and more deceptive. The focus became illicit rather than legitimate financial purposes. With rising deception investors bowed out, forcing Fastow and cronies to become the required “independent investors,” violating the concepts of independence and economic reality.

Enron’s famous joint venture Joint Energy Development Investments (JEDI) (1993) with California Public Employees’ Retirement System (CalPERS) was funded with Enron stock while CalPERS threw in $250 million in cash. JEDI acquired several production companies (it also loaned money, formed partnerships, and used other investment techniques), providing added growth opportunities for Enron. Enron bought out CalPERS in 1997 for $383 million, creating an SPE called Chewco. Not finding an “independent investor,” Fastow’s recruited employee Michael Kopper who used borrowed money, another violation; not much question this was fraudulent accounting. Fastow, Kopper, and others made self-enriching side deals not known by the Enron board or auditors.

Fastow became general partner in LJM (named for his children Lea, Jeffrey and Michael) in 1999 and later LJM2, creating vehicles to quickly provide accounting benefits (rather than real economic benefits)—and also enrich Fastow and his gang. The board of directors waived its conflict-of-interest requirements. Andersen audit partner David Duncan agreed to go along only if the board approved, which the board did. Fastow did not make it clear that he would generate substantial profits for himself or that many of the schemes would skirt the law (at best) and be subject to substantial future risk. The degree to which the SPEs were mishandled and Fastow allowed to manipulate them through the audit committee, auditor Arthur Andersen, and various law firms is remarkable.

The first LJM deal, the Rhythms Net hedge, locked in the gain recorded in 1999. LJM set up a subsidiary called LJM Swap Sub, selling a put option on Enron’s Rhythms Net stock. (A put option requires the seller, Enron, to sell the stock at a certain price if the buyer exercises the option.) Enron transferred 3.4 million shares of its own stock to LJM to serve as a hedge. This transaction had no economic substance, but benefitted Enron (and Fastow). Astonishingly, nobody objected to this transaction involving bankers at Credit Suisse First Boston and Greenwich NatWest, a British bank. The plan to unwind this transaction proved even more complex and three bankers from NatWest became the first people indicted in the Enron scandal for wire fraud. A new partnership called Southhampton Place became the buyer, controlled by Michael Kopper. Fastow, Kopper, and the bankers greatly enriched themselves. Naturally, the details were unknown to the board or the auditors.

Flush from the profit from LJM, Fastow set up an even larger partnership with LJM2. Within LJM2 four new SPEs, called Raptor I–IV, were formed, using Enron’s stock as primary assets. This accounting artifact provided hedges against the decline in value of various stocks and other assets. Fastow, the so-called independent investor, in effect, negotiated with himself between Enron and LJM2. Over 50 investor groups were found to invest some $400 million in LJM2. According to McLean and Elkind,⁷ the LJM partnerships contributed almost $230 million in earnings and more than $2 billion in cash flows to Enron. For example, LJM2 invested $30 million in a Polish power plant, on which Enron booked a $16-million gain for the December 1999 quarter. Because of problems, no outside buyer could be found, so the investment had to be repurchased for $32 million using other subsidiaries.

Raptor I used the total return swap. Raptor paid Enron for any losses on its investments, but kept all the gains. One investment was Avici systems, a maker of networking equipment. When Avici went public, its share price hit over $160 a share on August 3. Raptor I “hedged” Avici in September, but backdated to August 3 to lock in the maximum price. Enron booked a $75-million gain. The use of Enron stock as the primary capital proved to be problematic. Unfortunately, Enron’s stock started falling in 2000 and some of the Raptors were in trouble. Rather than take the necessary charges to earnings in 2000, the Raptors restructured to cross-collateralize them (meaning that the guarantees were provided by all the Raptors for each other).

There were over 20 deals made through LJM2, all complex, all deceptive, and all designed to provide accounting benefits to Enron and millions of dollars to Fastow and his accomplices. Per Swartz and Watkins,⁸ Fastow “earned” $58.9 million from LJM and LJM2.

Meeting Quarterly Earnings Targets

Central to accounting manipulation was meeting quarterly earnings expectations. Richard Kinder’s mission as chief operating officer (COO, until he left in 1996, then Skilling became COO) included meeting forecasts, initially using accepted strategies of cost savings, operating cuts, then accounting gimmicks. Incentives were clear—Kinder’s compensation package, as well as the other executives, was based on earnings and stock performance. Enron was generous only when substantial growth targets were met. Because trading operations were volatile, meeting earnings targets every quarter based just on operating results was virtually impossible. Rather than accept the inevitable and issue “warnings” to Wall Street, the hunt was on for new earnings. “Small loss periods” could be handled with standard strategies such as deferring operating costs, while “big losses” meant manipulation schemes like revaluing assets based on “fair value” (usually mark-to-model). Alternatively, Fastow could be counted on to create SPEs in virtually any deceptive, complex context.

Enron traders managed to lose $90 million in 1996 speculation. The solution involved revaluing JEDI investments using mark-to-market—not allowed for physical assets, but this worked so well more than a third of assets eventually were valued at Enron’s definition of market. Enron invested $10 million in Rhythms Net Connections. When Rhythms went public in 1999, Enron booked a $290-million gain, which was illicitly locked in using complex SPEs. A sham sale to Merrill Lynch was used to unload power plants floating on barges in Africa.

Acquisitions and Fraud

Enron acquired other companies to move into electric utilities, finance, risk management, and, toward the end, a telecommunications company. Why is not easily explained; Enron had no experience of any of these areas. Based on economic reality, most of these new enterprises were disasters. Enron expanded into Enron Development to build power plants around the world. Acquisitions to create Enron Broadband to enter telecom were timed just before the collapse of that industry. Some projects were marginally profitable, others flopped, but the same SPE manipulations set up complex deals so Enron could hide the losses and book nonexistent profits instead.

Political Pressure

As an S&P 500 company in a regulated industry, Enron logically answered to directors, auditors, the stock exchange, and multiple regulators. Despite the expected oversight and the lack of any real clout, Enron was willing to bully anyone. Cash enhanced influence—funds Enron willingly spent on banking deals, lucrative attorney and auditor consulting, and political contributions. The astounding lack of ethical constraints (by Enron or the other players) facilitated Enron’s success.

Enron dollars promoted hype, in part because financial analysts at banks receiving millions for Enron deals. Analysts apparently believed much of the hype. After all, Enron had expertise at energy trading and innovated trading and Internet technology. Beyond trading and the usually ignored pipelines, business strategy proved inept as Enron spent billions on overpriced and little understood investments; big losses could be quick or long term but always hidden in financial disclosures. Enron was vindictive against critics and usually successful at it. Credit Suisse First Boston analyst John Olsen was fired for recommending “Hold” (not a negative recommendation, but not strong buy). He had no success at Goldman Sachs or Merrill Lynch because they lost Enron banking business. Objective analysis became “flawed research.”⁹

Enron paid millions to politicians and political parties, as did Lay and executives. Wendy Gramm (wife of powerful Texas senator Phil Gramm) chaired the Commodities Futures Trading Commission (CTFC) regulating futures markets and pushed through deregulation. The reward was a seat on Enron’s board which included stock options. In a period of deregulation, Enron encouraged additional energy market deregulation through the Federal Energy Regulatory Commission. Enron and Lay supported powerful Texans politicians including Tom Delay (House Whip) and Senator Phil Gramm, plus President George W. Bush and Vice President Dick Cheney.

The 1992 Republican Convention in Houston was chaired by Lay. Lay supported Bush for president, earning the nickname “Kenny Boy.” Energy policy was Enron friendly, including billion-dollar international projects and loans. The biggest boondoggle was a giant (and basically unwanted) power plant at Dabhol, India, receiving support from Secretary of State Colin Powell. When Enron collapsed in late-2001, Lay asked for help from Fed Chairman Alan Greenspan, Treasury Secretary Paul O’Neill, and Commerce Secretary Donald Evans. At that point, federal officials did not return phone calls.

Restatements and Collapse

Enron had a market advantage in gas trading only for a limited time. Competitors gained energy trading savvy, limiting Enron’s profitability. In response, Enron traders assumed increasing risks and moved into trading areas without expertise. Unfortunately, Enron also decided it could be both an Internet company with Enron Online and a tech/telecom company with Enron Broadband. Both ventures bombed. Increasingly illicit acts followed, including hidden losses, side deals gone bad and so on. These were covered up mainly through complex SPEs transactions. This could likely go on until a complete market collapse, which happened with the tech bubble bursting in 2000.

Despite bad strategy and decision making, Enron’s stock price went up and peaked at $90 in August 2000. Only a few analysts such as hedge fund manager Jim Chanos were skeptical of Enron’s opaque disclosures. Most investors were bamboozled, but by mid-2000 Enron executives were bailing out of stock and options, including Lay and Skilling. Chanos sold short. SPEs had to be terminated and losses taken and chaos reigned at several Enron businesses such as Enron Broadband. While bailing out, Lay publicly proclaimed Enron doing great.

Eventually, the monitors stepped in. Enron disclosed big 3rd quarter 2001 losses, while auditor Arthur Andersen required write-downs of $1.2 billion based on “errors” reporting SPEs—of course, downplayed by Enron’s earnings release. Soon after the board discovered Fastow was lining his own pockets; he was fired. The SEC started a formal investigation; the bond rating agencies downgraded Enron back to junk. Andersen required additional restatement based on SPE manipulation, once again over a billion dollars. Without financial credibility, credit collapsed and energy trading became cash only. Enron finally declared bankruptcy on December 2, 2000—just after giving some $55 million in bonuses to executives while firing 4,500 employees.

Enron was the big news for weeks as hearing and investigations followed—SEC, Justice Department, California Public Utilities Commission, and several Congressional committees. Lay, other executives and board members, Arthur Andersen, accommodating lawyers, and bankers were on the hook. Fastow was one of the first to be convicted, sentenced to 10 years in prison on 78 criminal counts. Another 30 Enron executives were indicted; both Lay and Skilling were convicted (although Lay died before sentencing). This was complex, systemic fraud, sanctioned from the top and accommodated by virtually all the players supposed to insure clean operations and full disclosure. Most damaging was the use of sophisticated accounting during most phases of the crimes. Fair value, SPEs, and derivatives were difficult accounting issues (and, as demonstrating by the 2008 financial collapse, still are) and Enron showed how accounting could be used for criminal purposes in the 21st century.

What Happened at Arthur Andersen?

Enron proved to be the end of Arthur Andersen, found guilty of obstruction of justice after a mostly illustrious history rising to Big 8 status. Arthur Andersen founded his Chicago firm in Chicago with a focus on consistency and integrity. Initially relying on auditing, revenues started flowing in from tax work and then consulting:

in the ‘80s came the rise of the management-consulting business, a broader, less quantitative, and more lucrative line of work that involved a much higher degree of salesmanship. Slowly, auditing went from being the soul of the firm to a loss leader used to attract and retain the consulting contracts. Just as the vast riches represented by stock options helped corrupt ethics at some corporations, consulting helped push Andersen and its rivals off course.¹⁰

Anderson Consulting split in 1989.

Andersen increasingly shifted to “aggressive auditing,” accommodating most clients manipulating earnings and balance sheets to desired results: “in the new world, clients had become too valuable to defy. The distortion of the Tradition now meant you could best serve the client—and therefore, keep the client—by keeping it happy.”¹¹ This proved occasionally embarrassing and costly for clients getting caught. Andersen paid $110 million to Sunbeam stockholders, the another $100 million to Waste Management investors and the SEC.

The collapse of Andersen represents an unimaginable failure of leadership and governance. It raises questions about the anachronistic governance structure imposed by a private partnership, a structure better suited to a local enterprise than a global organization. In many ways, Andersen was more like a loose confederation of fiefdoms covering different geographic markets than an integrated company. Checks and balances were few and frequently ineffective. Insular and inbred, Andersen was unable to respond swiftly to crises or even to govern itself decisively. It took the firm five months to elect [Joseph] Berardino as CEO. Once in office, he was unable to fire a partner without a two-thirds vote of Andersen’s 1,700 partners around the world. Even as the firm was engulfed in turmoil, some partners squabbled over who should be its public spokesman. If it was the head of Andersen’s U.S. business, rather than Berardino who was CEO of the worldwide firm, perhaps the crisis could have been confined to America, some thought. Berardino’s emphasis on growth over audit quality, his reluctance to walk away from big clients with questionable accounting, and a stunning ignorance of potentially crippling issues all contributed to the firm’s undoing.¹²

Were the remaining (now Big 4) audit firms as corrupt as Andersen? Other big corporations were caught, while auditors claimed innocence (and occasionally incompetence). However, with only four major competitors, it was unlikely the Justice Department would take down another firm—perhaps prosecute a few partners. In addition, new regulation (mainly the Sarbanes-Oxley Act) proved a boon to auditing, requiring massively more hours and fees. Satisfying regulators, nor clients, became the new paradigm.

All the Rest

Enron, temporarily, became the largest bankruptcy in American history and perhaps the greatest business scandal—based on long-running complex manipulation. The result included Congressional hearings and massive media attention. Enthusiasm for Congressional reform waned until new scandals hit, including a new largest bankruptcy replaced Enron—WorldCom. The Sarbanes-Oxley Act of 2002 (SOX) passed within weeks.

WorldCom

AT&T gave up the fight to maintain its telco monopoly in the 1980s, spinning off its local phone subs (“Baby Bells”) while retaining long distance services. Competitors cropped up including Bernard Ebbers’ Long Distance Discount Service started in 1983. Mergers followed, then a name change to WorldCom in 1995. Merger magic (given the flexibility of reporting acquisitions) showed earnings growth. Bernie went for telecom giant MCI in 1998, paying $42 billion. Bernie was now a rich tycoon, using the WorldCom board to rubber stamp his ides:

Through the 1990s, the then-nine-member board was composed of insiders and execs from acquired companies. [The board] collected plenty of perks—from use of a corporate jet to financial support from Ebbers’ in their pet projects. And they piled up loads of WorldCom stock. … as many as 10,000 stock options per year. … [T]he board O.K.’d mega loans to Ebbers. They backed him through the stupendous expansion of WorldCom—to the brink of its collapse.¹³

Internal auditors at WorldCom discovered about $4 billion of accounting “irregularities,” later rising to over $11 billion. Unlike Enron this was simple fraud, mainly capitalizing operating expenses (especially capitalizing “line costs”), creating bogus revenues (including fees to other telecoms for access rights) and unreported liabilities. KPMG replaced Andersen as auditor. Ebbers resigned in April 2002, followed by the firing of CFO Scott Sullivan. WorldCom filed for bankruptcy in July 2002, the new largest bankruptcy (WorldCom’s peak market value was $115 billion, compared to Enron’s $63 billion). Sullivan copped a plea to securities fraud, Ebbers convicted of conspiracy and securities fraud—then sentenced to 25 years. The company eventually reorganized as a much smaller MCI.

Global Crossing

Global Crossing, another telecom with questionable intent, was founded by Michael Milken trader Gary Winnick in 1997. As with WorldCom, acquisitions and manipulation made this an international powerhouse. Market cap peaked at $45 billion in 2000. Side deals (such as big fees to Winnick’s holding company for “consulting”) made Winnick rich, assisted by lavish corporate spending. Like WorldCom and other new telecoms, massive sums were spent on fiber-optic cable (some 100,000 miles in 27 countries by mid-2001). The solution to avoiding bankruptcy in the face of the tech bust and the collapse of bandwidth pricing—fraud! The techniques looked similar to WorldCom: booking “capacity swaps” (exchanges with other telecoms) booked as revenue, capitalizing “acquisitions” as capital expenditures—all blessed by auditor Arthur Andersen. Like Enron and the others, Winnick and other executives sold out before an early 2002 bankruptcy (later bought by Singapore Technologies Telemedia). Winnick and the rest paid fines (including class action settlements) but were not indicted.

Tyco

Tyco International started as Tyco Labs in 1960, then went public and became a merger-crazy conglomerate. Dennis Kozlowski joined in 1975, becoming CEO in 1992—shortly to be tagged as “The Big K” and “deal-a-day-Dennis” for some 750 acquisitions. Acquisitions and merger magic showed big growth and rising earnings, with revenues rising about 50 percent a year. ADT Security Services was acquired as a “reverse takeover” to use ADT’s Bermuda headquarters to shelter earnings. The overworked and underfunded SEC started an investigation in 1999, but no charges were filed.

Tyco’s downfall followed its $9.2 billion 2001 acquisition of CIT Group, a huge commercial finance company. CIT continued issuing financial statement after the merger (CIT had a higher credit rating at the time), showing Tyco’s devious accounting tactics, especially “spring loading.” Tyco forced CIT to take big charges and losses before the official acquisition date, including a $5 billion write off of delinquent loans, loss adjustments of over $220 million, plus a $54 million charge to “acquisitions costs.” CIT showed a substantial loss just before the merger date. A big profit (over $70 million) was reported for CIT the following quarter.¹⁴ CIT became Tyco Capital and had increasing credit problems because of Tyco’s huge debt and poor overall credit. Tyco Capital was sold at a $6.3 billion loss (after taxes), resulting in an overall loss for the year of $9.4 billion. Net tangible assets were negative, making the goodwill virtually worthless.¹⁵ Despite the scandal, Tyco did not go bankrupt. Stock price collapsed from 63 to less than 12, but Tyco recovered as a smaller company.

The story turns to Kozlowski (and former Tyco CFO Mark Swartz). Kozlowski created a docile board, then insisted on massive compensation—$53 million in 1998 and $136 million in 1999, from $9 million in 1996. The loot was barely enough to support his new lifestyle: a $30 million New York apartment, mansions around the country, a $15,000 umbrella stand and $6,000 shower curtain, 130-foot yacht. The helicopters and airplanes were owned by Tyco. Kozlowski resigned in June of 2002, then charged with 38 felonies for raiding Tyco. Both he and Swartz were convicted and sentenced to long jail terms.

Adelphia

Under founder and cable pioneer John Rigas, Adelphia illustrated the ability to pilfer a corporation with an accommodating board of directors. Rigas used debt to grow a small cable franchise in 1952 into a high-tech, telecom giant with long-distance phone, cable, and Internet services—with revenues over $3 billion a year. The Rigas family turned the company into a corrupt cash machine: five members of the Adelphia nine-person board with family and they held the powerful executive positions; the family owned all the Class B shares (with most of the votes). After the tech downturn Adelphia was forced to restate earnings because of “co-borrowing agreements,” delisted by NASDAQ and declared bankruptcy in 2002. According to the Government Accountability Office (GAO):

Adelphia, at the direction of the individual defendants: (1) fraudulently excluded billions of dollars of liabilities from its consolidated financial statements by hiding them in off-balance-sheet affiliates; (2) falsified operation statistics and inflated Adelphia’s earnings to meet Wall Street expectations; and (3) concealed rampant self-dealing by the Rigas family…¹⁶

Fraud included false documents, capitalized operating expenses and sham transactions, plus the family self-dealings (including corporate-funded stock purchases, a golf course, margin loan payoffs, timber rights, and condos). John and son Timothy was convicted of fraud and conspiracy and sentenced to long prison terms.

And All the Rest

Manipulation and fraud tend to be rampant in the go-go years, including the 1990s as companies insist the profits perpetually continue and auditors seem to be more accommodating. Manipulation—apparently just short of the outright fraud line—seemed everywhere, especially in the tech industries. Enron energy competitors such as Dynegy, Williams, and El Paso Gas learned to behave like Enron; Qwest and other telecoms like WorldCom—and introducing many to “slamming.” (Qwest’s slamming was transferring long-distance customers to other services without permission.) Restatements followed, but short of fraud convictions and bankruptcy.

MicroStrategy provided large database software tracking, but manipulated sales by early recognition of revenues (before being earned) and software swaps. A SEC investigation followed, resulting in fines. Drug-store chain Rite Aid had multiple fraud schemes: gains from discontinued operations were treated as reducing operating expenses, failing to write off obsolete inventory, ignoring compensation expenses, capitalizing operating costs, and so on. Fraud convictions followed.

Major companies restated earnings, a rare event in earlier periods. The GAO investigated the period 1997 to 2002, finding 900-plus restatements by 845 companies, including the really big companies—72 of S&P 500 companies. Because the restatements continued, the GAO did a follow-up study in 2006, discovering 1,400 restatements by 1,100 corporations. Household names on the lists included General Electric, eBay, Bristol-Myers, Sears, AIG, Xerox, Hewlett-Packard, Campbell Soup, Time Warner, and Eastman Kodak.¹⁷

Major Regulations—Part I

Lenient enforcement during the good times, crash, then new regulations and stringent enforcement—the recurrent pattern and the tech bust was no exception. Following the chaos of Enron, Congressional hearings followed—the politicians were shocked, shocked! New standards were written up, then took a back seat to other matters. WorldCom hit and the SOX was passed within days. The perceived major issues were described and corrective action taken. Corporate governance was considered weak, with offending boards not meeting their fiduciary obligations. CEOs seemed to be able to blame the accountants for fraud and not take responsibility. Accountants were active participants and relevant accounting standards on new problematic issues not forthcoming. Executive compensation, especially stock options, was a key motivating factor. Auditing was too often accommodating, also true of regulators. Auditors claimed they were underpaid, while regulators claimed being underfunded.

SOX

The key Congressional committees were the Senate Government Affairs Committee and the House Finance Services Committee. SOX was passed by Congress on July 25 and signed by President Bush on July 30. The Act essentially attempted to address all the issues involved in Enron, WorldCom, and the rest, mainly corporate governance, lack of executive responsibility, and audit effectiveness—including internal control and audit oversight. The act had 11 categories, called titles, which are summarized in Table 6.1. Typical of most crises, Congress tried to solve all problems, apparently on the assumption that all were part of national public policy.

Perhaps the major area of attack was accountants and auditors. Auditors had been under the Congressional radar for decades, without getting enough support to change regulations. Enron would not happen without an accommodating Arthur Andersen; SPEs, market value mischief, and derivatives misuse would not happen without flexible accounting standards. Two major provisions were the creation of the Public Company Accounting Oversight Board (PCAOB) as the new audit regulator and the requirement for new internal control reports. Both were shocks to the accounting profession, mainly because of the uncertainty. All past oversight had been by AICPA committees. A federally sponsored regulator (established as a nonprofit funded by public companies, but with the SEC and potentially Congressional oversight) was new and potentially threatening. Once the board and staff were in place and procedures resolved, standard professional practices replaced uncertainly. Despite internal control being central to audits, corporations and their auditors initially feared internal control write-ups. Consequently, audit hours were massively increased to ensure clean opinions. Despite the problems with audits during the tech bubble and bust, auditors were in great demand and hours (and cost) zoomed up. Corporations spent millions to build up controls, but a number of firms reported internal control weaknesses. Controls improved over time and audits again became competitive (meaning lower fees and perhaps audit quality issues).

Table 6.1 Key provisions of Sarbanes-Oxley

Topic (by title)	Provision
1.   Public Company Accounting Oversight Board (PCAOB)	The PCAOB was created as the first federal regulator of public company auditing. The nonprofit establishes accounting standards, reviews audit results, and provides general oversight.
2.   Auditor independence	Many nonaudit services are prohibited. The lead audit partner must be rotated periodically; auditor must report to the corporate board audit committee.
3.   Corporate responsibility	Regulates corporate governance and responsibilities of key executives; the CEO and CFO must certify there are no untrue statements on the financial statements. Insider trading is prohibited in some conditions.
4.   Financial disclosure and internal control	Required SEC to study and regulate SPEs and other accounting issues; eliminates certain conflicts of interest. 404 requires an annual auditor report on internal control.
5.   Conflict of interests by financial analysts	Required major exchanges (e.g., New York Stock Exchange) to address analysts’ conflicts of interest.
6.   SEC funding	An underfunded SEC was identified as a problem; SEC appropriations increased substantially; various technical requirements for various groups.
7.   GAO or SEC reports	GAO and SEC required to write reports on audit firms, investment banks, credit rating agencies, and enforcement—areas whose deficiencies became central to the subprime loan debacle.
8.   Fraud accountability	Specific crimes and penalties were described, such as destroying or falsifying accounting and audit record, securities fraud. Included whistleblower provisions.
9.   White-collar crimes	Penalties for failing to certify financial reports and other offenses.
10.   Corporate tax returns	Tax return to be signed by CEO.
11.   Corporate fraud penalties	Under the Corporate Fraud Accountability Act, penalties for tampering with records result in greater criminal penalties.

Lesser accounting or audit issues also were dealt with. The FASB kept the job of standard setter, but funding was changed. As with the PCAOB, revenues would come mainly from charges to public companies based on market value. Not being obligated based on private sector donations, the FASB was expected to be more independent. Auditors were now banned from many nonaudit services (mainly consulting) to increase auditor independence.¹⁸ Although annual financial reports were long before SOX, additional reporting requirements were added including SPEs and other off-balance-sheet commitments and additional management and discussion analysis (MD&A) disclosures.

Given rubber-stamping boards of directors, including tolerating or encouraging blatant crimes such as at Enron and Adelphia, new corporate governance procedures were introduced, especially on corporate oversight. SOX increased oversight by the SEC and stock exchanges. Both the NYSE and NASDAQ rewrote governance standards for listed corporations, for example, increased board independence, banning management from audit, compensation, and nominating committee meetings.

Executives were now responsible for both internal control reports and financial statements—they could no longer claim ignorance, shifting the burden to nasty accountants. Unfortunately, there remained virtually no limits on executive compensation, probably the major motivation for short-term thinking and manipulation. The HealthSouth case soon would determine the limits of federal law on executive misbehavior.

Criticism of SOX was vehement but mainly from corporations directly affected and related parties. The critique was the expected response to regulation: too expensive, severe, and not at all useful. Public corporations threatened to go private or overseas. No question it was expensive, particularly the new internal control requirements.¹⁹ It gave the audit profession a major revenue boost and the Big 4 discovered a major shortage of CPAs, boosting college accounting programs.

Aftermath

Was SOX effective? Did economic reality and transparency prevail? As with most issues, it’s complicated. Transparency increased, internal control reports indicated that controls improved, while problem firms were identified. Corporate governance improved, executive compensation even slowed down—for a while. Scandals continued, but mainly manipulation survivors from the 1990s. HealthSouth was a major culprit, with a CEO later identified as a narcissistic psychopath. Other firms with regulatory issues were repeat offenders that would become key players in the later subprime crisis—AIG, Fannie Mae and Freddie Mac, Citigroup.

Richard Scrushy, founder and CEO of HealthSouth, built outpatient surgical clinics, which became a billion-dollar public company in part through acquisitions and merger magic. Continued quarter-by-quarter success required accounting fraud, resulting in a 2002 earnings restatement of $2.5 billion—just about all its reported earnings since 1997. Investigations by the SEC, FBI, and Justice Department resulted in charges of accounting fraud, money laundering, and mail fraud. Five former CFOs and other executives pled guilty. Most important, Scrushy was the first CEO charged for knowingly filing false financial reports—a key SOX reform. Amazingly, Scrushy was acquitted, with the plea: “the accountants did it!”²⁰ Apparently, the moral is accountants are evil, hire great lawyers after getting caught, and new regulations result in unintended consequences.

The Federal National Mortgage Association (Fannie Mae) buys or guarantees mortgages as a government-sponsored enterprise (GSE). Originally a New Deal program, it was privatized by Lyndon Johnson in 1968 to get Fannie Mae’s debt off the government’s books. The Federal Home Loan Mortgage Corp. (Freddie Mac) was created at the same time as a competitor. Both would later jockey for position as the most corrupt. The government pushed home ownership as public policy, with the assistance of Fannie CEOs David Maxwell in the 1980s and Jim Johnson in the 1990s. They developed the skills of single-issue “lobbyists” with immense political power (including banks, real estate groups and home owners in all congressional districts)—great for executives and investors, questionable for public policy. Obvious problems included huge holdings with little equity and lack of investment diversity.

Fannie Mae under CEO Franklin Raines seems to have crossed the line from manipulative to potentially illegal acts with growth through the use of derivatives supplemented by accounting fraud—the auditor of course was Arthur Andersen for both Fannie and Freddie. Executive bonuses were massive, the typical motivation for fraud. After Enron, Andersen was replaced by PricewaterhouseCoopers, who discovered income smoothing (mainly overstating earnings in bad years and understating earnings in good years) and weak internal controls. Derivative losses went unrecognized. Billion-dollar restatements followed. Freddie cooperated with regulators, but Fannie Mae did not. A SEC investigation forced Fannie restatements (over $6 billion in earnings) and the firing of Raines in 2004. The manipulative environment at Fannie did not change much under new CEO Daniel Mudd. Instead, Fannie continued the questionable accounting practices, increased holdings of subprime mortgages and became a major contributor to the subprime mortgage crisis of 2008.

Executive compensation in general and stock options in particular were major accounting issues with Enron and the other failing tech corporations. The issue had spread to most public corporations, apparently the benefits of “zero-cost options” just too enticing. FASB changed the rules with SFAS 123R requiring the expensing of stock options beginning in 2006. Speed vesting became a thing in 2005 to allow early vesting (and therefore no expensing) of options. The ethics may have been questionable but allowed according to GAAP. Of more concern were issues of backdating and spring-loading, both potentially illegal. Backdating results when the grant date of options is set to an earlier date with a lower stock price. Companies were caught when that date was the low stock price for the period (regulators were unimpressed with the argument of sheer coincidence). Companies also used exercise backdating, with executives claiming to exercise options at an earlier date with a lower stock price. This is contractual fraud, literally defrauding the company of potentially millions of dollars when the options are exercised. Spring-loading in this case is giving options before good news is reported or after bad news. For example, a Wall Street Journal investigation identified 186 companies handing out unexpected options to over 500 executives after the huge stock price drop from the 2001 9/11 attacks. Hundreds of companies came under SEC and Justice Department investigation for stock option irregularities.

Tax scams continued and questions arose about the continued existence of the Big 4 accounting firms; criminal indictments for any would mean failure, just like Arthur Andersen. Two big areas were tax havens (offshore subsidiaries with low or zero taxes plus secrecy) and tax shelters (which allows unusual deductions or other means of tax reduction like limited partnerships). Switzerland, followed by 50 or so other countries, were recognized as tax havens, each with unique features to lower taxes and avoid detection.

Oil limited partnerships, usually drilling, allowed big tax breaks. For rich investors, dry holes worked fine. Both KPMG and Ernst and Young (E&Y) were charged with tax shelter fraud. KPMG settled with a $456 million fine to avoid further prosecution. The IRS charged E&Y with marketing illegal tax shelters plus fraudulently conning the IR out of $2 billion. To avoid killing more big accounting firms, the IRS prosecuted partners rather than the firms.

One of the great financial innovations of the 1980s was derivative uses for multiple investments, risk, leverage, and speculative purposes. Financial rocket scientists proved equally adept at ethically questionable, high-risk derivative plays to sell to gullible investors. These included tax avoidance schemes. Equity swaps proved equivalent to selling big-gain stocks without any taxes. “In recent years the capital gains taxes collected from wealthy individuals in the United States have been close to zero, in large part because of Equity Swaps. … The Equity Swaps were a pure, unadulterated tax scam.”²¹ Complex derivatives could allow corporations to treat preferred stock as equity on the balance sheet and (deductible) debt for tax purpose. Others resulted in sham trades specifically to show losses, but only to reduce taxes while having no direct effect on the financial statements.²²

Other financial issues at this time included a mutual funds scandal, internal control, and other problems at AIG, and many growing issues involving excess leverage, derivatives, SPEs, and other issues eventually leading to the next great crisis, the subprime meltdown.

New Accounting Rules

Under SOX Section 401 requirements, the SEC issued new reporting and off-balance-sheet transactions (including SPEs) rules, mainly disclosed in Management Discussion and Analysis (MD&A) and footnotes. The FASB had major agenda items (including the seemingly unsolvable problems of stock options, SPEs, derivatives, and market value) and encouragement to move toward principles-based rather than rules-based pronouncements. The FASB issued rules on all of these. (The SEC has run hot and cold on the idea of convergence of U.S.-based GAAP with the IASB. At that time, it was hot, hot, hot.)

With more funding and presumably greater independence, FASB passed standards that addressed Enron and tech crash accounting issues. These included stock options (No. 123R, 2004), derivative disclosures (No. 167, 2009), and special purpose entities plus other off-balance-sheet items (Interpretation 46R on variable interest entities and No. 161, 2008). Other topics were new pension and other postretirement benefits accounting (158, 2006). New rules on mark-to-market (in 2009, after the subprime crisis) were disappointing, effectively eliminating marking down financial assets to market values in 2009. The rationale was that the market was “failing” and therefore write downs did not reflect economic reality. The problem with this analysis was dealing with the earlier eagerness to write-up assets—and claim additional compensation. In other words, a one-directional use of market value. Unlike the other major one-directional use of market, lower-of-cost-or-market, this was not conservative accounting.

From a purely conceptual perspective, the most significant standard was 123R, requiring corporations to expense stock options beginning in 2006. It also is the major example of the importance of independence. The FASB saw the need for expensing at least by the early 1990s and was prevented from implementation for strictly political reasons. Many of the problems with excess executive compensation and therefore motivation for manipulation could have been avoided at that time. Stock options continued but were now priced in the income statement. Executive compensation fell for a while, but restricted stock (corporate stock available only after a period of time or until specific performance goals met) and other forms of compensation grew.

Subprime Meltdown

Financial failures in the United States and most of the developed world are recurring features, although a financial crash has never occurred in Canada since 1840.^23,24 Typically, the causes seem mainly unnecessary risks and excesses that defy common sense. It appears beyond belief that mortgage loans could be central to financial chaos—what could be more secure than a mortgage with 20 percent down and collateralized by real estate? It took literally millions of active participants, cheap and readily available cash, a sophisticated financial system gone wrong, plus a fair share of crooks, complicit executives and regulators. Strangely, many of the perpetrators were rewarded rather than punished based in part on the “too big to fail” theory. Small investors, mortgage debtors, and people in general got no such break.

Subprime was the first “trillion-dollar scandal,”²⁵ with the analysis shifting from billions in operating losses of major banks to trillion-dollar bailouts. The bailout triumvirate of Hank Paulson, Ben Bernanke, and Tim Geitner received mainly praise, while Geitner actually got promoted to treasury secretary. According to finance practice and theory the praise was justified, while promoters of justice and motivation efficiency looked on in disbelief. As in virtually all financial panics, Wall Street investment banks were central, intermediaries between predatory mortgage originators and gullible investors of exotic derivatives.

The New Deal assisted housing with Fannie Mae; the Community Reinvestment Act of 1977 outlawed redlining (essentially commercial racial segregation). Later regulation pushed increased home ownership, especially low income and minority households—which often meant subprime (higher credit risk and interest rates, plus greater probability of default) mortgages. Fannie and Freddie were encouraged to hold more subprime mortgages. Unfortunately, mandates to stop predatory practices and other abuses were neglected.

The investment banks initially were partnerships, but the majors became public corporations beginning in the 1970s. This changed incentives from protecting partners’ equity to maximizing short-term earnings (with “other people’s money”)—and therefore executive compensation. Michael Lewis, a former Solomon Brothers employer and best-selling author, thought going public meant complete self-destruction: “I had been waiting for the end of Wall Street. The outrageous bonuses, the slender return to shareholders, the never-ending scandals…. Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet, they just kept on growing.”²⁶

Beginning with the Black-Scholes model in the 1970s, options could be accurately priced, making them potentially profitable instrument. Bank hired battalions of math experts, “quants,” to create portfolios of instruments to hedge or speculate on any number of complex bets. Users often could not tell the difference between speculation and hedging. Once investors were convinced mortgage-backed securities (MBSs) had ultra-safe higher yields (partly because ratings were overstated) MBSs became money machines.

Another high risk issue involved matching the maturities of financial assets and liabilities, a basic principal of bank asset-liability management. Short-term interest rates remained low, so banks borrowed short term then invested in longer-term higher yielding assets. After the SEC lifted equity limits in 2004 on big investment banks, the banks pushed leverage to 25 to 30 times equity, driving earnings and bankruptcy risk ever higher. Add the off-balance-sheet SPEs and highly leveraged derivatives, the banks could be toppled with even a small blip. Bear Stearns and Lehman Brothers were the biggest offenders and collapsed first.

One derivative innovation was the credit default swap which would pay up in cases of debtor default. AIG and other financial institutions claiming to be experts sold a lot of these to alleviate risk on debt; the price was cheap because the risk was considered low-to-nonexistent. A 1 percent annual premium on a $100-million MBS was a million dollars in revenue. Thus, the banks used these derivatives as revenue generators rather than hedging tools. Unfortunately, the MBSs rated AAA were ultimately riskier than junk bonds, not comparable to Treasury securities. The collateralized debt obligation (CDO) market (a 1980s innovation at Drexel Burnham) were typically repackaged low-rated and hard to sell tranches of MBSs—basically “diversified super junk” but given high-credit ratings. “Moody’s and the other rating agencies turned their backs on their own integrity.”²⁷

Securitizing financial assets became a banking activity and major banks eventually securitized transactions totaling trillions of dollars. The purpose of securitization is to pool assets to create “slices” of credit risk (tranches) to appeal to investors with particular levels of risk tolerance. Banks could bundle standard lending assets (credit card receivables, mortgages, auto loans, or student loans), getting them off the books at a substantial profit: “structured finance contributes to a more complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transactions cost.”²⁸ Amazing products at least in theory, but abused by banks and others. Until sold to investors, the underlying assets usually were sent to an SPE or other off-balance-sheet entity. It was only discovered later that diversified piles of junk were still junk.

Subprime borrowers, by definition, had poor credit histories (or none at all), including delinquencies, charge-off, and possibly bankruptcy. Evidence includes low credit scores, low income and poor debt-to-income ratios. Creditors charged higher interest rates to compensate for increased credit risk and often protected themselves by requiring collateral. This should have worked for housing, assuming substantial down payments, but lenders continually reduced down payment requirement, especially because of government pressure to increase mortgage lending.²⁹

During the 1980s mortgage companies began specializing in subprime lending. Thanks to predatory lending practices, demand became insatiable, some $20 trillion in new mortgages were originated between 2001 and 2008.³⁰ Mortgage company techniques included adjustable rate mortgages (ARMs) starting at low (“teaser”) rates, interest-only, and liar loans (no requirement to prove income) to push subprime. As long as housing prices were rising and interest rates low (e.g., a second mortgage could replace defaults), this could go on, although housing prices often doubled (an obvious sign of a bubble).

Problems hit in 2006 as sales declined and housing prices peaked. According to the Case-Shiller Index (where prices were set at 100 at the start of 2000) prices peaked in June 2006 at 226 (then fell to 146 by the end of 2009, down 35 percent). The experts did not see the collapse coming, considering the trend only a local problem and at most a moderate problem nationwide. The panic begins in 2007. As mortgages started collapsing (i.e., mortgage payments were not being made) Moody’s started downgrading MBSs. That meant losses and the inability to sell securities except at a substantial loss. A big event in the “subprime meltdown” was the failure of two Bear Stearns hedge funds speculating in MBSs in June 2007.³¹ Several mortgages companies declared bankruptcy.

Collapse

Of the five major investment banks, Bear Stearns was the smallest and the most committed to mortgages, acquiring mortgage originators and vertically integrating the process from origination to repacking and selling, investing directly in these products, plus the aforementioned hedge funds. This worked during the good years, such as 2006 when the company’s net income was $2 billion, up 40 percent from the previous year. But it was a “house of cards” according to author William Cohan.³² Like most big banks, Bear played the repo market, borrowing overnight (or longer) using repurchase agreements, over $100 billion by 2008—great for giant net income until the crash hit. After Moody’s downgraded Bear in March 2008, repo investors moved out, including $6 billion from Fidelity. It required a bailout just to survive the weekend—$12.9 billion from the Fed. The bailout continued as JP Morgan agreed to acquire Bear only after the Fed essentially assumed some $30 billion of mortgage-related “toxic assets.”

Next to collapse were Fannie and Freddie. After the earlier bouts of accounting fraud, excessive executive pay, and political payoffs they did not reform. Instead, they expanded their mortgage positions including substantial involvement in subprime—holding or guarantying over $6 trillion, about half of the total U.S. mortgage market. Fannie’s leverage ratio averaged 20 to 1 (assets 20 time larger than equity) in 2007 plus big net losses. Equity turned negative in 2008 ($15 billion in the hole) after additional losses. Freddie was roughly the same, including negative 2008 equity of $31 billion. The Federal Housing Finance Agency, the GSEs new regulator, put Fannie and Freddie into conservatorship on September 7. They stayed there even after profits returned, with earnings going to Treasury rather than build stockholders’ equity.

The remaining investment banks and AIG were collapsing by Fall. Ben Bernanke claimed: “We came very, very close to a global financial meltdown, a situation in which many of the largest institutions in the world would have failed, where the financial system would have shut down.”³³ Problems were especially severe at Merrill Lynch and Lehman Brothers for the same reasons as Bear: (1) big short-term borrowing backed by questionable collateral, (2) huge derivative holding, and (3) bundles of toxic assets on the books. Creditors and derivative counterparties had little confidence in either firm.

Lehman was up next, the only major bank to fail to get a bailout and became America’s largest bankruptcy. CEO Richard Fuld got the dubious distinction of being declared the worst CEO of all time by Portfolio, beating out Jimmy Cayne of Bear Stearns and Enron’s Ken Lay. Lehman moved into mortgages late (including acquiring mortgage brokers and other intermediaries) and, given the profitability (including the manipulative innovations of SPEs and derivatives, while ignoring obvious risks), became number one in subprime and somewhat less bad Alt-A mortgages. Lehman traders recognizing the bubble notified the executives without success—given high profit and big compensation euphoria, reality apparently is hard to face. Reform started, but too late to make a difference. Lehman was out of money after a 3rd quarter loss of $4 billion—only a merger or bailout would work.

Bank of America, a possible white knight, acquired an equally stressed Merrill Lynch for $50 billion, an extraordinarily high price. Only Britain’s Barclays Bank was left, but British regulator Financial Services Authority did not approve. Hank Paulson at Treasury and Ben Bernanke at the Fed refused a bailout. Lehman filed for bankruptcy on September 15, 2008. Then the financial world collapsed.

Almost immediately, AIG was downgraded from AAA to A and credit to AIG stopped. AIGs insurance business was blue chip, but the company bet heavily on credit default swaps (and lost $100 billion for 2008), derivatives that protected creditors in cases of default and bankruptcy. On September 17 the Fed stepped in with a “secured credit facility” for AIG up to $85 billion. Basically, AIG was able to pay up for creditor losses and eventually recover—the outcome the regulators and Wall Street demanded, but enraged most others.

The other big news: credit froze up. Up first were money market funds, seemingly the safest of short-term investments. Lehman losses on overnight repos and other short-term borrowing meant a crisis. Money market fund Reserve Primary “broke the buck” (reducing shares from $1 to 97¢ (the fund later liquidated). The Fed again stepped in with $150 billion. The strongest investment banks, Goldman Sachs and Morgan Stanley, faced bankruptcy in this climate. They increased equity and became bank holding companies with access to Fed cash. Other big mortgage-related banks were seized by the Federal Deposit Insurance Corporation (FDIC) and usually acquired by other banks for bargain prices. According to Treasury Secretary Paulson: “The financial system essentially seized up and we had a system-wide crisis.”³⁴ Further Fed action bailed out (provided cash) to most other credit markets: the Temporary Liquidity Guarantee Program (by the FDIC) to guaranty new bank debt, Commercial Paper Funding Facility (using an SPE) to purchase commercial paper, Term Asset-Backed Securities Loan Facility (TALF) to banks, and so on. Fed action dropped the fed funds rate down to almost zero, the zero-interest rate policy (ZIRP) effectively driving short-term rates to basically nothing. The legality of these operations was questionable. Volcker claimed the Fed went to: “the very edge of its lawful and implied powers, transcending certain long embedded central banking principles and practices.” Anna Schwartz, an economist, called it “a rogue operation…. The Fed had no business intervening here.”³⁵

Treasury could not pay out cash unless approved by Congress, unlike the independent Fed. Paulson’s plan was a giant bailout to build up the equity positions of banks.³⁶ The result was called TARP for Troubled Asset Relief Program, providing Treasury $700 billion with few strings attached.³⁷ The triumvirate of Paulson, Bernanke and New York Fed President Tim Geitner bought preferred stock and other bank equity in banks, beginning with $25 billion each to Citigroup and Bank of America October, 2008 and lesser amounts to other big banks. Little banks liquidated by the hundreds, but the Wall Street banks, whose actions arguably caused the debacle, were protected.³⁸

Subprime became a global problem, a financial crisis for much of the world in several different ways. Some countries had similar housing bubbles such as United Kingdom, which were mainly bailed out by the countries’ central banks. Many foreign investors bought gigantic amounts of MBSs and other securitized debt, apparently believing that investment grade securities ratings (although lacking transparency and difficult to analyze) made then default free. Central banks all over the world (but mainly in Europe) protected their major banks.

The Great Recession started at the end of 2007 (and continued into 2009). A new president, Barack Obama, was elected with a Democratic majority in Congress and job one became saving the economy. Stock prices collapsed, unemployment started a long slide to double digits, and annual federal deficits peaked over a trillion dollars. A stimulus package helped the economy but was canceled after a couple of years when Republicans regained Congress. Recovery would be slow—not necessarily a bad thing but not orthodox macroeconomics. The regulatory shift went from bailouts to reform.

Dodd-Frank and Other Regulations

In mid-2009, President Obama announced his reform plan, with costly new regulations (the banking view) or modest reform with limited chance of success (many economists and pundits). A Consumer Financial Protection Agency would be added, advocated by professor and later Massachusetts senator Elizabeth Warren. The SEC took regulatory responsibilities for mortgage companies, including transparency through greater financial disclosures. Agencies would have additional crisis tools including “resolution authority” to take over (including finding buyers or liquidate) failing financials. More derivative regulation was proposed such as a clearinghouse with more requirements for traders, plus better disclosure of trades. The United States would push for similar rules globally. Legislation similar to this would pass, especially Dodd-Frank.

Reform required federal legislation. Jurisdiction was held by the House Financial Services Committee under Chairman Barney Frank and the Senate Banking Committee under Chris Dodd. The presumed intent was to eliminate the most corrupt Wall Street practices (e.g., predatory lending), increase transparency (such as over-the-counter derivatives), and deal better with future crises—all complex, with high hurdles including bank lobbying, satisfying many different interests, and politics as usual. (Congressional leadership for example would just as soon have the campaign issues rather than deal with the political fallout.)

Full frontal politics made passage a slow process with many concessions to members and special interest. The final version, considered considerably watered down by experts, was a 2,200 page monster passed in mid-2010. Regulation included the Consumer Financial Protection Agency (CFPA) to limit predatory practices, derivative requirements including all trades not on an exchange must use a clearinghouse, some SEC regulation of private equity and hedge funds, SEC regulation of rating agencies, a version of the Volcker Rule reducing proprietary trading by banks,³⁹ stockholder votes on executive pay (but not binding), and additional Fed powers for emergency lending programs (but with Congressional oversight). The CFPA has shown some success to date. New rules on derivatives take some pressure off standard setting, but with nominal values in the trillions and as highly levered instruments the potential for future fiascos continues. Regulations also may reduce the potential future harm of SPEs.

Fannie and Freddie were not mentioned in the bill, meaning future legislation is required. Income generated by the GSEs goes directly to Treasury rather than to increase equity for stockholders. With essentially zero equity, the potential for a new crisis remains. Dodd-Frank required numerous studies on various issues not specifically addressed. An obvious Democrat/Republican dichotomy exists. Democrats applauded the oversight, but most Republicans voted against the bill (mostly as unnecessary and costly); for a few, it does not go far enough.

Adequate bank capital is essential to system stability but addressed by the Basel Accords, not Dodd-Frank.⁴⁰ Capital was initially 8 percent of risk-adjusted assets (default and other risks varies from, say, Treasury securities to subprime loans). More complex rules were introduced in 2004 (Basel II) which in effect reduced required capital. The mortgage bust of 2008 proved these capital rules were inadequate. Capital limits were increased in 2010 (Basel III), still 8 percent of risk-adjusted assets plus a “conservation buffer” of an additional 2.5 percent. Again, specific standards were complex.

Global Actions

Desperate action continued around the world, beginning with the G20 (central bankers and finance ministers from the big economies). The basics of financial reform included the need for adequate capital, effective analysis of systemic risk, rules to counter cyclical downturns by building appropriate buffers during prosperity, plus better long-term executive incentives. The European Commission proposed a European system of Financial Supervisors and a European Systemic Risk Council. Increased bank capital was urged by all.

Then the Greek banking and debt crisis erupted in 2010, with the potential to topple the European Union. Major concern was the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain), the economically weak countries in the European Union. Austerity was required by Greece to receive an EU or European Central Bank bailout, and most EU countries followed suit. Tax increases, budget cuts and more austerity measures continued, resulting in recessions and a slow growth recovery.

By and large the European countries moved toward fiscal austerity, with spending cuts and increased taxes. British Prime Minister David Cameron called for austerity with tax increases (including an increase in the value-added tax from 17.5 to 20 percent) and budget cuts. Economists and other fiscal experts debated the appropriateness of budget cutting during a worldwide recession. Canada once again avoided a financial collapse. Britain voted to withdraw from the European Union (“Brexit”), which brought in a new prime minister, Teresa May.