Page 2 of 5 CREDIT
BUST BYPASSES BANKS Part 1: The
rise of the non-bank financial
system By Henry C K Liu
players in the runaway debt market,
particularly in complex market segments, trading
about 30% of the US fixed-income market, 55% of US
derivative transaction, 80% of
high-yield/high-risk derivatives, 80% of
distressed debts and 55% of the emerging-market
bonds.
Investors in hedge funds include
mutual funds, insurance companies, pension funds,
banks, brokerage house proprietary
trading desks, endowment
funds, even central banks.
When
private-equity firms acquire public companies to
take them private, the acquisition is done mostly
with debt. Most corporate mergers and acquisition
are funded with debt. Foreign wars and domestic
tax cuts are funded with sovereign debt. Debt
instruments are routinely traded as if they were
equity.
Banks and off-balance-sheet
'conduits' Since bank clients such as hedge
funds and private-equity firms are private
entities that cater to supposedly "sophisticated"
investors, neither the banks nor their private
clients are required by US regulation to make full
disclosures of their financial situations. Yet
mutual funds and pension funds get the money they
manage from members of the general public who do
not qualify individually as "sophisticated"
investors. They should be entitled to better
disclosure requirements.
As banks only set
up and run investment "conduits" as independent
entities to help their risk-prone clients monetize
their securitized assets, such as receivables from
credit cards, automobile loans or home mortgages,
by selling ABCP, such conduits are kept off the
balance sheet of banks.
The rise and
decline of collateral management When
dealing in the arcane derivatives market in
particular, collateral management is an
indispensable risk-reduction strategy.
The
Enron implosion was caused by "special-purpose
vehicles", which were early incarnations of
"conduits" backed by phantom collaterals. Enron's
collapse was a high-profile event that briefly
brought credit risk to the forefront of concern in
the financial-services industry. Collateral
management rose briefly from the Enron ashes as a
critical mechanism to mitigate credit risk and to
protect against counter-party default.
Yet
in the recent liquidity boom, collateral
management has again been thrown out the window
and rendered dysfunctional by faulty ratings based
on values "marked to theoretical models" that fall
apart in disorderly markets.
Kenneth Lay,
once the high-flying chairman of Enron, before his
untimely death faced securities-fraud as well as
bank-fraud charges after Enron's bankruptcy. The
bank-fraud issue revolved around an obscure
Federal Reserve banking regulation from the
Depression era, called Regulation U, which sets
out certain requirements for lenders, other than
securities brokers and dealers, who extend credit
secured by margin stock.
Margin stock
includes any equity security registered on a
national securities exchange; any debt security
convertible into a margin stock; and most mutual
funds. The regulation covers entities that are not
brokers or dealers, including commercial banks,
savings-and-loan associations, federal savings
banks, credit unions, production credit
associations, insurance companies, and companies
that have employee stock-option plans. This limits
the amount of credit a bank can extend to
customers for buying on margin. The purpose of the
law is to prevent banks from taking on unwarranted
or excessive risk.
Prosecutors alleged
that Lay signed documents at Bank of America,
Chase Bank of Texas and Compass Bank in which he
agreed that he would not use the $75 million in
personal credit lines to buy or maintain stock on
margin but then proceeded to do exactly that. Had
he been convicted, Lay would have faced up to 30
years in jail for each count.
On Lay's
official website, the Houston community leader,
free-enterprise icon and superstar in the energy
business denounced the charges as "based on arcane
laws" and added that "my legal team can find no
record during this law's 70-year existence of
these provisions ever being used against a bank
customer [like me] until now".
The role
of banks in the Enron fraud When
speculation grew about the role Citibank played in
the collapse of Enron, shares of Citigroup fell
12%.
The US Senate heard testimony from
Senate investigators about the role US banks and
their investment-bank subsidiaries might have
played in backing the specious accounting at Enron
in a complex scheme known as "pre-pays", under
which Enron booked loans as energy trades and thus
as profits to make the firm look far more
profitable than it really was.
The
investigators contended that Enron could not have
shown such profitability but for the shady help of
large commercial banks, such as Citigroup and
JPMorgan Chase, and their investment-banking arms.
Under General Accepted Accounting Principles
(GAAP), loans issued to Enron should have been
booked as debt rather than revenue.
Both
Citigroup and JPMorgan claimed that "pre-pay"
transactions are entirely lawful.
Each
bank engaged in about a dozen deals that involved
questionable transactions with the failed energy
trader. Enron then illegally hid the loans by
cloaking them in transactions that were booked as
energy trades to show it was earning more money
than it really was. This in turned boosted not
only Enron's share price but also its credit
rating, permitting it to continue to secure loans
at preferential rates. The convoluted transactions
involved the leveraged purchase of natural gas and
other commodities over long periods with credit to
look like sales and booked as revenue to increase
profits.
Outrageously, while Enron booked
the transactions as profits from phantom revenue,
it did not report them on its tax returns,
electing instead to log them as loans to deduct
interest payments. About $5 billion of such loan
amounts remained outstanding when Enron filed for
protection under Chapter 11 of the US Bankruptcy
Code, which allowed the company to operate as a
debtor-in-possession to try to minimize loss to
creditors. According to the Senate report, the
transactions, which took place from 1992 to 2001,
in effect hid part of Enron's mounting debt, which
eventually bankrupted the doomed energy giant.
The University of California, whose
pension fund invested in Enron stocks, led a
shareholder class-action suit against Enron and
its banks, alleging that internal Enron documents
and testimony of bank employees detailed how the
banks engineered sham transactions to keep
billions of dollars of debt off Enron's balance
sheet and create the illusion of increased
earnings and operating cash flow.
The suit
listed specifically that Merrill Lynch purchased
Nigerian barges from Enron on the last day of 1999
only because Enron secretly promised to buy the
barges back within six months, guaranteeing
Merrill Lynch a profit of more than 20%. As a
result of this fraud, Merrill Lynch ultimately
paid $80 million to settle with the SEC.
Also listed as evidence was the fact that
Barclays Bank entered several sham transactions
with Enron, including creating a "special-purpose
entity" called Colonnade, a shell company to hide
Enron's debt, named after the street in London
where the bank is headquartered. Also on the list
was investment bank Credit Suisse First Boston,
which engaged in "pre-pay" transactions with
Enron, including serving as one of the stop-offs
for a series of round-trip, risk-free commodities
deals in which commodities were never actually
transferred or delivered.
Although the
three lead banks and others settled with the Enron
fraud victims for $7.2 billion, several huge banks
named in this suit still have not paid a penny to
the victims of the fraud. After years of trial
preparation and just a few weeks before the
scheduled trial, a 2-1 Fifth Circuit Court of
Appeals decision on March 19 let the banks off the
hook and destroyed the hope of Enron victims for
any further recovery.
The appeals court
acknowledged that the conduct of the banks was
"hardly praiseworthy", but ruled that because the
banks
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