Page 4 of 5 CREDIT
BUST BYPASSES BANKS Part 1: The
rise of the non-bank financial
system By Henry C K Liu
unit. Grubman, in a two-page
memo to Weill titled "AT&T and the 92nd Street
Y", offered that if Weill, a member of the
AT&T board and a close associate of AT&T
CEO C Michael Armstrong, would help Grubman's twin
children get into a much-sought-after New York
nursery school, Grubman would take on a more
positive view of AT&T's business model as
Weill had suggested. Weill proposed a donation of
$1 million to the school if the Grubman
kids
were admitted.
The exposure of the
Grubman-AT&T deal revealed an embarrassing
picture of how Wall Street firms put their own
interests well ahead of those of the small
investors they were supposed to be helping with
independent research during the years of the
information-technology bubble. The tale eventually
led to the departure of both Grubman and Weill
from Citigroup, with Grubman barred from the
security industry for life. Weill personally
survived the multibillion-dollar Enron fraud
unscathed, only to fall over the questionable
donation of $1 million to help an employee put his
children in a nursery school in return for a
biased stock analysis. Immunity mounts in
proportion to the scale of malfeasance.
On
July 28, 2003, the SEC instituted and settled
enforcement proceedings against JPMorgan Chase and
Co and Citigroup Inc for their roles in Enron's
manipulation of its financial statements. The SEC
accused each institution of helping Enron mislead
its investors by characterizing what were in
essence loan proceeds as cash from operating
activities. The proceeding against Citigroup also
resolved SEC charges stemming from the assistance
Citigroup provided Dynegy Inc in manipulating that
company's financial statements through similar
conduct.
For JPMorgan Chase, the SEC filed
a civil injunctive action in US District Court in
Texas. Without admitting or denying the SEC
allegations, JPMorgan Chase consented to the entry
of a final judgment in that action that would (1)
permanently enjoin JPMorgan Chase from violating
the anti-fraud provisions of US federal securities
laws, and (2) order JPMorgan Chase to pay $135
million as disgorgement, penalty, and interest.
The settlement suggested that JPMorgan Chase had
not been enjoined from violating the anti-fraud
provisions of the federal securities laws before
the Enron collapse.
For Citigroup, the SEC
instituted an administrative proceeding and issued
an order making findings and imposing sanctions.
Without admitting or denying the SEC findings,
Citigroup consented to the issuance of the SEC
Order whereby Citigroup (1) was ordered to cease
and desist from committing or causing any
violation of the anti-fraud provisions of the
federal securities laws, and (2) agreed to pay
$120 million as disgorgement, interest, and
penalty. Of that amount, $101 million pertained to
Citigroup's Enron-related conduct and $19 million
to the Dynegy conduct.
The SEC enjoinment
against the two errant banks is like using the
disallowance of further bank robberies as
punishment for a previous bank robbery.
The SEC intended to direct the money paid
by JPMorgan Chase and Citigroup to fraud victims
($236 million to Enron fraud victims and $19
million to Dynegy fraud victims) pursuant to the
Fair Fund provisions of Section 308(a) of the
Sarbanes-Oxley Act of 2002. That amounted to a
mere pittance of the billions in losses suffered
by the victims.
History repeats
itself On May 10, 2004, Citigroup under new
CEO Charles Prince said that it would pay $2.65
billion to investors who bought securities of
WorldCom that had been highly recommended by its
analyst Jack Grubman before the telecommunications
company collapsed. It also said it would put aside
several billions of dollars more in reserves for
other legal claims, raising the total cost to more
than $10 billion to clean up its problems stemming
from the failure of WorldCom and Enron, as well as
questionable practices in the offering of new
issues and the publishing of sham stock research
during the high-flying days before the tech
stock-market bubble burst.
The after-tax
cost to Citibank would total $4.95 billion, or 95
cents a share against its second-quarter earnings.
Prince emphasized that that was only about equal
to its profit for one quarter, and bond-rating
companies said they would not lower their rankings
of Citigroup's debt. In other words, it was no big
deal.
Before taxes, Citigroup's total cost
of settling the WorldCom suit, paying regulatory
fines relating to Enron and research analysts, and
setting aside reserves for other litigation came
to $9.8 billion, with losses on loans to WorldCom
and Enron adding another $500 million.
"These are historical matters," Prince
said in May 2004. "They arose in a different era."
Last month, it appeared that history was repeating
itself.
SEC tolerance The
enforcement division of the SEC commented on the
settlement with the two errant banks that "if you
know or have reason to know that you are helping a
company mislead its investors, you are in
violation of the federal securities laws". It went
on to say that it intended "to continue to hold
counter-parties responsible for helping companies
manipulate their reported results. Financial
institutions in particular should know better than
to enter into structured transactions where the
structure is determined solely by accounting and
reporting wishes of a public company." It
deflected attention from the fact that the
disciplinary action was merely a gentle tap on the
wrist.
The SEC pointed out that JPMorgan
Chase and Citigroup engaged in, and indeed helped
their clients design and execute, complex
structured finance transactions. The structural
complexity of these transactions had no business
purpose aside from masking the fact that, in
substance, they were loans. As alleged in the
charging documents, by engaging in certain
structural contortions, these financial
institutions helped their clients: (1) inflate
reported cash flow from operating activities; (2)
underreport cash flow from financing activities;
and (3) underreport debt.
As a result,
Enron and Dynegy presented false and misleading
pictures of their financial health and results of
operations. Significantly, with respect to Enron,
both financial institutions knew that Enron
engaged in these transactions specifically to
allay investor, analyst, and rating-agency
concerns about its cash flow from operating
activities and outstanding debt. Citigroup knew
that Dynegy had similar motives for its structured
finance transaction.
As alleged by the
SEC, these institutions knew that Enron engaged in
the structured finance transactions to match its
"mark to market" earnings (paper earnings based on
daily changes in the market value of certain
assets held by Enron) with cash flow from
operating activities. As alleged, by matching
mark-to-market earnings with cash flow from
operating activities, Enron sought to convince
analysts and credit rating agencies that its
reported mark-to-market earnings were real, ie,
that the value of the underlying assets would
ultimately be convertible to cash in full.
The SEC further alleged that these
institutions also knew that these structured
finance transactions yielded another substantial
benefit to Enron: they allowed Enron to hide the
true extent of its borrowings from investors and
rating agencies because sums borrowed in these
structured finance transactions did not appear as
"debt" on Enron's balance sheet. Instead they
appeared as "price risk management liabilities",
"minority interest", or otherwise. In addition,
Enron's obligation to repay those sums was not
otherwise disclosed.
Acting like a Marshal
Wyatt Earp who had just cleaned up Dodge City, the
SEC congratulated itself for cleaning up the Wild,
Wild West of structured finance by gracefully
acknowledged the assistance of the Federal Reserve
Bank of New York, the Office of the Comptroller of
the Currency, and the New York State Banking
Department in connection with its Enron-related
actions. These agreements, between the
institutions and their primary banking regulators,
obligated them to enhance their risk-management
programs and internal controls so as to reduce the
risk of similar misconduct. The regulator focused
only on bank obligation to "reduce the risk of
similar misconduct", not to eliminate the
misconduct entirely. Zero tolerance was not the
message.
With these actions, the SEC
raised to six the total number of separate actions
it brought in connection with the Enron fraud in
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