Capitalism's bad apples: It's the barrel that's rotten
By Henry C K Liu

There is a general rule about the way society treats criminals: place responsibility for antisocial acts on the individual, thus absolving society from blame.

The mismatch between society's attitude toward heroes and criminals rests in society's claim of credit on heroes and rejection of responsibility for criminals. A criminal is one who has betrayed societal values by violating a prescribed code of conduct, who is deranged but not legally insane, a deviant, an anomaly, a manifestation of social disease, a virus against the system, a unit malfunction and a personal malfeasance.

Adolf Hitler was labeled a madman to protect German culture and fascism, notwithstanding the curious fact that Hitler rose to power in Germany in a discernible sociocultural context. Even organized warfare must be conducted within the limits of regulated behavior. War crimes and crimes against humanity are not tolerated.

Yet market fundamentalism argues for wholesale deregulation to allow economic crimes against humanity. Charles Ponzi was deemed an unprincipled conman to insulate unregulated capitalism itself from being revealed as a systemic Ponzi scheme.

In the December 18 US Senate Commerce Committee hearing on the Enron collapse, the verbal barrage that committee members unleashed on Kenneth Lay, the resigned chairman of Enron, once the United States' seventh-largest company and now bankrupt, amounted to wholesale trampling of Lay's constitutional rights. The irony of Fifth Amendment capitalists was not lost on those who remember the McCarthy hearings on communists under the Smith Act, which outlawed a targeted political party in the democratic United States. The issue of Lay's guilt or innocence is of course a matter for the judiciary branch and Lay's right under the constitution's Fifth Amendment to avoid self-incrimination is fundamental to US justice.

The same senators had not been skittish about having their pictures taken with Kenneth Lay the hero capitalist, or accepting vast sums in political contributions from him, his company, his consultants and lobbyists. Up to the sudden collapse of Enron, Lay was regarded by all as the star of deregulated markets, close friend of the president, a political mover and shaker who played key roles in putting George W Bush in the White House, a shining example of the high level of human potential that can be achieved with free enterprise.

Senator Peter Fitzgerald, a Republican from Illinois, comparing Lay to Charles Ponzi, now labeled him worse than a carnival barker, for a carnie will at least "tell you up front that he's running a shell game". Was Fitzgerald telling the nation that deregulated market fundamentalism with structured finance is a shell game?

The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterizes corporate financial statements as "a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South Carolina, characterized Lay's political prowess as "cash and carry government". The New York Times reported the following day that Hollings had received campaign contributions from Enron and Arthur Andersen dating from 1989.

Until Enron filed for bankruptcy, the system's top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering" and the vehicle was structured finance or derivatives.

The prevailing view in the legal profession is that the beleaguered Enron executives will most likely not be convicted of economic crimes under existing laws, only criminal liabilities arising from perjury, conspiracy, obstruction of justice and mail fraud. Anderson, the disgraced accounting/consulting firm, was found guilty of obstruction of justice, but not of economic malfeasance.

Coincidentally, the New York Times carried on the same day of the Senate Enron hearing an obituary on Victor Posner, whose financial dealings landed himself, Ivan Boskey and Michael Milkin, the junk-bond king, in jail over technical criminality for insider trading, but not for the violent damage their good work at Drexel did to the system and the millions of innocent victims in it.

On February 26, Jeffrey K Skilling, former president and chief executive of Enron, who was the sole top company official willing to testify without claiming Fifth Amendment protection, managed to engage accusing senators in a veiled debate about the system's responsibility. Skilling, named in April 2001 by Worth magazine as No 2 of the 50 top CEOs in the US, behind only Steve Ballmer of Microsoft, maintained that while what Enron management did might have been unethical, it was most definitely not illegal within then applicable laws. Yes, the company's management did cause a great deal of financial casualties and destruction, but it is not at all clear that it committed financial war crimes in the eyes of the law. At most, it was collateral damage. At any rate, Enron management did no more than what was common practice industrywide.

Unlike Skilling and his less forthcoming colleagues who can place their financial future under the protection of existing security laws, the lawmakers must subject their political future to the test of public opinion. Thus lawmakers were lining up for the microphone to make indignant grandstanding statements. Yet Skilling was quite effective in laying the blame for the financial mess at the door of unregulated structured finance (derivatives), which Congress, under pressure from the finance industry, had repeatedly refused to regulate, albeit also at the urging of the both the Federal Reserve Board and the Treasury, and even the SEC, which only faintly warned against accounting manipulation of corporate balance sheets.

It is ironic that the head of a company that had vigorously championed deregulation and market discipline, a company whose spectacular recent growth was financed by wholesale theft from the future if not directly the public, by booking future revenue as current income, deferring associated liabilities as off-balance-sheet future capital expenditure, by disguising loans as income with hedges in derivative transactions that produce spectacular instant profit, is now calling for Congress to regulate the widespread use of the "material adverse change" clause in derivative contracts and related financing that allows investors to pull their funds abruptly and completely on practically no notice. Not only was the barn manager allowed to play with fire, he is now asking for the authority to keep the barn doors closed to prevent the horses from fleeing for their lives. To deflect the embarrassing subject, one senator ridiculed the suggestion as a version of the old movie It's a Wonderful Life, notwithstanding that it was a rather good film.

There is another systemic fault that surfaced briefly in the exchanges when Senator Barbara Boxer of California accused Skilling of "unloading" stocks while encouraging unsuspecting Enron employees to buy. When Skilling responded that he too had been hurt by the Enron collapse, being one of the major shareholders as a result of the dubious practice of lucrative stock options granted to management, albeit that his selling of a small portion of his holdings amounted to a proceed of US$60 million, no senator challenged him on what justified that astronomical level of executive compensation. The chairman of Citigroup was reported to have received compensation, including stock options, in excess of $1 billion over the past decade. All accepted it as the American way.

Obscene disparity of income is accepted as the heart rather than the cancer of finance capitalism. Yes, a lot of people connected with Enron at all levels lost 95 percent of their holdings, but the remaining 5 percent of residual asset could range from tens of millions to a mere thousands of dollars. Even if the average employee were exempt from the "lockup" provision in his or her pension plan, and was allowed to bail out his or her pension holdings at $4.50 a share, down from its peak of $90, many would still have walked away with merely a few thousand dollars, putting their retirement dreams in ruins. Risking one's pension with a downside of $60 million is very different from a downside of $6,000, hardly an egalitarian game of a receding tide lowering all boats.

Skilling even ventured to propose introducing deposit insurance for derivative investors, though he fell short of suggesting that the insurance be financed by taxing the peak profits. It is another example of socializing the risk and privatizing the profits. Is Enron the opening shot of the return of New Deal populism? Skilling was probably telling the truth that when he resigned from his post a year ago, he did not expect Enron to go under, or he would have sold out his holdings completely. If Federal Reserve Board chairman Alan Greenspan could not resist denial of the inevitable outcome of a debt bubble, why should a mere mortal like Skilling?

General Electric was dragged into the hearing when the committee staff inaccurately listed GE offshore subsidiaries as numbering only 24 as compared with Enron's 3,000, presumably to show GE as the model of good corporate behavior. Aghast, Skilling responded that most who are in the slightest way familiar with structured finance know that GE has been every bit as aggressive as Enron, and GE in fact is engaged as counterparty in many Enron trades. GE's dominance in the commercial paper market is what gives it the financial advantage over many competitors, including commercial banks, in structured finance. Bankers feared Jack Welch and Gary Wendt (leaders of non-bank financial institutions) more than they fear Saddam Hussein or Osama bin Laden. When Wendt ran GE Capital, he had a reputation of taking no prisoners. GE of course is now facing its own credit rating and share value problems.

With the exception of cases of contempt of Congress, the US legislature is powerless to put any of the Enron officials behind bars, or to force them to disgorge their ill gains. That is the courts' responsibility. Even the SEC can only impose civil fines. The rule of law often allows the unethical but legal to happen with impunity. Already, Greenspan, who steadfastly opposed regulating the structured finance markets, has told Congress that independent boards in corporate governance are harmful to economic growth. Karl Marx left out a big slice when he surmised that surplus value would lead to capitalism's structural demise, in assuming that the financial system was inherently honest. To preserve the mirage of an honest system, Congress needs to find crooked financiers.

Seven months later, the July 24 Senate Subcommittee on Investigation hearing, chaired by Senator Carl M Levin, a Democrat from Michigan, on the role of financial institutions in the Enron scandal fingered JP Morgan Chase and Citigroup, two of the world's largest banks, as culprits in helping Enron Corp arrange billions of dollars in loans that disguised as income to mask its deteriorating financial condition, and to hide the material details of some deals from unsuspecting investors. The subcommittee alleged that JP Morgan Chase and Citigroup were knowing participants in Enron's efforts to disguise billions of dollars of debt as income from energy trades, by using the now notorious "prepay forward commodities transactions" (PFCT). Chase and Citigroup also sold the prepay structures to at least 10 other clients.

The PFCTs brought Enron more than $8.5 billion of misreported income in the six years before it collapsed last fall. Had Enron properly accounted for the loans, its debt obligations would have increased by more than 40 percent, to $14 billion in 2000. That would have led to drastically lower credit ratings for the company. Prepays are arrangements in which companies are paid to deliver a product - in Enron's case, oil and natural gas - at a later date. But Enron and several large banks structured the deals in ways that compromised the independence of the transactions, making them loans rather than sales for accounting purposes. Senate investigators alleged that Enron did not reveal that fact to its shareholders, and instead booked the deals as cash from operations, making its finances look better than they were, thus inflating its share prices.

Chase and Citigroup engaged in the deals by using secretive offshore entities called Mahonia, Delta and Yosemite. Senate investigators alleged that while the entities, based on the Isle of Jersey in the English Channel and in the Cayman Islands, are not legally tied to the banks, they are, in essence, controlled by them through lawyers and charitable trusts. Investors might have been purposefully given misleading information about Enron's health in the sale of notes via the Yosemite investment trust formed by Citigroup. Citigroup raised more than $2.4 billion for Enron in six Yosemite bond offerings between 1999 and 2001.

The prepay deals are also under scrutiny by the Manhattan district attorney's office and the SEC. JP Morgan Chase and Citigroup are also being sued by Enron shareholders. Separately, JP Morgan Chase is fighting in court a group of insurance companies that refuse to pay for the failed prepay deals because they claim to have been deceived about the nature of the transactions.

Senator Levin had the smoking gun in an internal e-mail dated November 1998 within Chase stating that Enron "loves these PFCT deals as they allow Enron to hide funded debts from equity analysts ..." The internal e-mails and recorded phone conversations showed that Chase knew Enron was using prepay deals deceptively, using them to hide what were in effect loans. According to criteria set out by the since disgraced Andersen, Enron's auditor, one of the conditions that must be in place for a prepay to be considered a legitimate transaction is that the third party involved had to be independent.

Mahonia, the offshore vehicle known as a Special Purpose Entity through which JP Morgan funneled hundreds of millions of dollars to Enron, was set up in the Channel Islands at the behest of JP Morgan. The bank executives claimed that Mahonia was independent, to the visible dissatisfaction of Levin, who called Enron's use of the prepays to disguise debt "an accounting sham" and said the company had "the help and knowing assistance of some of the biggest financial institutions in our country". The senator referred to a recording of a telephone conversation last September between Morgan and Enron executives in which they discussed ways to make Mahonia appear more independent, such as getting it a separate fax number.

Senate investigators alleged that the banks collected large fees and earned consideration for more deals with Enron, in addition to interest payments, for structuring the PFCT deals. Both banks are counterattacking, arguing that their actions were consistent with years of widespread industry practice and had been vetted by lawyers and auditors. PFCT is a common and widely used form of structured finance.

As the biggest trader of derivatives, JP Morgan Chase also dismissed speculation that it may have to put up more money to satisfy counterparty credit requirements should its stock price fall below a certain level. Derivatives are contracts whose value is derived from underlying securities or commodities. Marc Shapiro, vice chairman for finance, risk management and administration at JP Morgan Chase and Co, told the press that prepays are routine structured finance plays that enable corporations to get funds from new sources that have fueled the boom of the past decade, and that it is "gross injustice" to the people involved suddenly to label it fraud now. Shapiro, co-chairman of the merger integration team within JP Morgan and Chase and a member of the merged firm's executive and management committees, outlined six tenets of success in financial risk management in a recent speech: diversification, independence, transparency, alignment, active management and the importance of stress tests. The Enron case apparently fell short on all six tenets. There was structural misalignment of incentives that led to deviant behavior by executives.

JP Morgan Chase issued a press release on Monday together with a letter signed by chief executive officer William B Harrison in response to the United States Senate's Permanent Subcommittee on Investigations' request last Thursday for additional information about Mahonia, which states: "The capital markets system in the United States has been a key contributor to the most powerful economy in the world. Structured finance and Special Purpose Entities are important components in that system and contribute significantly to our economy. They are designed to help clients meet their financing needs, including reducing their borrowing costs, improving liquidity and diversifying their funding sources. Special Purpose Entities are used in transactions that range from the commonplace, including mortgage-backed securities and credit card securitizations, to highly structured transactions. The fact that structured finance transactions may be complex or that Special Purpose Entities may be organized offshore does not make them improper or unethical."

The thrust of the subcommittee hearing was that more disclosure of off-balance-sheet debts or liabilities is needed to prevent abuse. Yet the focus on disclosure is obviously misdirected. With more disclosure, these deals would not have been done because their whole purpose was to evade existing disclosure requirements on financial manipulations to provide corporations with funds which they otherwise could not raise. Several witnesses from the finance industry and regulating agencies testified that there was nothing wrong with these structured finance deals if full disclosure was made. It is the same as saying that murder is all right if no killing is involved.

Derivatives can be used to restructure transactions so that liability positions are legally moved off balance sheet, floating rates turned into fixed rates (and vice versa), currency denominations changed, interest or dividend income can become capital gains (and vice versa), liability turned into assets or revenue, payments moved into different periods in order to manipulate tax liabilities and earnings reports, and high-yield securities made to look like conventional AAA investments (See The dangers of derivatives , May 23.)

So what is full disclosure? To tell the investing public that structured finance is an elaborate arrangement to mask the real financial condition of corporations? That, by the way, before you invest in this company, the management would like to tell you that the income reported in the balance sheet is not real?

The dilemma for Congress is that while Enron's bankers are in the hot seat for alleged corporate and bank fraud, structured finance is on trial for systemic fraud. But structured finance is so widely used that if it should be stalled by new requirements of full disclosure, the financial system as it currently exists might well end.

WorldCom has overshadowed Enron as the largest bankruptcy in history. Federal prosecutors have let it be known that fired top executives of WorldCom will be indicted for fraud within days. The company admitted it inflated earnings by nearly $4 billion. WorldCom also could be indicted as a corporation by the US Justice Department. The SEC, citing "accounting improprieties of unprecedented magnitude", filed civil fraud charges last month against WorldCom. Yet it is not clear that these executives can be found guilty independent of systemic fraud, given that what they did was not separable from industry practice norms.

The accounting of IRU (Indefeasible Right of Use) of communication network capacity, particularly "dark trades" of unused fiber-optics capacity widely employed in the telecommunication sector, has inflated revenue for the entire sector, by booking future revenue as current income and related future liabilities as off-balance-sheet future capital expenditure. Global Crossing also has massive IRU problems. Qwest and Sprint are also on the watch list.

Finance capitalism is operating with less and less reliance on capital. Capital has become a notional value in structured finance. Credit is no longer anchored by equity but by circular hedges. Debt-to-equity ratio is no longer a relevant consideration. Practically all US major businesses nowadays, with their high debt leverage based on an unprecedented asset bubble, would have negative real equity if the price/earning (P/E) ratio were to return to historical norms. Blue-chip corporations are being shut out of the unsecured short-term commercial paper market as their credit ratings are downgraded. Corporate credit ratings have been inflated by exorbitant market capitalization value, which in turn reflects irrational P/E ratios. Even now, during what many on Wall Street contend to be a savage bear market, the Standard & Poor's 500 Index yields 25 times earnings. It would have to fall by another 41 percent to reach the median valuation prevailing since 1957. When that happens, the derivative defaults will hit the financial system like a tsunami.

Federal securities regulators investigating the collapse of Enron are turning their eyes toward Wall Street. The SEC, as part of its Enron probe, is reviewing the financing lines that banks such as JP Morgan Chase and Citigroup provided to Enron and other energy-trading companies. Regulators are examining whether the banks helped to create the intricate and misleading financial structure that eventually led to Enron's bankruptcy filing.

Separately, the SEC is reviewing the adequacy of JP Morgan Chase's disclosures about its exposure to Enron and in particular whether these disclosures were made in a timely fashion. The Federal Reserve Bank of New York, which has supervisory responsibility of New York banks, is also looking into civil liabilities. The Wall Street Journal criticized both banks by pointing out that "what is legal isn't always ethical".

Both New York banks confirm they have significant exposure to Enron. The role of commercial banks in the Enron saga throws the spotlight on the 1999 Financial Modernization Act, which in effect repealed the Depression-era Glass-Steagall Act. Glass-Steagall was meant to separate the business of lending from underwriting to prevent a repeat of the financial turmoil of 1929, and the Depression that ensued.

The SEC review underscores that Wall Street firms could ultimately face potential liability in the collapse of Enron, and now the second-largest US bankruptcy after WorldCom. At the very least, the review highlights the close ties and varied trading positions Wall Street firms had with Enron. Some of the world's leading banks and brokerage firms provided Enron with crucial help in creating the intricate financial structure that fueled Enron's impressive rise. Enron had billions of dollars of derivatives contracts outstanding with Wall Street, and until these contracts are unwound, the ultimate exposure of securities firms and commercial banks won't be clear. But by now it is clear that Enron was not a unique case.

The Financial Times just revealed that US and European banks and bondholders lent an estimated $500 billion to the crippled US gas and power sector. US energy companies borrowed heavily in the late 1990s to take advantage of deregulation, investing in infrastructure and building up trading operations. The debt of the top eight energy traders soared by 200 percent to $115 billion in the three years to May 2002.

Asia is not immune to corporate fraud and creative accounting. While security laws in Asia are generally less sophisticated with regard to aggressively creative accounting, it does not follow that Asian corporations are less prone to dubious lessons on ingenious structured finance schemes from enveloping-pushing global investment banks.

The ripple effect has surfaced with press reports of Merrill Lynch downgrading four major Hong Kong corporations for potential accounting problems. One of these is deeply involved in telecommunication investment and finance and it would be highly unusual for it to be free of the financial problems facing the debt ridden global sector as a whole. A prominent Hong Kong property tycoon, a US citizen, was an outside director of the Enron board and a member of the board's auditing committee.

JP Morgan Chase and Citigroup are both major players in Asia. It is only natural that what these banks did for Enron, WorldCom and Global Crossing, they would also do for their Asian corporate clients.

Henry C K Liu is chairman of the New York-based Liu Investment Group.

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