Inside Job (24 page)
Authors: Charles Ferguson
Enron’s accounting firm, Arthur Andersen, was criminally prosecuted and forced out of business. Several Enron executives went to prison; the former president, Jeffrey Skilling, is still
serving his twenty-four-year term, while Kenneth Lay, the CEO, died shortly before commencing his sentence. Class-action lawsuits were also filed against Enron, Arthur Andersen, and the banks. A
partial list of the financial settlements with the banks from both the private and public actions are shown in Table 2 below.
But not a single one of the banks, or the individual bankers, that helped Enron fake its profits was criminally prosecuted. Aiding and abetting fraud was now
permissible.
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The Internet Bubble: Eliot Spitzer as a Lonely Man
AT THE SAME
several banks were helping Enron commit accounting fraud, the Internet frenzy was driving the US stock market, particularly the Nasdaq.
Nearly the entire investment banking industry, its oldest and most prestigious firms very much included, fraudulently magnified the Internet bubble to gain business. The Internet bubble marked the
first appearance of the new culture of dishonesty throughout mainstream finance.
Consider a priceless exchange between a Merrill Lynch broker and Henry Blodget, a youthful Merrill technology analyst, in 1998. In an internal e-mail regarding one of his favourite stock
recommendations, Blodget described his private view of the company as “pos”. The broker asked Blodget why his view was “positive”, since she thought the company’s
numbers looked pretty weak. Blodget helpfully explained that “pos” didn’t mean positive. It meant
piece of shit
.
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Morgan Stanley’s Mary Meeker, another star technology analyst, was reportedly paid oceans of money for helping Morgan Stanley secure Amazon’s investment banking business. (Both she
and the bank were later sued on the basis of those conflicts.) Meeker was also deeply involved in pitching the AOL/Time Warner merger to the Time Warner board. Morgan Stanley stood to reap a large
fee if the deal closed. And close it did, becoming one of the worst corporate mergers in history.
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Even Blodget and Meeker weren’t as conflicted as Jack Grubman, the telecommunications analyst at Salomon Brothers (later Salomon Smith Barney). For years, he pushed Global Crossing and
WorldCom, both of which turned out to be fraudulent disasters. Grubman was especially close to Bernie Ebbers, then CEO of WorldCom, coaching him on his presentations to other analysts. Ebbers was
later convicted of
accounting fraud, and is still in prison. An angry broker complained that Grubman maintained his “buy” rating on Global Crossing “from
$60 all the way down to $1.”
As the bubble peaked, Grubman decided to downgrade a half dozen of the companies he followed but then reversed himself at the request of the investment bankers. After long denigrating AT&T,
he switched to a “strong buy” in 1999—allegedly based on the company’s new cable strategy, but really, it appears, because Salomon’s new parent, Citigroup, had just
won AT&T’s investment banking business.
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Such behaviour was common during the Internet bubble. Particularly for dot-com companies, the divergence between investment banks’ public statements and the private views of analysts was
frequently vast. Investment banks supposedly maintained “Chinese walls” between their research and investment banking departments, but it was a charade. Favourable analysts’
reports were a key marketing tool in selling investment banking services, and analysts’ pay was explicitly based on the investment banking revenues they generated. So they danced to their
masters’ tune, much as the rating agencies did during the mortgage bubble.
The Internet bubble was very profitable—the volume of private placements, IPOs, mergers, and acquisitions was far greater than anything seen before on Wall Street. A very high fraction of
it was fraudulent, and it caused an enormous wave of losses, bankruptcies, failed acquisitions, and write-downs in 2000 through 2002. Companies such as Excite, Infospace, pets.com, WorldCom, Covad,
Global Crossing, boo.com, startups.com, Webvan, e.digital, and many others received high investment ratings from bankers shortly before collapsing. Frequently the banks also paid fees, which might
be considered barely disguised bribes, to individual executives in order to obtain their company’s business. But because the major investment banks all wanted IPO business, and because they
syndicated portions of most IPOs to each other, none of them was incented to be honest in their analyst research.
The Clinton administration did nothing—not the SEC, not the Justice Department, nobody. The Bush administration was no better. The
SEC became interested only after
the New York State attorney general, Eliot Spitzer, filed a series of highly publicized lawsuits against the leading banks, which public pressure then compelled the SEC to support. In late 2002
there was a mass settlement with ten banks for $1.4 billion for “fraudulent research reports”, “supervisory deficiencies”, and subjecting analysts to “inappropriate
pressures” from investment bankers. The largest single penalty, $400 million, was paid by Citigroup, while Merrill and Credit Suisse First Boston paid $200 million each, and Goldman Sachs
paid $110 million. A few mid-level analysts—
very
few—were prosecuted. Blodget and Grubman were barred from the securities industry for life and paid fines of $4 million and $15
million, respectively. Meeker was not fined and went on to lead Morgan Stanley’s technology research unit.
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Here are some excerpts from my interview with Eliot Spitzer.
SPITZER
:
Indeed, the defence that was proffered by many of the investment banks was not “You’re wrong”; it was
“Everybody’s doing it, and everybody knows it’s going on, and therefore nobody should rely on these analysts anyway.”
CF
:
Did they really say that to you?
SPITZER
:
Oh yes . . . this was said to us. This was . . . And the other piece of it was, “Yes, you’re right, but
we’re not as bad as our competitors, because everybody does it, and you should go after them first.” And so there really wasn’t an effort to deny that this intersection of
analysts and investment bankers had generated a toxic combination. It was really, “Why are you going after us?” Again, it was the jurisdictional issue, and there were what they
called Spitzer amendments floated up on Capitol Hill. Morgan Stanley went down to the House Financial Services Committee, this is when it was under Republican control, and they worked very hard
with the SEC support to get an amendment through that would’ve limited and eliminated our jurisdiction and our ability to ask the questions. We beat that back with a fair bit of
publicity.
Then I asked him about criminal prosecution:
CF
:
Did you ever think of prosecuting any of these people criminally?
SPITZER
:
We thought long and hard about it.
CF
:
Why didn’t you?
SPITZER
:
I’ll tell you why. . . . The only realistic targets in that criminal case would’ve been the analysts who are
essentially mid-level individuals at the investment houses. And so I said to myself, “Yes, we could probably make a criminal case against a mid-level analyst, but the analyst is doing
what he has been asked and told to do by the creation of an entire structure that preordained this outcome.” We probably won’t be able to make a criminal case against those higher
up in the spectrum.
CF
:
Even though you think they were guilty?
SPITZER
:
Even though they understood that the system was generating analytical work that was flawed, it was going to be impossible to
prove that the CEO knowingly instructed somebody to say something that was untrue, just because the e-mail chatter was down [t]here. As you move up the hierarchy, the CEO would say,
“Well, of course we have analysts, of course they’re telling the truth. Now, do we compensate them based upon how much investment banking business they bring in? Sure, but I never
said to them, ‘Lie.’ ” But the lies flowed almost necessarily from the system that was created.
CF
:
Was it, and is it, your personal opinion that the senior people were in fact guilty?
SPITZER
:
My view is that anybody within the investment bank was aware of the fact that the analytical work was tainted by the desire
to bring in investment banking business, and that . . . the entire business model depended upon it. . . .
So if you use the word “guilty” in a generic sense, yes, they were guilty of knowing that something was wrong. Guilty in a
sense that they were provably
guilty of a criminal case is a very different matter.
CF
:
Not provably. My question was not about . . . I understand your point about proof. But there’s a difference between proof and what your
opinion is about their real culpability.
SPITZER
:
Were they guilty of knowing that the analytical work was being tainted and damaged by the desire to get investment banking
business? Yes.
Part of Spitzer’s reluctance to prosecute may have come from the realities of his situation. He had fewer than twenty attorneys dealing with the investment banks, who outspent him at least
ten to one; the Bush administration and the SEC were, to put it mildly, unenthusiastic; and although the offences and their damage were serious by the standards of the time, they were utterly
trivial compared to those committed since. The question of proof is, of course, an important one, and we will return to it in considering the mortgage bubble and the financial crisis.
JPMorgan Chase Captures a County
MUNICIPAL BOND ISSUANCE
is one of the murkier backwaters of finance, as subprime mortgages used to be. It is also notoriously corrupt, and left a wake
of extraordinary destruction in Alabama’s Jefferson County, which includes the state’s largest city, Birmingham.
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In the late 1990s, Jefferson County settled a long-running dispute with the US Environmental Protection Agency by undertaking a major sewer project, financed with $2.9 billion in long-term
fixed-rate bonds with an interest rate of 5.25 percent. As rates fell in the early 2000s, bankers descended on the county offering to restructure the debt and save millions in interest payments.
JPMorgan Chase led a group of thirteen banks in structuring the deal and allocating its components. Instead of simply refinancing with straightforward fixed-rate bonds at
a
lower rate, the banks created an artificially complex deal to increase their fees. They issued $3 billion in various floating-rate instruments, while supposedly offsetting the risk of rate
increases with interest-rate swaps. JPMorgan Chase used instruments called auction-rate securities, which caused billions in losses for many cities in 2008, along with other variable-rate
bonds.
According to Bloomberg and the SEC, the banks earned $55 million in fees for selling the auction-rate securities. The interest-rate swap contracts generated another $120 million in fees, which,
according to an analyst later engaged by the county, was about six times the market norm. JPMorgan Chase was able to make this deal because it
also
made under-the-table payments of $8.2
million to local officials and brokerage firms. The largest payments, however, were made to other banks, including $3 million to Goldman Sachs and $1.4 million to a New York municipal bond
specialist for agreeing to withdraw from the competition. All of the illicit payments were charged as fees deducted from the funds raised for the county. Naturally, there was no disclosure of the
payments in the bond prospectuses.
At first the overall deal, leaving aside the inflated banking fees and bribes, appeared to work. The county commissioners bragged about their financial prowess, and Morgan helped them set up
seminars for other counties. But when the exotic bonds that JPMorgan Chase had recommended collapsed during the financial crisis of 2008, the transaction turned into a disaster. When the county
announced that it would exit the deal, JPMorgan Chase billed the county $647 million, and threatened to sue.
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As this is written, the county has defaulted on most of its debt and declared bankruptcy. The sewage improvements may never be completed, and sewage and water rates have risen to the point where
poorer residents must choose between heat and water. The SEC forced JPMorgan Chase to drop its breakup fee and to pay the county $50
million in damages on top of a $10
million fine. The local prosecutor has won prison sentences for the corrupt county commissioners.