The collapse of Enron has swiftly morphed into a go-to-jail financial scandal, laden with the heavy breathing of political fixers, but Enron makes visible a more profound scandal--the failure of market orthodoxy itself. Enron, accompanied by a supporting cast from banking, accounting and Washington politics, is a virtual piñata of corrupt practices and betrayed obligations to investors, taxpayers and voters. But these matters ought not to surprise anyone, because they have been familiar, recurring outrages during the recent reign of high-flying Wall Street. This time, the distinctive scale may make it harder to brush them aside. "There are many more Enrons out there," a well-placed Washington lawyer confided. He knows because he has represented a couple of them.
The rot in America's financial system is structural and systemic. It consists of lying, cheating and stealing on a grand scale, but most offenses seem depersonalized because the transactions are so complex and remote from ordinary human criminality. The various cops-and-robbers investigations now under way will provide the story line for coming months, but the heart of the matter lies deeper than individual venality. In this era of deregulation and laissez-faire ideology, the essential premise has been that market forces discipline and punish the errant players more effectively than government does. To produce greater efficiency and innovation, government was told to back off, and it largely has. "Transparency" became the exalted buzzword. The market discipline would be exercised by investors acting on honest information supplied by the banks and brokerages holding their money, "independent" corporate directors and outside auditors, and regular disclosure reports required by the Securities and Exchange Commission and other regulatory agencies. The Enron story makes a sick joke of all these safeguards.
But the rot consists of more than greed and ignorance. The evolving new forms of finance and banking, joined with the permissive culture in Washington, produced an exotic structural nightmare in which some firms are regulated and supervised while others are not. They converge, however, with kereitzu-style back-scratching in the business of lending and investing other people's money. The results are profoundly conflicted loyalties in banks and financial firms--who have fiduciary obligations to the citizens who give them money to invest. Banks and brokerages often cannot tell the truth to retail customers, depositors or investors without potentially injuring the corporate clients that provide huge commissions and profits from investment deals. Sometimes bankers cannot even tell the truth to themselves because they have put their own capital (or government-insured deposits) at risk in the deals. These and other deformities will not be cleaned up overnight (if at all, given the bipartisan political subservience to Wall Street interests). But Enron ought to be seen as the casebook for fundamental reform.
The people bilked in Enron's sudden implosion were not only the 12,000 employees whose 401(k) savings disappeared while Enron insiders were smartly cashing out more than $1 billion of their own shares. The other losers are working people across America. Enron was effectively owned by them. On June 30, before the CEO abruptly resigned and the stock price began its terminal decline, 64 percent of Enron's 744 million shares were owned by institutional investors, mainly pension funds but also mutual funds in which families have individual accounts. At midyear, the company was valued at $36.5 billion, having fallen from $70 billion in less than six months. The share price is now close to zero. Either way you figure it, ordinary Americans--the beneficial owners of pension funds--lost $25-$50 billion because they were told lies by the people and firms they trusted to protect their interests.
This is a shocking but not a new development. Global Crossing went from $60 a share to pennies (as with Enron, the market had said it was worth more than General Motors). CEO Gary Winnick cashed out early for $600 million, but the insiders did not share the bad news with other shareholders. Workers at telephone companies bought by Global Crossing had been compelled to accept its stock in their retirement plans. (Winnick bought a $60 million home in Bel Air, said to be the highest-priced single-family dwelling in America.) Lucent's stock price tanked with similar consequences for employees and shareholders, while executives sold $12 million in shares back to the failing company. (After running Lucent into the ground, CEO Richard McGinn left with an $11.3 million severance package.) There are many Enrons, as the lawyer said.
The disorder writ large by the Enron story is this regular plundering of ordinary Americans, who are saving on their own or who have accepted deferred wages in the form of future retirement benefits. Major pension funds can and do sue for damages when they are defrauded, but this is obviously an impotent form of discipline. Labor Department officials have known the vulnerable spots in pension-fund protection for many years and regularly sent corrective amendments to Congress--ignored under both parties. In the financial world, the larceny is effectively decriminalized--culprits typically settle in cash with fines or settlements, without admitting guilt but promising not to do it again. If jailtime deters garden-variety crime, maybe it would be useful therapy for corporate and financial behavior.
The most important reform that could flow from these disasters is legislation that gives employees, union and nonunion, a voice and role in supervising their own pension funds as well as the growing 401(k) plans. In Enron's case, the employees who were not wiped out were sheet-metal workers at subsidiaries acquired by Enron whose union locals insisted on keeping their own separately managed pension funds. Labor-managed pension funds, with holdings of about $400 billion, are dwarfed by corporate-controlled funds, in which the future beneficiaries are frequently manipulated to enhance the company's bottom line. Yet pension funds supervised jointly by unions and management give better average benefits and broader coverage (despite a few scandals of their own). If pension boards included people whose own money is at stake, it could be a powerful enforcer of responsible behavior.
The corporate transgressions could not have occurred if the supposedly independent watchdogs in the system had not failed to execute their obligations. Wendy Gramm, wife of Senator Phil, the leading Congressional patron of banking's privileges, is an "independent" director of Enron and supposedly speaks for the broader interests of other stakeholders, from the employees to outside shareholders. Instead, she sold early too. With notable exceptions, the "independent" directors on most corporate boards are a well-known sham--typically handpicked by the CEO and loyal to him, even while serving on the executive compensation committees that ratify bloated CEO pay packages. The poster boy for this charade is Michael Eisner of Disney. As CEO, he must answer to a board of directors that includes the principal of his kids' elementary school, actor Sidney Poitier, the architect who designed Eisner's Aspen home and a university president whose school got a $1 million donation from Eisner. As Robert A.G. Monks and Nell Minow, leading critics of corporate governance, asked in one of their books: "Who is watching the watchers?"
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Do not count on "independent" auditors, as Arthur Andersen vividly demonstrated at Enron. While previous scandals did not involve massive document-shredding, Andersen's behavior is actually typical among the Big Five accounting firms that monopolize commercial/financial auditing worldwide. Andersen already faces SEC investigation for its role in "Chainsaw Al" Dunlap's butchery of Sunbeam and has paid $110 million to settle Sunbeam investors' damage suits. A decade ago Andersen fronted for Charles Keating's notorious Lincoln Savings & Loan, which bilked the elderly and then collapsed at taxpayer expense--despite a prestigious seal of approval from Alan Greenspan (Keating went to prison; Greenspan became Federal Reserve Chairman). But why pick on Arthur Andersen? Ernst & Young paid out even more for "recklessly misrepresenting" the profit claims of Cendant Corporation--$335 million to the New York and California public-employee pension funds. Cendant itself has paid out $2.8 billion to injured investors, but hopes to recover some money by suing Ernst & Young. PriceWaterhouseCoopers handled the books at Lucent, accused of inflating profits by $679 million in 2000 and prompting yet another SEC investigation.
The corruption of customary auditing--and the fact that an industry-sponsored board sets the arcane accounting tricks for determining whether profits are real or fictitious--is driven partly by the Big Five's dual role as consultants and auditors. First they help a company set its business strategy, then they examine the books to see if management is telling the truth. This egregious conflict of interest should have been prohibited long ago, but the scandal has reached a ripeness that now calls for a more radical solution--the creation of public auditors, hired by government, paid by insurance fees levied on industry and completely insulated from private interests or politics. Actually, this isn't a very radical idea, since the government already exercises the same close scrutiny and supervision over commercial banks. Because that banking sector lost its primary role in lending during the past two decades, the same public auditing and supervisory protections should be extended to cover the unregulated money-market firms and funds that have displaced the bankers. Enron is unregulated, though it functioned like a giant financial house. So is GE Capital, a money pool much larger than all but a few commercial banks. Mutual funds and hedge funds are essentially free of government scrutiny. So are the exotic financial derivatives that Enron sold and that led to shocking breakdowns like the bankruptcy of Orange County, California.
The government failed too, mainly by going limp in its due diligence but also by withdrawing responsibility through legislative deregulation. The one brave exception was Arthur Levitt, Clinton's SEC commissioner, who gamely raised some of these questions, but without much effect because he was hammered by the industry and its Congressional cheerleaders. Corrupt accountants and investment bankers now have a friendlier commissioner at the SEC--lawyer Harvey Pitt, whose firm has represented Arthur Andersen, each of the Big Five and Ivan Boesky, whose fraud case was settled for $100 million. Pitt blames Arthur Levitt's inquiries for upsetting the accounting industry's self-regulation. Given his connections, Pitt should not just recuse himself from the Enron case--a crisis of legitimacy for the SEC--he should be compelled to resign. Similarly sympathetic cops are scattered throughout the regulatory agencies. At the Federal Reserve, a new governor, Mark Olson, headed "regulatory consulting" in Ernst & Young's Washington office. Another new Fed governor, Memphis banker Susan Bies, has been an active opponent of strengthening derivatives regulation.
But the heart of the scandal resides in New York, not Washington. The major houses of Wall Street play a double game with their customers--doing investment deals with companies in their private offices while their stock analysts are out front whipping up enthusiasm for the same companies' stocks. Think of Goldman Sachs still advising a "buy" on Enron shares last fall, even as the company abruptly revealed a $1.2 billion erasure in shareholder equity. Goldman earned $69 million from Enron underwriting in recent years, the leader among the $323 million Enron paid Wall Street firms. Think of the young Henry Blodget, now famous as Merrill Lynch's never-say-sell tout for the same Nasdaq clients whose fees helped fuel Blodget's $5-million-a-year income (Merrill has begun settling investor lawsuits in cash). Think of Mary Meeker at Morgan Stanley Dean Witter, dubbed the "Queen of the Net" for pumping up Internet firms while Morgan Stanley was taking in $480 million in fees on Internet IPOs. The conflict is not exactly new but has reached staggering dimensions. The brokers whose stock tips you can trust are the ones who don't offer any.
The larger and far more dangerous conflict of interest lies in the convergence of government-insured commercial banks and the investment banks, because this marriage has the potential not only to burn investors but to shake the financial system and entire economy. If the newly created and top-heavy mega-banks get in trouble, their friends in power may arrange another cozy government bailout for those it deems "too big to fail." The banking convergence, slyly under way for years, was formally legalized in the 1999 repeal of Glass-Steagall, the New Deal law that separated the two sectors to eliminate the very kind of self-dealing that the Enron case suggests may be threatening again. We don't yet know how much damage has been done to the banking system, but its losses seem to grow with each new revelation. JP Morgan Chase and Citigroup provided billions to Enron while also stage-managing its huge investment deals around the world and arranging a fire-sale buyout by Dynergy that failed (Morgan also played financial backstop for Enron's various kinds of trading transactions). Instead of backing off and demanding more prudent management, these two banks lent additional billions during Enron's final days, perhaps trying to save their own positions (we don't yet know). Instead of warning other banks of the rising dangers, Chase and Citi led the happy talk. Both have syndicated many billions in bank loans to other commercial banks--a rich fee-generating business that allows them to pass the risks on to others (federal regulators report that the volume of "adversely classified" syndicated loans has risen to 8 percent, tripling the problem loans since 1998).
These facts may help explain why former Treasury Secretary Robert Rubin, now of Citigroup, called an old friend at Treasury and suggested federal intervention. Rubin's bank has a large and growing hole in its own loan portfolio. Could Treasury please pressure the credit-rating agencies, Rubin asked, not to downgrade Enron? Though he styles himself as a high-minded public servant, Rubin was trying to save his own ass. Indeed, he called the very Treasury official who, as an officer of the New York Federal Reserve back in 1998, had engineered the cozy bailout of Long Term Capital Management--the failing hedge fund that Citigroup, Merrill and other major financial houses had financed. Gentlemanly solicitude for big boys who get in trouble connects Washington with Wall Street and spans both political parties.
In this new world of laissez-faire, when things go blooey, the government itself is exposed to risk alongside hapless investors--if the commercial banks are lending federally insured deposits along with their own investment plays or are exercising what amounts to an equity position in the failed management. This is allegedly forbidden by "firewalls" within the mega-banks, but when a banker gets in deep enough trouble, he may be tempted to use the creative accounting needed to slip around firewalls. "A bank that has equity shares in a company that goes south can no longer make neutral, objective judgments about when to cut off credit," said Tom Schlesinger, executive director of the Financial Markets Center. "The rationale for repealing Glass-Steagall was that it would create more diversified banks and therefore more stability. What I see in these mega-banks is not diversification but more concentration of risk, which puts the taxpayers on the hook. It also creates a financial sector much less responsive to the real needs of the economy."
The fallacies of our era are on the table now, visible for all to see, but the follies are unlikely to be challenged promptly--not without great political agitation. The other obvious deformity exposed by Enron is the insidious corruption of democracy by political money. The routine buying of politicians, federal regulators and laws does not constitute a go-to-jail scandal since it all appears to be legal. But we do have a strong new brief for enacting campaign finance reform that is real. The market ideology has produced the best government that money can buy. The looting is unlikely to end so long as democracy is for sale.