Citigroup chairman Sanford I. Weill hasn’t had much to say about Enron since the scandal broke. But in late July he made a remark that pretty well summed up his feelings: “I wish I’d never heard of Enron.” In fact, Weill would probably love to erase WorldCom, Adelphia, Tyco, Qwest, and a number of other financial train wrecks from his short-term memory too.
So, no doubt, would William Harrison, chairman of J.P. Morgan Chase, Citigroup’s No. 1 competitor. Let’s face it: It has been a long, uncomfortable summer for the two banking behemoths, which seem to be in the hot seat every time a financial scandal or corporate bankruptcy pops up these days. It was Citigroup that loaned $300 million to WorldCom, and J.P. Morgan that was up to its neck with Adelphia and Kmart. In a July Senate hearing, damning internal e-mails emerged showing how the two banks may have helped Enron hide $8.5 billion in debt from investors. As regulators were investigating the actions of Citigroup’s star telecom analyst Jack Grubman, a former employee stepped forward claiming Grubman allocated shares in hot tech IPOs to various telecom CEOs in return for investment-banking deals. The banks even suffered the indignity of an attack on the Wall Street Journal’s editorial page, which labeled them “Enron enablers”–and said they deserved the beating they were getting in the press.
Whatever business matters may underlie their behavior, the most serious issue for the two banks may be reputational. They appear to have loaned money without really caring whether their clients could pay it back. They appear to have leveraged their balance sheets to get investment banking business from their borrowers. They appear to have behaved in a guileful way and helped their corporate clients undertake unsavory practices. And they appear to have had an entire division that, among other things, helped corporations avoid taxes and manipulate their balance sheets through something called structured finance, which is a huge profit center for each bank.
J.P. Morgan and Citi have already paid a steep price. During the Senate hearings, investors shaved $46 billion in market capitalization from Citigroup in two days and $12 billion from J.P. Morgan Chase. The banks have also lost the trust of many clients. Pension funds–among their most important customers for stock and bond offerings–are filing lawsuits alleging that the banks didn’t do their homework on Enron and WorldCom.
And the worst may be yet to come. J.P. Morgan and Citi could face a litany of civil and criminal charges. Reports say Manhattan district attorney Robert Morgenthau’s office is making inquiries into the banks’ transactions with Enron. If prosecutors can prove the banks helped Enron and WorldCom dupe investors, they could be on the hook for billions in fines and settlements, according to Donald Langevoort, a professor at Georgetown University School of Law. “For the eight or ten Wall Street firms that were involved in multiple deals, we could be talking anywhere from $10 billion to $100 billion” in civil and criminal penalties and settlements, says Langevoort. “This is the next big area of civil litigation,” agrees Dennis H. Taylor, a former SEC investigator and special U.S. Attorney who is now with the Texas law firm Shepherd Smith & Bebel. “There were the breast-implant lawsuits. Then asbestos. This is going to be Wall Street’s asbestos case.”
Even now, after all the ugly revelations, the banks insist they have done nothing wrong. They say that their due-diligence process is sound, that they are not to blame for duplicity by Enron and WorldCom, that Enron bears the responsibility for misusing their exotic financial structures to hide debt, and that there is no link between their lending practices in the late 1990s and the record number of telecom bankruptcies this past year.
Few find such explanations convincing. Ever since the Glass-Steagall Act was repealed in 1999, financial institutions have been free to operate as one-stop-shopping centers for commercial and investment banking. Both J.P. Morgan and Citi have used their hefty balance sheets to dispense cheap loans and lines of credit while consulting on mergers and acquisitions, underwriting equity issues, and floating high-yield bonds. The banks strenuously maintain they never used their lending clout to win lucrative investment-banking deals. But one former banker says, “Look at who was making the big loans to the top telecoms and who was doing the telecom [underwriting] deals. That’s not a coincidence.” Between 1998 and 2001, J.P. Morgan Chase and Citigroup increased their share in nearly every realm of corporate financing. (The banks chalk up those gains to strong execution abilities and good customer relationships.)
What has really gotten the banks into trouble in the short term is structured finance, one of their fastest-growing and most profitable activities. Structured finance covers a lot of territory. It might involve simple financing of capital projects. But it also includes complicated deals that let companies carve off assets–mortgages, leases, or accounts receivables, say–and borrow money based on their value. Often companies create so-called special-purpose entities (SPEs) to hold these assets. SPEs, in turn, are often located offshore (think the Cayman Islands) and usually off the balance sheet of the client, helping cut tax liabilities. It’s a high-margin business for the banks: Analysts estimate that structured finance accounted for 20% of J.P. Morgan Chase’s profits last year and 10% of Citigroup’s.
In fact, there’s nothing new about structured finance. Chase created Enron’s first SPE, named Mahonia, in 1993. The initial goal of the entity was to reduce Enron’s taxes. But according to Senate investigators, Enron later used Mahonia, as well as a Citigroup-designed entity called Delta, to disguise $8.5 billion in bank loans as energy trades in an arrangement called a prepay. When legit, an energy prepay treats the money received from a bank as payment for natural gas or oil to be delivered in the future. Except in Enron’s case, allege investigators, the energy contracts were fictitious. If that debt had shown up on Enron’s balance sheet, its debt-to-equity ratio would have been 96% rather than the more palatable 69%.
The banks insist there’s nothing sinister about prepays. They say the transactions were properly accounted for, and if they weren’t, the fault would not be theirs–it’s up to the corporation and its auditors to validate the business purpose of the prepays and determine how they are recorded. Yet internal e-mails indicate that key players inside the banks–including J.P. Morgan Chase co-chairman Marc Shapiro, whose name appears in some of the e-mails–were aware that the deals looked and smelled funny. A May 2001 internal Citibank memo about an Enron prepay suggests adding one penny to the spread between the bid and offering price to make the transaction look a little bit more like a real trade, which would be “good for both [Enron and Citigroup] from an auditing/regulatory perspective.” (A different Citi executive testified to the Senate that the trade was indeed real.) Internal e-mails at J.P. Morgan Chase discuss how Enron loved a particular transaction because it could “hide funded debt from the equity analysts.” And about a month before Enron went bankrupt in 2001, another J.P. Morgan banker expressed amazement at the scope of Enron prepays with other banks: “$5 billion in prepays!!!!!” wrote the banker, to which a colleague responded, “Shut up and delete this e-mail.”
With all the money they raised for failed telcos, how much do the banks stand to lose from their lending activities? As it turns out, not very much–but that raises eyebrows too, because it means the banks shifted all their risk to others. Among their favorite hedges were credit derivatives. In one type of derivative, banks break loans into tiny bits, package them with pieces from many other loans, and sell the hybrid to investors. Citigroup loaned Enron about $4.8 billion over six years, but by using derivatives called credit-linked notes the bank slashed its exposure to $1.2 billion.
If the banks could lay off their risk, what discouraged them from overlending? Perhaps nothing. “Traditionally, when a bank made a loan, the bank would be in the best position to monitor the loan and make sure it gets repaid,” says Frank Partnoy, a former derivatives trader at Morgan Stanley and now a professor at the University of San Diego School of Law. “With Enron, Citigroup had no incentive to monitor whether Enron would repay its debts because it had shifted the risk away.”
The banks insist they followed strict credit policies and didn’t lend too much money to any company or industry. That J.P. Morgan Chase had $2.6 billion of exposure to Enron when it filed for Chapter 11 shows the firm “still had skin in the game,” says an executive at the bank. But about $1 billion of that sum was hedged with an insurance contract and another $1 billion is secured with Enron assets. By contrast, U.S. insurance companies have a $4 billion exposure to Enron stock and bonds, and more than $5 billion to WorldCom. A number of pension funds are suing the banks over an $11.9 billion WorldCom bond offering in May 2001, charging the banks didn’t investigate the “red flags” that would have alerted them to WorldCom’s woes. Furthermore, they say the banks only did the bond deal to keep WorldCom from tapping into its short-term debt facilities, which would have exposed the banks to more risk. The banks say that their due diligence was thorough and that the fraud was of a sort impossible for underwriters to detect.
The nightmare for the banks isn’t over. Their stocks will likely be volatile over the next few months as the investigations unearth more embarrassing information. Earnings could take a hit as nervous corporate executives steer clear of structured-finance products. Belatedly, the banks are trying to buff their reputations with a few quick fixes. In early August, Citigroup’s Weill said that if a corporation won’t fully disclose the debt impact of a structured-finance deal, Citigroup would not participate. Regulators, though, may come up with more stringent reforms. And the banks face years of civil lawsuits that may ultimately cost them billions.
Still, even in this era of the CEO perp walk, criminal charges against the banks aren’t likely. Compared with civil litigation, the hurdle to a guilty verdict in a securities-fraud case is very high because of the difficulty of proving intent. Even handing up an indictment takes tons of time and manpower. If pressed, say analysts, the banks will simply blame their dicey actions on a few rogue personnel. “There will definitely be sacrificial lambs,” predicts Mike Mayo, a bank analyst at Prudential Securities. “And they could be fairly high up in the organization.”
But not too high up. Politically ambitious prosecutors may pull their punches even if they have a good case against the banks. They must consider the effect that allegations of fraud at one of the world’s largest banks would have on the banking system, the global equity markets, and the economy. The e-mails alone sent the Dow into a 236-point tailspin. What would happen if criminal charges were filed? “The backdrop of all of this is a fragile stock market and a lack of investor confidence,” says former Justice Department special prosecutor Taylor. “Any prosecutor who wants to go after a very large financial institution is probably going to have to talk to the Federal Reserve first.”
So the good news for Weill and Harrison in this summer of woe is that Citigroup and J.P. Morgan Chase may simply be too big and powerful for anyone to touch. That could be the bad news for the rest of us.