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The Role of Investment Banks in the Boom and Bust
The decade of the 1990’s saw tremendous economic growth in America. Significant advancements in technology, the growth of Internet commerce, and government efforts toward market deregulation resulted in a bullish stock market, instilling a general sense of optimism that pushed business investment to new heights. By every apparent measure, America was experiencing an unprecedented economic boom. As we now know, the “irrational exuberance” of the era was due in no small part to deceptive accounting practices and lax oversight and underwriting processes which inflated corporate earnings and resulted in heavy investor losses. While most of the media’s attention has focused on the “creative” accounting of those firms who fell the hardest, investment banks such as Merrill Lynch, Citigroup’s investment division, Salomon Smith Barney, and J.P. Morgan-Chase succumbed to the temptations of the market and played a major role in tainting corporate balance sheets. Investment banks facilitated the creation of special-purpose entities (SPEs) intended to hide or re-classify debt through structured financings and prepay transactions, all of which was designed to augment the value of their clients stock. We will take a look at a few of the more complex and egregious examples of this behavior in examining the role investment banks as a whole played in the 90’s in fabricating earnings, hiding debt, and fraudulently promoting client stocks. As previously mentioned, many people attribute the bursting of “the bubble” to accounting firms such as Arthur Anderson, whose strong reputation was destroyed by the accounting scandal that felled giant Enron. In the years that would follow, Congress and federal regulatory agencies would pass the Sarbanes-Oxley Act, which stipulated that executive management must personally sign off on all financial statements, effectively eliminating the “golden parachute” of plausible deniability in the event of any irregularities. What has received far less fanfare, however, was the role investment banks played in these deceptions. Consider the example of Global Crossing, a telecommunications firm whose bankruptcy filing was the fourth largest in US history. According to a 2003 investigation by the General Accounting Office, research analysts at Merrill Lynch and Salomon Smith Barney were allegedly pressured to issue misleading research reports on Global Crossing’s financial status in exchange for potential investment banking contracts. In 1999 alone, over $4 billion in underwriting fees for I.P.O stock was paid to investment banks, the largest annual total for that service in history. Given that Global Crossing was about to go public in an industry experiencing explosive growth, the lure of these lucrative contracts allegedly seduced Salomon Smith Barney to issue unwarranted buy ratings. Similar allegations have been made against Salomon Smith Barney involving an I.P.O of stock for another telecommunications firm, Qwest, and an arrangement Salomon entered into with the C.E.O of WorldCom, Bernie Ebbers. In 1997, Salomon Brothers, as they were then called, offered Ebbers more than two-hundred thousand I.P.O shares of Qwest. This pre-market purchase would quickly payoff for Ebbers, as the heat of the market drove Qwest stock up twenty-seven percent within the first three days of its release. According to the G.A.O, between 1996 and 2001, Salomon helped Ebbers make eleven million dollars by giving him favorable buy positions in I.P.O releases. During that same time, WorldCom paid Salomon a hundred and forty million dollars in fees for its underwriting of the company's debt and equity, and another seventy-six million in fees for its advice on mergers and acquisitions. While Qwest and WorldCom became household names after their precipitous falls and Salomon was pulled from the jaws of ignominy when it was purchased by Citigroup, the damage to the markets had been done. The conflict of interest between the due diligence duties of research analysts and the sales culture of the traditional investment banking side of the business caused Salomon, as well as other investment banks, to engage in securities fraud for profit. The 90’s boom market also elicited investment banks to engage in less direct, but equally deceitful business arrangements to assist clients in ameliorating the bottom line. In the case of Merrill Lynch’s dealings with the energy trading giant Enron, Merrill established a special purpose entity as a vehicle through which Enron would engage in a structured financing arrangement designed to disguise debt as net income. First, it is important to bear in mind that throughout the financial world, SPEs can and do act as legitimate sources of cash for the sponsor entity in exchange for securities backed by the funds. Additionally, SPEs may be used to generate assets the sponsor entity uses toward other financial arrangements, all of which is lawful and customary. However, under the generally accepted accounting principles put forth by the Financial Accounting Standards Board, SPEs meeting certain criteria do not appear on the balance sheet of the sponsoring entity. Thus, transactions in connection with an SPE can be legally excluded from the sponsor entity’s financial statements. It was this categorical flexibility which Enron exploited through the use of an SPE known as Ebarge, LLC (Ebarge) established by Merrill Lynch in 1999, to whom Enron sold three Nigerian power barges and reported a net gain just two days before the year-end closing date of their financial statements. Through a series of complex financial arrangements involving the sale of the barges and a verbal agreement to liquidate Merrill Lynch’s equity exposure in the deal at a specified level of return within six months, Enron reported Merrill Lynch’s involvement, which was in essence a loan, as an investment. Therefore, instead of recording gains from selling an asset, Enron should have reported the transaction as a secured borrowing, thereby reducing the company’s net income and increasing its debt outstanding. Merrill Lynch would later contend in court that they were told by Enron the transaction had been vetted by outside auditors. Nevertheless, in whatever capacity they served Enron, it is reasonable to suspect that Merrill Lynch knew they were engaging in an illicit exchange which would ultimately overstate Enron’s earnings. Because of Merrill Lynch’s involvement in this and other spurious business dealings, the Securities and Exchanges Commission and Attorney General of New York Eliot Spitzer levied over two-hundred million dollars combined in penalties against Merrill Lynch in May of 2002, not including a four million dollar fine on a top Merrill internet analyst, Henry Blodget, who was also barred from the securities industry the following year. J.P. Morgan Chase also entered into dubious dealings with Enron revolving around an SPE. They created Mahonia, LTD (Mahonia) to misrepresent several billion dollars in loans from offshore entities to Enron as energy trades. Using prepay transactions, which were and still are commonplace in the energy trading industry, Enron received cash in advance on futures contracts with Mahonia, which was ostensibly presented as a 3rd-party in the deal but was actually controlled by Chase. Again, Enron was able to use the SPE reporting loophole to transform the loans into cash flow generated by “energy trading activities.” Federal investigations into these transactions have revealed that between 1992 and 2001, Enron and Chase conducted a total of twelve such prepay transactions with a combined value of over $3.7 billion. As we have seen, investment banks played a significant role in defrauding investors in the 1990’s. Firms used investment banks to artificially inflate earnings in return for highly profitable securities deals. The deregulation push occurring in the decade prior dissolved the legal boundaries that had previously kept certain financial institutions separated, such as investment banks, broker-dealers, and insurance firms, now allowing them to aggregate their services into large financial holding companies. The Graham-Leach-Bliley Act of 1999 repealed most of those restrictions which had been in place since 1933. The result was a conflict of interest between the various business units within those holding companies. The traditional role of investment analysts as objective counsel on stock purchases disappeared, transforming impartial advisors into so-called “sell-side analysts,” whose goal was to increase the earnings of clients in whom the investment banks had an interest. Likewise, the traditional banking side was affected by the moral hazard temptation: the possibility of promising investment deals provided an incentive to loosen due diligence processes and create loans to unsound firms in the hopes of attracting them as clients. The advantage of investment banks as being a wholly unbiased, separate control on the market was lost. Corporate behavior went unchecked, causing serious damage to the strength of the US economy and the reputation of the financial community. Essential to the proper functioning of financial markets are the complementary principles of trust and risk. As history has shown, the era of the 1990’s was an example of where conflicts of interest within investment banks compromised the transparency of both the creditworthiness of firms (trust in them as solid businesses) and the returns on investments (the accuracy of risk), all in the pursuit of profits. As Congress and federal regulators continue developing legislation to avoid a repeat of such a crisis, the 3 pillar approach of good risk management, wise capital management, and tempered market discipline will hopefully become the standard for current and future members of the investment banking world.
Works Cited
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