Posted on 08/12/2002 6:24:13 PM PDT by shrinkermd
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.
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