An Economy of Two, Three Many Enrons

— Robert Brenner

U.S. TREASURY SECRETARY Paul O'Neill has attributed the mushrooming financial scandals to the immorality of a "small number"of miscreants.  The Wall Street Journal has already listed twenty-seven major companies as under a cloud—including such household names and/or stars of the stock market bubble as Adelphia, AOL Time Warner, Bristol Meyers, Dynegy, Enron, Global Crossing, Kmart, Lucent Technologies, Merck, Qwest, Reliant Services, Rite Aid, Tyco International, Universal, Vivendi, WorldCom, and Xerox.

Since the top two U.S. banks, Citigroup and J.P. Morgan Chase, (as well as Merrill Lynch), are also being probed for criminal conduct, one is entitled to ask what Secretary O'Neill would consider a large number.

This is all the more so as the rapacious practices of these firms, whether or not technically illegal in any given case, are unquestionably endemic to Corporate America.  The scandals bear witness not just to the staggering level of individual corruption characteristic of today's American crony capitalism but to systemic problems in the real economy.

It is because the epidemic of fraud reflects not merely the subjective malice aforethought of corporate leaders, but the objective ill-health of the corporations themselves, that it has taken such a heavy toll on investor confidence and the stock market.

Plummeting Profits, Skyrocketing Stocks

Corporate accounting frauds are the direct outgrowth of a deeply flawed U.S. economic boom between 1995 and 2000 that was largely driven by an historic run up of stock prices—rather than vice versa.  Their raison d'etre was straightforward: to cover up the reality of an increasingly desperate corporate profits picture.

By conveying the appearance of ever-expanding returns, the cooked books enabled stock prices to continue to rise. This allowed corporations to raise money and increase investment in the absence of profits, chief executives to amass fabulous fortunes through stock options even as their firms careened toward bankruptcy, and overcapacity dangerously deepened.  The historic equity price bubble was thus blown up further and the misinvestment boom extended, making the ensuing crash and recession that much more severe.

Between 1997 and 2000, at the very same time as the much-vaunted U.S. economic expansion was reaching its peak, corporate profits in absolute terms and the rate of return on capital stock (plant, equipment, and software) in the non-financial corporate economy were falling sharply—as recently revised figures show, by 15-20% in both cases!

Under normal circumstances, as a consequence of this decline in profits and profitability corporations would have found themselves with reduced surpluses available, while netting diminished funds for capital accumulation from every dollar invested.  They would also have had a smaller incentive to invest, since the realized rate of profit constitutes firms' basic gauge of their expected rate of rate of profit.  The growth of investment would therefore have slowed, and the economic expansion would have had to decelerate.

As it was, however, even as profits were sinking, stock prices were soaring into the firmament.  In 1995, in order to prevent an already recession-bound Japanese manufacturing sector from collapsing, the United States had been obliged to shift to a high dollar policy (from the low dollar policy it had been pursuing over the previous decade).  A Japanese crisis would not only have posed a profound threat to the stability of the world economy, but, in view of the mountain of U.S. debt held by Japanese creditors, could have driven up U.S. interest rates, precipitating a downturn.

As both cause and consequence of the ascending dollar, money poured into the United States from around the world, forcing down long-term interest rates and setting off the initial leap upward of equity prices.  Alan Greenspan kept the party going by refusing to raise short-term rates for four years and by loosening credit in response to every crisis.  Non-financial corporations in particular had exploited the resulting easy money regime, borrowing massively in order to buy back their own stocks in enormous quantities, thus pushing up their value even further.

As a result of the impetuous ascent of their share prices, corporations were able to avoid facing the unpleasant reality of declining returns.  They could access funds with unprecedented ease, either by issuing shares at ridiculously inflated prices or by borrowing money from banks against the collateral represented by those same over-priced equities.

As the century drew to a close, corporate borrowing and debt, as well as issuance of shares, thus reached heights never before scaled.  As the stock market ballooned wealthy households also saw their on-paper assets rise astronomically.  Thus they were able to reduce their rates of saving practically to zero, ratchet up their consumption, and help corporations sell the fast-growing output resulting from their skyrocketing expenditures on plant, equipment, and software.

Simply put, the "wealth effect" of the stock market run-up, manifested in record corporate and consumer borrowing and unprecedented corporate stock issuance, enabled business to maintain a powerful boom in investment through most of the 1990s.  On the basis of this investment surge, the growth of the Gross Domestic Product (GDP), of employment, and even, eventually, of wages excelerated until the middle of 2000.

The catch, of course, is that fast-rising profits are normally required not only to fund and motivate increased investment, but also, sooner or later, to justify and support fast-rising stock prices.  Fast-rising profits were precisely what was lacking.  Faced with this patent failure of "fundamentals," corporate executives were under mounting pressure to keep stock prices aloft by any means necessary.

Since their own compensation was so dependent upon the value of their stock options, they also faced an irresistible temptation to do so.

As the profits crisis intensified, one after another great corporation—especially in the "New Economy" technology, media, and telecommunications sector (TMT)—simply falsified its accounts so as to exaggerate short-term earnings and pump up corporate equity values.

These companies received aid bordering on the heroic from Wall Street's greatest all-purpose banks, which stood to net enormous fees from underwriting their issuance of shares, flotation of bonds, and mergers and acquisitions.  If companies used the banks' investment services, more loans would be made available to them.

They also secured invaluable assistance from the banks' "stock analysts," who touted their earnings prospects to the public so as to drive up shares, not to mention ostensibly "independent" auditors who came to serve them as investment consultants at the very time they were supposed to be auditing their books.

It cannot be overstressed that the government itself has paved the way for the efflorescence of these companies' accounting creativity.  Beginning around 1980, with the explicit purpose of restoring the power and profits of a U.S. financial sector that had been hard hit by the runaway inflation and low demand for credit of the 1970s, the federal government systematically dismantled the system of financial regulation that had been put in place by the New Deal in the wake of the last great bubble and bust.

By revoking regulations and norms that had been designed to prevent the very forms of corruption and conflict of interest that have recently come so prominently into play, the government succeeded beyond its wildest dream: By 2000 the profits of the financial sector as a percentage of total corporate profits reached an all-time high of 20%.

The prettification of company balance sheets helped the expansion to continue, but only to a point.  As the reality of the profits swoon gradually imposed itself over the course of 2000 and 2001, stocks plummeted, investors gradually awoke, and stocks fell some more. By this time the stock market's wealth effect had gone into reverse: corporate borrowing and stock issuance was drying up, investment in new plant and equipment was in decline, unemployment was rising, the economy was languishing in recession—and the collective leadership of corporate America was laughing all the way to the bank.

Enron Sets an Example

The Enron case is paradigmatic.  As most everyone now knows, Enron's managers hoked up one after another "off-balance sheet" subcompany in order to hide its gigantic liabilities and thereby fraudulently pump up its earnings.

This was possible because Arthur Andersen, perhaps the country's leading auditing firm, covered-up their depredations, no doubt encouraged to do so by the one million dollars a week it was receiving in conulting fees from Enron.  (In recent years, the so-called Big Five auditors have been making three times as much money from their consulting as from their auditing services).

Enron's artificially inflated earnings kept its share prices going up, allowing the company to keep expanding and leading insiders to make monumental returns from the sale of their stocks.  In the short period between January 1999 and December 2001, ten of Enron's leading shareholders came away with more than a billion dollars between them by unloading company shares, including $221.3 million and $70.7 million, respectively, for Enron CEO Kenneth Lay and Enron President Jeffrey Skilling.

The company's employees and shareholders ended up, of course, paying almost the entire gigantic cost of the collapse.  As the company's market capitalization fell from a peak of $70 billion to essentially zero, Enron's employees lost the savings and pensions they had been induced to hold in the form of Enron stock at the very same time that they were being laid off.

What has more recently come to light is the indispensable partnership role played by Citigroup and J.P. Morgan Chase, the country's number one and number two banks, along with Merrill Lynch, in the birthing of Enron's outrageously fraudulent accounts.  These huge financial conglomerates set up offshore shell companies for the sole purpose of acting as Enron's sham energy trading partners and to help hide the company's growing debts to themselves.

The shells thus made bank loans to Enron—to the tune of $8 billion over six years—but in the books these loans appeared as payments for purchases.  Perhaps the most stunning example of this maneuver was the "purchase" of three barge-mounted power stations parked off the coast of Nigeria by Merrill Lynch in December 1999 for $12 million.  This enabled Enron to book $12 million more in profit on its year-end financial report.  Merrill Lynch received from Enron, in exchange, a $250,000 fee and 15% interest on what was in reality a loan that was paid off within six months (as which point Merrill Lynch returned the barges to the Enron-led LJM2 partnership).

By such schemes Enron portrayed what were in fact liabilities as assets, understating its debt by 40% and overstating its cash flow by as much as 50%, and thus enhancing its share price and its ability to borrow.  Citigroup and J.P. Morgan Chase, for their part, netted $200 million in fees for their trouble and, unsurprisingly, successfully pitched similar arrangements to more than twenty other leading energy companies.

Nor did Citigroup sit by idly and accept the costs of having advanced funds to a company on the way to bankruptcy.  In May 2001, as Enron was plunging into oblivion—a fact that Citigroup was better-positioned than anyone else to know—the bank simultaneously carried out a major sale of Enron bonds and reduced its own loan exposure to Enron.  As a result, pension funds across the country are suing Citigroup.  It, along with both J.P. Morgan Chase and Merrill Lynch, is under investigation by both Congress and New York's attorney general.

The Great Telecoms Rip-off

Some of the greatest new stars of the telecommunications industry followed the trail blazed by Enron—from financial overreach to fraudulent profits inflation to bankruptcy—on an even more titanic scale and with incalculably greater repercussions for the economy.

Due to these firms' pivotal place in the heart of the supposed technological revolution, their machinations played a disproportionate part in pumping up the equity price bubble during its last, most frenzied years and thus in amassing industrial over-capacity, precipitating the equities market crash and setting off the ensuing recession.  The experience of telecommunications, perhaps more than that of any other group of companies, is emblematic of the rise and fall of those Siamese twins, the bubble economy and The New Economy.

The passage of the Telecommunications Act of 1996, which deregulated the telecommunications market, opening it to all comers, constituted the enabling condition for the telecoms frenzy.  A phalanx of new entrants rushed in. They hoped to capitalize on what they assumed would be the endless expansion of the Internet and, by virtue of what they assumed would be their technological superiority, to wrest market share from such firmly established behemoths as Deutsche Telekom, NTT, AT&T and Verizon.

Expanding through mergers and acquisitions with the greatest speed possible, they sought to win the approval of equity markets bedazzled by growth and size, drive up their share prices and on this basis secure the finances needed for even further growth.  It was just one of the multiple Ponzi games that helped drive the economy.

The emerging telecommunications companies were soon laying down tens of millions of miles of fibre optic cable across the United States and under the oceans, receiving in so doing the indispensable assistance of the leading Wall Street investment banks and their so-called "communications analysts."

The former took care of floating their loans and issuing their shares.  The latter, as investment counselors, encouraged them to undertake mergers and acquisitions that would of course be arranged by the investment banks for which they worked.  Meanwhile, as ostensibly independent "stock analysts," they made sure to pump up these companies' shares by touting them to a gullible broader public, on the basis not of their profits, but their growing size and, eventually, even the amount of line they had laid down. The grateful companies could then reward the investment banks with even more business.

In these processes of promotion, Salomon Smith Barney, the investment banking arm of Citigroup, played the vanguard role, led by their communications analyst, the appropriately named Jack Grubman.  After passage of the Telecom Act, Salomon helped eighty-one telecom companies raise some $190 billion in debt and equity.  For its efforts, it received hundreds of million in underwriting fees and tens of millions more for advising them on mergers and acquisitions.

This was especially the case for those heading Salomon's in-group of rising telecom stars—notably including the soon to be notorious, Global Crossing, and Qwest.  Salomon raised $24.7 billion, $5.4 billion, and $5.6 billion, respectively, for these three companies and received from them in fees $140.7 million, $83.8 million, and $34.4 million, respectively.

Salomon and Grubman were, it must be stressed, hardly alone in such efforts.  Manifesting the herd behavior for which they are rightly infamous, bankers and their "stock analysts" across the economy fell all over themselves in order to get in on the action.  They showered the telecommunication sector with more funds than they could sensibly invest, virtually force-feeding expansion and insuring overcapacity.

Fund managers were subject to the same crowd dynamic.  Those who stayed away risked under-performing their competition, so institutional investors ended up buying telecoms shares as if there was no tomorrow, driving their values into uncharted territory.

It goes with out saying that Alan Greenspan and the Fed, as well as the SEC, did absolutely nothing to interfere with the expanding bubble and turned a blind eye to the mounting corporate frauds that we now know were helping to sustain it. They had no desire to imperil a stock market runup that was the only force sustaining the expansion of the real economy.

By Spring 2000, at the apex of the stock market's ascent, despite the fact that the telecom companies produced less than 3% of the country's GDP, their market capitalization—the value of their outstanding shares—had reached a staggering $2.7 trillion, or close to 15% of the total for all U.S. non-financial corporations.

With such enormous apparent collateral, telecoms could borrow without limit.  Between 1996 and 2000, they took on $1.5 trillion in bank debt and issued an additional $600 billion in bonds.  On this basis, they were able to increase investment over this period in real terms (i.e.  measured in 1996 dollars) at an annual average rate of more than 15% per year and to increase jobs by a spectacular 331,000.

The problem was, of course, that everyone was doing it. In 2000, no fewer than six U.S. companies were building new, mutually competitive, nation-wide fiber-optic networks.  Hundreds more were laying down local ones and several additional ones were constructing lines under the ocean.  All told, 39 million miles of fiber optic line now criss-crossed the planet, enough to circle the globe 1566 times.  The unavoidable by-product has been a mountainous glut, the utilization rate of telecommunications networks hovering today at a staggeringly low 2.5-3%, that of undersea cable just 13%.

Under such conditions, making a profit became virtually impossible.  Even as their equity prices soared into the heavens and their purchases of new plant, equipment, and software mounted ever more rapidly, the profits of the telecommunications companies went to hell. From a peak of $35.2 billion in 1996, the year of deregulation, profits (after the payment of interest on company debt) in the communications industry sunk to $6.1 in 1999 and minus $5.5 billion in 2000, especially as interest payments on the industry's mountainous debt exploded.

Against the background of rising investment, rising debt, and falling returns, the pressure to sustain elevated equity prices became ever more excruciating, and the temptation to inflate profits via fraudulent bookkeeping apparently irresistible.  Here Salomon's stable of telecom upstarts led the way. Global Crossing and Qwest began to routinely "round trip" their business, leasing out their own lines to their competitors, leasing equivalent lines from their competitors for their own use to compensate, and recording the returns from the former as income, while booking the latter only over a number of years, as if it were depreciation on plant and equipment.

By this method, both companies inflated revenue by at least $1 billion in 2001, an amount probably significantly greater than the recorded profits of either.  Both companies are now facing criminal probes, although it speaks volumes for the nature of government "oversight" in this era that it was only in August 2002 that the SEC explicitly outlawed such "swaps."

The crimes of Global Crossing and Qwest are of course mere peccadillos, compared to the grand larceny achieved by WorldCom.  WorldCom has rewritten, so to speak, the book on corporate fraud.  At most recent count—there's probably more to come—WorldCom, between 1999 and 2001, had overstated its earnings by $7.2 billion.  It accomplished this largely (though not entirely) through the simple ruse of treating expenditures on day-to-day items like wages as if they were payments for capital goods.  They could thus record them as depreciation and put off into the future their appearance as costs on the company's balance sheet.

In summer 2000, there began an unending parade of disastrous company earnings reports, and the rout was on. In 2001, communications industry profits fell by 6% compared to the year before, and 9.3% more in the first quarter of 2002 (computed on a yearly basis).  By the middle of 2002, telecom shares had lost 95% of their value, with the result that about $2.5 trillion of market capitalization had gone up in smoke.  Telecom debt now stands at around $525 billion.  This is almost triple the value of both the outstanding junk bonds at the end of the 1980s and the cost of the Savings and Loan bailout.

In this context, the scandals have hit the stock market and the economy so hard, not because of what they have said about the moral status of corporate executives, but because they have confirmed investors' worse suspicions about plummeting corporate returns.

The revelation of WorldCom's fraud shook the markets in especially devastating fashion because it made perfectly clear that one of the most apparently successful companies in the telecoms business had made no profits in either 2000 or 2001 (and quite possibly in 1998 and 1999 either).  WorldCom "seemed to have some kind of secret formula for producing decent returns where its rivals couldn't" but when this illusion was punctured the telecom bubble was punctured too.

Still, it should not be thought that the entrepreneurs behind the great telecom bust were so clumsy as to get caught up in the financial carnage they left in their wake.

Between July 2000 and July 2002, shares in Qwest Communications fell from their high of $57.78 by 97%, leaving the company on the verge of collapse.  But this did not interfere with Qwest founder Philip F. Anschutz's becoming the most successful failed executive of our epoch by netting a cool $1.9 billion from the sale of Qwest stock.  Anschutz's CEO at Qwest Joseph Nacchio similarly pocketed more than $248 million from stock sales before he was pushed out in June 2002.

Global Crossing filed for bankruptcy in early 2002, a mere five years after its founding in 1997 and only two years after its market capitalization had peaked at $47 billion.  Still, the company's Chairman Gary Winnick, who had rehearsed for his telecom role by selling junk bonds with Michael Milken in the 1980s, was able to sell $734 million in shares on a $20 million investment, while top executives David Lee, Barry Porter, and Abbott Brown gained $216.3 million, $174.2 million, and $125 million, respectively, in the same manner.

In 1992, corporate CEOs held 2% of all equity outstanding of U.S. corporations; today they own 12%!  This has got to be the among the most spectacular acts of expropriation by the expropriators in the history of capitalism.  Karl Marx would have been impressed.

The Telecoms Bust

The economic rationale for the great telecoms bubble was the expectation that demand for Internet services would grow more or less exponentially, leading to comparable demand growth for bandwidth.  The never-ending expansion of the telecoms sector that was expected to result constituted, in turn, the economic justification for a parallel of explosion in the sector making telecommunications equipment and, in turn, the sector making components for the telecoms equipment makers.  The bust, when it came, thus proceeded from the dotcoms, to the telecoms, to their suppliers, to makers of their suppliers' parts.

The boom turned out of course to constitute a bubble as great in its way as that of telecoms itself.  Despite their infinitesimal contribution to GDP, the stock market value of Internet firms reached of 8% of that of all U.S. corporations as the equity price run-up peaked.  But the reality was that most of these companies made only losses, and the few that were making profits were trading at impossibly high price-earning ratios.

In a sample of 242 Internet companies studied by the Organization for Economic Cooperation and Development (OECD), only thirty-seven made profits in the third quarter of 1999, with just two of these companies accounting for 60%.  For the 168 of these companies for which detailed data was available, total losses in the third quarter amounted to $12.5 billion.  But this did not prevent their market capitalization from reaching $621 billion.  Not surprisingly, by Spring 2000, in the wake of their continuing losses, many of these so-called e-businesses were on the verge of running out of money.  The crash and collapse of the industry came soon after.

The bursting of the Internet bubble was the catalyst for the telecommunications bust beginning in the middle of 2000.  Because telecommunications accounted for such a disproportionate share of capital accumulation, the reverberations of its collapse were immense.  By 2000, the industry was accounting for 12% of the U.S. economy's equipment spending and one-quarter of the increase in such spending.  In 1999-2000, telecommunications investment grew at annual rate of around 10%, but in 2001 it probably fell by more than 20%.

In the very brief period between the end of 2000 and the middle of 2002, as more than sixty companies went bankrupt, the telecommunications industry laid off more than 500,000 workers, which is 50% more than it hired in its spectacular expansion between 1996 and 2000.  By comparison, it took the auto industry a two full decades to shed 732,000 jobs.

Telecommunication companies buy networking equipment to route Internet traffic, computer servers to offer Web hosting, software to provide services, and fiber-optic gear to transport bits of information.  Their declining orders have thus hammered the profitability of the suppliers.  These include almost all of the leading lights of the high-tech boom, most of whom have sustained catastrophic collapses in their share prices and financial conditions—including the near legendary Cisco Systems as well as Lucent, Nortel and Motorola.

When the leading equipment makers were stymied by the drop-off of demand, they could not avoid dealing a heavy blow to the components producers that supply then, including the makers of semi-conductors.  Such stock market darlings as JDS Uniphase and Sycamore bit the dust. The semi-conductor industry, hard-hit by the steep drop-off in computer sales as well as the telecoms fall-off, entered into its worst downturn since the early 1980s.  All told the chain reactions set off by the fall of telecoms were responsible for something like a quarter of the decline in economic growth between the first half of 2000 and the first half of 2001, and thus, to a hugely disproportionate extent, for the economy's fall into recession in 2001.

"The Late '90s Never Happened"

The crisis of overproduction and equity values in telecoms took place in tandem, and to some extent overlapped, with a parallel crisis in the high technology sector more generally, prominently including computers and semiconductors.  The depth of this crisis is revealed in a Wall Street Journal analysis of 4200 companies listed on the Nasdaq Stock Index, home of the New Economy.  For these companies, losses in the twelve months between 1 July 2000 and 30 June 2001 totaled no less than $148.3 billion, a little more than the $145.3 billion in profits these same companies had reported during the entire period from September 1995 through June 2000!

As one economist pithily put it, "What it means is that with the benefit of hindsight, the late `90s never happened."  Were one to take into account the earnings of these same companies over the year or so since the study was completed, as well as to adjust for the overstatements of profits by many of them, the trajectory would likely appear significantly worse.

Once the depth of the profit crisis is grasped, the pervasiveness of corporate manipulation of company accounts to puff up earnings is fully explained, especially once cognizance is taken of the openings for the dissemination of disinformation provided by Wall Street's accounting norms.  Companies use virtually any trick in the book to pump up so-called "pro-forma" earnings (those that are reported quarterly to stockholders and the financial community) before they admit their real earnings, calculated according to strict GAAP (Generally Accepted Accounting Practices) standards, to the Securities and Exchange Commission sometime later.

Needless to say this system of dual reporting invites abuses, such as exaggerating short-term earnings to sustain equity prices long enough for corporate insiders to unload their stock.  That just about all of Corporate America takes advantage of it was amply proved in a recent study  For the first three quarters of 2001 the Nasdaq 100 companies reported, on a pro forma basis, profits of $19 billion, while these same 100 companies reported, on a GAAP basis, losses of $82 billion to the SEC for very same period—a little over $100 billion less! (For the same period, Microsoft, Intel, Cisco Systems, Oracle, and Dell taken together overstated their profits by a factor of three.)

The high tech crisis has unfolded within the context of a broader U.S. economy already weighed down by overcapacity and over-production in international manufacturing.  Between their 1997 peak and the first quarter of 2002, manufacturing profits fell by an astounding 65%.  Until recently, it had been thought that profits had held up a good deal better in the non-manufacturing sector, but newly released government data has revised them sharply downward.

It is the combined realization that the official rate of profit on capital stock in the non-financial corporate sector as a whole is now (first quarter 2002) at its lowest level of the postwar period (except for 1980 and 1982) and that a broad swathe of America's greatest corporations have been lying about their earnings that has been so devastating to the stock market.

Yet, on top of seven straight quarters of declining investment on plant and equipment and a sudden decline of the growth of consumer spending over the past four or five months, the economy can ill-afford still another drop in equity prices.  The latter would inevitably carry with it—through the "reverse wealth effect"—a still further downward pressure on both corporate investment and consumer spending.  The odds in favor of the feared, but long scoffed at, double-dip recession get higher by the day.

Robert Brenner is an editor of Against the Current.  His latest book is The Boom and the Bubble: The US in the World Economy (Verso Press, 2002).  For the background to the developments sketched in this article, see the author's "After the Boom: An Economic Diagnosis," in ATC 98, May-June 2002.

ATC 100, September-October 2002

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