The Wall Street Fix
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Eliot Spitzer's investigations exposed Wall Street's corrupt business model. But real reform will have to address the deeper, unresolved issue of banking deregulation.

May 8, 2003

The Wall Street fix publicly trumpeted by market regulators last week pointed the finger of blame rather narrowly at stock analysts for posing as friendly advisers to investors while actually operating as salesmen and deal-makers for investment banks. But the Wall Street fix perpetrated by America's new superbanks is a much bigger game that has been stacked against ordinary investors by far more than the conflicts of interest and fraudulent recommendations of high-profile research analysts.

During the last decade, a web of hidden, favor-laden relationships married some of the nation's biggest banks created in the 1990s to their corporate clients and their CEOs in ways that made it practically impossible for the banks and their top executives to properly care for the interests of the investing public.

"There is no question that we have created a web of relationships that provide the opportunity for massive abuse," asserts New York State Attorney General Eliot Spitzer. "And what we uncovered last year demonstrates there was massive abuse."

But even as aggressive an investigator as Mr. Spitzer has not addressed the broader systemic problems raised by superbanks -- the new financial conglomerates that combine banking, investment and insurance businesses in one firm. For that to happen, it will probably take another round of scandals and investigations to reverse the climate of trust-the-market deregulation in Washington.

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Consider, for example, Citigroup, America's first superbank -- which consists of Citibank, the Travelers insurance company, and the Salomon Smith Barney investment bank. Watch how Citigroup cornered the business of a cash cow like WorldCom, the brash telecom upstart that eventually bought out MCI, and then put the interests of Citigroup and WorldCom ahead of millions of ordinary depositors and investors.

Even as aggressive an investigator as Mr. Spitzer has not addressed the broader systemic  problems raised by superbanks - the new financial conglomerates that combine banking, investment, and insurance businesses in one firm.

Two years of investigations have established that Citigroup curried favor with WorldCom and its CEO, Bernie Ebbers, by providing excessively positive ratings of WorldCom shares by Salomon Smith Barney's telecom analyst Jack Grubman, and by effectively handing Mr. Ebbers millions in personal windfalls through lucrative IPOs of hot new telecom stocks.

But it turns out that, sub rosa, Citigroup was doing much more than that. In early 2000, when WorldCom was starting to sink -- and was looking for investment banks to help it float a multi-billion dollar debt offering -- Citigroup was eager to land that investment banking business. It used its Travelers insurance arm to offer the lure of an unprecedented sweetheart deal for Mr. Ebbers.

Travelers issued a staggering $1 billion mortgage to Mr. Ebbers through Joshua Timberlands, a private company controlled and largely owned by Mr. Ebbers. Such lavish funding enabled Mr. Ebbers to begin converting his WorldCom wealth into hard assets without selling his millions of shares of WorldCom stock, which would have rung alarm bells on Wall Street and sent WorldCom shares into a tailspin.

This is how it worked. Mr. Ebbers, whose close financial advisers included investment bankers at Citigroup, took his first step in August 1999, when, according to land records, Joshua Timberlands bought 460,000 acres of rich forests stretching across Tennessee, Mississippi, and Alabama from Kimberly Clark, another Citigroup client. Travelers arranged a $499 million loan to Mr. Ebbers. That was underwritten jointly by Travelers and other financial institutions. That loan was eventually folded into the $1 billion mortgage from Travelers in February 2000.

"So, here you have Bernie Ebbers getting cash in his pocket by virtue of getting a loan from Travelers, an arm of Citigroup, to buy this timberland, and then turning around and selling part of it for cash," asserts Sean Coffey, an attorney representing the New York State Common Retirement Fund. The fund has sued Wall Street banks, seeking to recover $300 million in losses on WorldCom.

Timber was just part of a private business empire that Mr. Ebbers was building, and which ultimately came to include luxury yachts, a boat-building company, a lumber mill and ranch in Canada -- not just any ranch but the biggest ranch in all of Canada, 500,000 acres. That ranch, Mr. Coffey found, was financed with a $43 million loan from Citibank, backed by 2.3 million shares of Mr. Ebbers's WorldCom stock.

Mr. Coffey finds Citibank's acceptance of WorldCom stock as collateral for the loan a very troubling link because Citibank has an interest in the stock price of WorldCom being high enough to cover the loans they've made to Mr. Ebbers -- yet, in another part of the same building you've got Jack Grubman issuing analyst reports saying, 'Buy, buy, buy that stock,' to drive the price up."

Not only does that conflict of interest work against investors but also, according to documents filed in Tennessee, Travelers became an equity partner of Mr. Ebbers in Joshua Timberlands -- a fact never disclosed to investors, who were sold WorldCom stocks and bonds by Salomon Smith Barney. In fact, the link between Travelers and Salomon was personified by Michael Carpenter, who simultaneously served as chairman of Travelers and CEO of Salomon, a tie that raises questions about how objective Salomon could be about Mr. Ebber's company, WorldCom.

Technically, it is illegal for a bank to "tie" its loans to a corporate client in order to pressure that company to do its securities business with the bank. But the $1 billion Travelers mortgage and the Citibank loans to Ebbers for his Canadian ranch show how easy it is to get around those regulations, because any quid pro quo in that deal was not contractually explicit.

The fact is that Wall Street banks have become so huge and diverse, their resources have become so enormous, and they operate in so many different lines of business, that they are rife with conflicts that can injure investors but have become exceedingly difficult for regulators to police. The cure, according to the Securities Industry Association, is disclosure -- making public all relevant information of banks' relationships with their clients. But that information was not voluntarily disclosed in the case of WorldCom and Citigroup. Instead, the documentation was carefully obscured, and even the regulators did not spot it.

For example, Mr. Ebbers' $1 billion mortgage from Travelers insurance company is not really the concern of bank regulators, whose focus is the safety and soundness of banks, not insurance companies. Insurance is regulated by states, which are not responsible for monitoring the tying of loans to investment banking deals. The Securities and Exchange Commission, the agency charged with protecting investors and overseeing the securities industry, has no direct responsibility for monitoring an insurance company's $1 billion mortgage to a corporate CEO. So no one is really watching to see if investors' interests are being sacrificed to deal-making among insiders.

The stakes for investors can be huge. Take, for example, the marketing of $17 billion in WorldCom bonds to public investors in May 2000 and May 2001 by bank syndicates led by Salomon Smith Barney, the corporate sibling of Travelers. Investor attorneys from New York to California contend that Salomon Smith Barney did not fully disclose details of the financial arrangements that Travelers, Citibank and Salomon had developed with WorldCom and Mr. Ebbers -- important information for investors. Mr. Coffey adds that the debt offering enabled Wall Street banks to reduce or limit their own financial exposure to WorldCom at the very time they were deepening the financial risk of pension funds and individual investors by promoting WorldCom as a sound investment.

After the Crash of 1929, Congress tried to simplify the policing of Wall Street, and to reduce its conflicts of interest, by passing the Glass-Steagall Act to separate the banking and securities businesses. But in the 1980s and 1990s, under pressure from the banks, Glass-Steagall was steadily eroded by decisions of the Federal Reserve Board, mostly during the tenure of Alan Greenspan, a former director of J. P. Morgan, the investment bank. Mr. Greenspan has been an ardent advocate of greater deregulation, which was needed, he said, to help American banks compete against foreign banking conglomerates.

Mr. Greenspan's reinterpretation of the old law opened the way for the formation of new superbank conglomerates, and specifically for Sanford Weill to create Citigroup in 1998. With Mr. Greenspan's blessing, Mr. Weill put under one roof not only a massive bank and a huge securities firm, but one of America's largest insurance companies. Under the pressure of that fait accompli and effective lobbying from all sectors of the financial industry, Congress finally repealed Glass-Steagall in 1999.

Attorney General Spitzer sees the formation of the megabanks as the basic cause of the mushrooming abuses on Wall Street. "The problem at its root is a flawed business model," asserts Spitzer, "and that business model is the product of a government regulatory decision to repeal Glass-Steagall, and to seek this tremendous concentration of power [in superbanks], and then the abuse of that power by the investment houses."

Like Felix Rohatyn, long one of Wall Street's leading investment bankers, and Martin Mayer, a widely published author on banking, Mr. Spitzer argues that Congress and the Federal Reserve should consider re-tightening the laws to impose clearer controls on superbanks and to separate their various functions.

"I think that's absolutely something we have to reconsider," Mr. Spitzer declares. But he quickly observes that in the current political climate such action is unlikely. And that very significant omission undercuts the force and long-term impact of the settlement announced last week by Mr. Spitzer and other regulators.

Hedrick Smith, former Pulitzer Prize-winning correspondent for The New York Times, is senior producer and correspondent for "The Wall Street Fix." Since 1988, he has created and reported on 16 different PBS programs and mini-series. His most recent productions for FRONTLINE were "Inside the Terror Network" and "Bigger Than Enron," both of which aired in 2002.


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published may 8, 2003

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