During the '90s, America's financial institutions transformed themselves into giant conglomerates, offering credit, equity, insurance, fund management, analysis, and just about everything else. It is increasingly clear that this model pushed the limits of the law, hurt the average investor, and distorted both debt and equity markets. In the name of efficiency and synergy, the financial conglomerates indulged in egregious conflicts of interest. Citigroup (C
), J.P. Morgan Chase (JPM
), Merrill Lynch (MER
), and others are now being called to task by legislators, regulators, and--most important--investors. In the post-boom post-mortem now under way, it would be wise to ponder if the model of a one-stop universal bank is itself flawed. Twice in a century, conglomeration has been associated with financial bubbles that led to serious economic harm and loss of public trust. It's time to reinstitute checks and balances inside the U.S. financial system.
We know that financial institutions helped Enron and others artificially boost profits by disguising loans as trades while hiding debts in special-purpose vehicles. Now coming to light is the role the conglomerates may have played in creating the bubble itself. Take the case of telecom. Financial giants used loss-leading loans to telecom companies as a way of getting investment banking business and fees. That helped inflate capital investment in broadband beyond long-term demand. Capacity was also pumped up by the push to generate fees from mergers and acquisitions. Telecom companies were encouraged to expand at a fast and furious rate. Windfalls from initial public offerings also led financial institutions to encourage telecom startups that had few long-term prospects. The net result? Huge overcapacity was financed and built, and it couldn't be used. In the end, the telecom bubble burst.
THE RAGE FOR FEES. Financial institutions apparently sought to enrich CEOs, managers, and directors personally in their drive for investment-banking fees. Citigroup's Salomon Smith Barney unit gave WorldCom CEO Bernard Ebbers 869,000 IPO shares in 21 companies from 1996 to 2000. WorldCom's chief financial officer and two directors also received IPO shares. All made huge personal gains. It wasn't illegal, but it was unseemly in its suggestion of quid pro quo. Average investors were not privy to these IPO shares, and the practice did a disservice to the IPO companies that saw their stock flipped rather than placed in steady hands. Issuers and average investors were hurt in the quest for fees.
It gets worse. Citigroup's chief telecom-research analyst, Jack Grubman, supposedly objective, appears to have talked up WorldCom and other telecoms in his reports in order to generate investment banking business. Grubman's $20 million-a-year compensation was based in large part on the amount of investment banking fees he brought to Citigroup. And New York State Attorney General Eliot Spitzer is looking into whether Citigroup Chairman Sanford I. Weill leaned on Grubman to change his rating of AT&T (Weill is on the board). Soon after Grubman upgraded it from "neutral" to "buy," AT&T (T
) gave Citigroup's Salomon Smith Barney an extremely lucrative underwriting assignment. Coincidence?
On Wall Street, the appearance of conflict of interest became the embrace of conflict of interest. At Merrill Lynch, 97 managers personally invested in Enron's LJM2 partnership, which Merrill had structured. On a sales video for the partnership, Enron Chief Financial Officer Andrew S. Fastow boasted that his own conflict of interest--as a manager of LJM2 and CFO of Enron--would benefit all investors. "It is very hard for me not to see competing bids," he said on tape. Instead of fleeing this obvious conflict, Merrill's people bought in. They made out well personally, as did Fastow.
HOODWINKED INVESTORS. Investors in Enron or WorldCom or Qwest Communications, however, have not. In the opaque financial world of exchanging subsidized loans, hot IPO paper, and analysts' opinions for fee-based investment business, investors were left holding the bag. The financial institutions got their money and profits up front and shunted most of the investment risk to average investors, who ended up with the stock and debt in their 401(k)s and mutual funds--some of which were run by the conglomerates themselves. Their stock, of course, has since lost much of its value. People could not evaluate the true risk of their investments because financial conglomerates were distorting market signals.
Even Federal Reserve Chairman Alan Greenspan was hoodwinked. Had Greenspan known that capacity was artificially inflated and profits overstated in telecom, he might have tightened monetary policy earlier, slowing the economy and perhaps avoiding the bubble.
We are just beginning to understand how that '90s bubble was created. Eerily, it shares at least one common cause with the bubble of the '20s--giant, complex financial conglomerates operating in opaque ways that distort the markets and mask the true nature of risk. If investor trust is to be rebuilt, then transparency, credibility, and competition must be restored to the nation's financial system.
To his credit, Citigroup Chairman Weill is taking a lead in reinstating some checks and balances in finance. Citigroup will not sell complex financial products--such as special-purpose vehicles--that hide debt, unless companies fully disclose them on their balance sheets. Weill supports action to improve research objectivity by prohibiting analysts from going on investor road shows. But is that enough? Can financial conglomerates really police themselves when their very concentration of services makes it difficult to avoid conflicts of interest? Investors have already formed their own opinion. Citigroup now trades down at a "conglomerate discount." Congress has to decide whether a 21st century version of the Glass-Steagall Act is needed as well.
Get BusinessWeek directly on your desktop with our RSS feeds.
Add BusinessWeek news to your Web site with our headline feed.
Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video.
To subscribe online to BusinessWeek magazine, please click here.
Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
Printer-Friendly Version
