When Financial Bubbles Burst
Enron Case Is One More Example of a Troubled System
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HOUSTON, Texas, FEB. 16, 2002 (Zenit.org).- Investors and businesspeople could profit from a look at Catholic social teaching in the wake of recent scandals involving out-of-control financial speculation and the dangers it poses for money markets.
In January, the Enron bubble burst. During the 1990s, the Texas-based firm typified the changes in the stock market. The company began life as a natural gas pipeline operation. With the deregulation of the energy sector it quickly expanded operations, becoming a financial services firm that traded everything from energy to bandwidth.
The success of Enron -- it became the seventh biggest U.S. company with a stock market value of more than $60 billion -- concealed a number of weaknesses. For example, accounting rules allowed it to count as revenues the amount of every transaction, rather than just the profit from its deals.
The Wall Street Journal reported Jan. 14 that some of the world´s leading banks and brokerage firms provided Enron with crucial help in creating its intricate and misleading financial structure. Observers accuse the banks and brokers of willingly overlooking the firm´s flaws, because they were receiving hundreds of millions of dollars in fees from Enron.
Enron also epitomized the use of lavish stock options to reward its executives. Chairman Ken Lay made $205 million in stock option profits in the last four years. Enron chiefs were able to cash in before the crash in stock prices, but rank-and-file employees were not so fortunate.
The New York Times on Jan. 14 detailed how this happened, quoting internal company e-mails. Last August, Lay sent an e-mail to all employees saying, "I want to assure you that I have never felt better about the prospects for the company." By that time, he and company chief executive Jeffrey Skilling had already cashed in more than $160 million worth of Enron stock. The stock has since lost 99% of its value, wiping out the retirement savings of many of Enron´s 20,000 employees.
Enron also highlights how big companies are able to avoid the social obligations faced by others: Enron paid no federal corporate income taxes in four of the past five years, the Washington Post reported Jan. 22.
The company set up almost 900 subsidiaries in tax havens in places such as the Cayman Islands, the Netherlands, Mauritius and Bermuda. Enron was also able to deduct the cost of stock options. So the many millions that Enron´s executives and board members received in options were deducted for tax purposes. In 2000, for instance, a tax bill of $112 million turned into a refund of $278 million.
When speculation becomes fraud
In recent days a number of fraud scandals have erupted. Ireland´s largest bank, Allied Irish Bank, is missing $750 million because of illicit trading by an employee at its U.S. subsidiary, Allfirst Financial. When the FBI caught up with John Rusnak, the currency trader admitted he had engaged in a series of trades that escalated as he tried to make up for his losses, the Wall Street Journal reported Feb. 8.
The Allied Irish loss is the sixth biggest in the past 15 years involving rogue trading, and the biggest since Sumitomo Corp. in 1996 disclosed a $2.6 billion loss in copper trading, according to the Washington Post on Feb. 7. Another famous case was when Barings PLC, Britain´s oldest merchant bank, folded after one of its traders in Singapore, Nicholas Leeson, lost $1.4 billion on Japanese stock-index futures.
Allied Irish said the currency trading loss would reduce its 2001 net income by $516.7 million, to $347.7 million. In the first days after the announcement of the fraud, the price of Allied shares fell more than 16% on the Irish and New York stock exchanges.
Then on Feb. 8 the Wall Street Journal reported that a Lehman Brothers broker, Frank Gruttadauria, vanished along with tens of millions of dollars from the accounts he managed. He soon surrendered to authorities, but investigations are under way into whether he may have stolen up to $125 million from clients over a 15-year period at a number of large Wall Street firms.
The problem of stock options came up again in the case of Global Crossing. The fiber-optic communications company that was once worth nearly $50 billion has recently filed for bankruptcy. Global Crossing built a worldwide network to capitalize on the surge in communications demand that was expected to come from the rise of the Internet.
But the company overextended itself, and now owes more than $12 billion to banks and creditors. Founder Gary Winnick, however, has realized more than $730 million from selling stock while the company was riding high.
The Securities and Exchange Commission is investigating whether Global Crossing improperly inflated its revenue figures, the New York Times reported Feb. 9. The FBI is also examining the company´s accounting practices.
Critics speak out
Germany´s finance minister, Hans Eichel, wrote an article for the Financial Times, published Feb. 7, warning, "In a largely integrated international financial system, distortions in national financial markets and financial institutions can pose a threat to global financial stability."
The German official is particularly concerned about weak banking supervision in offshore financial centers and insufficient monitoring of the risks taken by hedge funds. Eichel pointed out that hedge funds are not subject to any restrictions on their investments and they respond very rapidly to changing conditions, as well as engaging in short-selling, "which in times of market turmoil can lead to a general price collapse."
Financial Times columnist Peter Martin in a Feb. 12 article also expressed concern. He pointed out that each day, $1.2 trillion of foreign currency is bought and sold, and $580 billion is traded in over-the-counter currency and interest rate derivatives. Even though these figures include some double counting, the sums involved are huge.
Martin argued that many traders underestimate the risk they run and overestimate the long-term rewards. He called for a reduction in financial trading, contending that it too often causes substantial losses.
For guidance into business matters, the Pontifical Council for Justice and Peace in 1994 published "The Modern Development of Financial Activities in the Light of the Ethical Demands of Christianity." The document details a number of problems related to speculation. Among them: It can lead speculators to a loss of the sense of economic and social responsibility linked with the control of assets; it often ignores the common good; and it often is associated with a radical increase in indebtedness. Moreover, the document warns, speculation concentrates on rapid gains that can undermine an economy, and it also tempts individuals to get rich at any price.
The Church does not want to outlaw financial markets. The pontifical council notes that many of the instruments misused by speculators have a legitimate function for investors and producers. "A blanket condemnation of speculation is misplaced," the document states.
The authors explain that the challenge is how to use these instruments in a more restrained way. Both individuals and firms need to set clear limits, the document recommends. The goal would be to avoid the "all-consuming desire for profit" (as John Paul II calls it) that can easily lead to avarice. Finding the right balance in the use of financial instruments is not easy. But it is worth the price, as any Enron investor would likely say.