Creative Financing's Gaping Loopholes

The settlement between JP Morgan and insurers over controversial Enron deals shows how badly banks still need stronger oversight

By Emily Thornton and Laura Cohn

Listen up, investors, if you think what happened at Enron could never happen again in the wake of the 2002 reforms. Consider what JP Morgan Chairman and CEO William B. Harrison had to say about his company's $600 million settlement with insurers over controversial commodities trades with the bankrupt and now-infamous energy trader.

Harrison couldn't help but boast a little in announcing the Jan. 2 settlement. The bank recouped far more than what analysts had predicted, given the controversial nature of the trades. "We believe our firm acted appropriately on all the transactions involving the insurance companies," Harrison stated in a conference call (reporters weren't permitted to ask questions). Asked later to elaborate, Harrison declined through a spokesperson.

However, his statement is a pretty bold assertion in our view. And unless regulators take further steps to crack down on Wall Street's creative financing schemes, it suggests that bankers will gladly play a role in more of them in the future.


  Harrison's statement is disturbing on several levels. America's second-largest bank may have succeeded in forcing insurers to pay more than half of the $1 billion in bonds they issued as insurance -- essentially guarantees -- on the transactions between a JP Morgan-created offshore entity called Mahonia and Enron Corp. But the evidence presented in the month-long federal civil trial highlighted plenty that the bank shouldn't be proud of.

For example, JP Morgan bankers knew by November, 2000, that they were involved in circular deals -- sales in which Enron was basically drawing cash advances using Mahonia and JP Morgan as conduits, evidence presented at the trial showed. While the transactions were legal, they were densely structured so that JP Morgan was essentially advancing funds through Mahonia to Enron without the money showing up as debt on the energy trader's balance sheet. The insurers argued that they thought they were signing off on gas deliveries from Mahonia to Enron, pure and simple. JP Morgan insists the insurers always understood the nature of the complex deals.

At least some JP Morgan bankers were well aware that such financing schemes helped to obscure the massive debt on Enron's balance sheet, according to exhibits entered as evidence at the trial. In a 1998 internal e-mail, George Serice, a Houston-based JP Morgan credit-risk manager, laid out their attractiveness in painfully candid terms: "Enron loves these deals as they are able to hide funded debt from their equity analysts," Serice wrote, allowing the disgraced energy giant to book the debt "as deferred revenue or (better yet) bury it in their trading liabilities." (Parenthetic remark in previous sentence is Serice's.)


  Complex deals involving cash advances raised concerns with JP Morgan Vice-Chairman Donald H. Layton. "We are making disguised loans, usually buried in commodities or equities derivatives (and I'm sure in other areas)..." Layton wrote in an internal 1999 e-mail to credit-risk managers that was introduced as evidence in the trial. (Parenthetic remark in previous sentence is Layton's.) He also wrote: "I am queasy about the process."

When pressed to explain what he meant, Layton testified that his concern was with such lending practices in general, and he could not recall the controversial transactions with Mahonia. Layton would have no further comment for this article, JP Morgan said.

From the get-go, JP Morgan has insisted it followed the law in all its opaque deals with Enron. In July, under questioning from Senator Carl Levin (D-Mich.), then chairman of the Senate Permanent Subcommittee on Investigations, bank execs asserted that there was nothing improper about its Mahonia deals -- the same assertion Harrison made last week. Yet in August, under growing pressure, JP Morgan announced it was forming a committee to review its practices.


  The bank declined to discuss the review committee's work. Instead, it referred BusinessWeek Online to the testimony of Michael Patterson, head of the new committee, before Levin's subcommittee in December. "The core lessons we have learned," Patterson testified, was that the bank must take more responsibility to ensure that transactions are "property accounted for and disclosed," that transactions "are not misused to deceive investors or others," and "to consider carefully" how transactions might be perceived.

The reason for Patterson's trip to Washington? Levin had more questions about what the senator termed "sham loans" designed by JP Morgan to help Enron reap up to $60 million in Canadian tax benefits. JP Morgan earned $5.6 million in fees for structuring these Canadian deals, which were separate from the Mahonia deals.

Levin asked Patterson directly if his firm would participate in the Canadian deals today. Patterson's reply: "I think not." Yet, the bank continues to maintain that the Mahonia transactions were not only legal but ethical and appropriate. Privately, JP Morgan officials expressed annoyance at being dragged before Congress again to talk about helping Enron save money on taxes, arguing that all corporations try to reduce their tax bills.


  Perhaps all corporations do. But Big Business is now coming off one of its worst years since the 1920s, a year in which massive accounting scandals and loss of investor confidence in markets contributed to keeping the U.S. and the rest of the world in an economic slump. Today it's common wisdom that Enron's superaggressive accounting and mind-numbingly complex transactions were used to inflate assets, hide massive debt, and mislead investors. The fallout from Enron, WorldCom, Global Crossing, and other corporate scandals prompted Congress to approve one of the largest overhauls of accounting and securities regulation in history.

On Jan. 2, Levin's subcommittee called for one more reform -- a larger government role in overseeing the types of financial transactions that camouflaged Enron's true condition. The panel cited a regulatory gap that companies like Enron exploited: The Securities & Exchange Commission doesn't oversee banks, and bank regulators don't oversee accounting practices.

Some Washington insiders are concerned that all of the Levin subcommittee digging into Enron will be ignored and forgotten. The reason: Congress convened on Jan. 7 with Republicans retaking control of the Senate. While Senator Susan Collins (R-Me.) will take over the full governmental Affairs Committee and says she plans to continue to look into corporate wrongdoings, it's not clear who will head Levin's investigations panel. Whoever it is, "the new chair won't have the same priorities as Levin did," says L. Douglas Lee, a Washington veteran who's president of Potomac (Md.) consulting firm Economics from Washington. "The Democrats are more interested in pursuing this than the Republicans are."


  A spokesperson for JP Morgan says it's unfair to hold the bank or any other company up for criticism for "following what the rules were at the time" of the Enron-Mahonia transactions. "The current mindset has changed, and people are deciding whether to change the rules, but we shouldn't retroactively punish those who followed what was in place."

Fair enough. But policymakers and shareholders have learned quite a lot over the past year. Collins and regulators would be wise to follow through on Levin's recommendations and give the SEC new powers to oversee bank lending practices. One thing is for sure: Comments such as those from JP Morgan's Harrison suggest that banks will continue to help companies take advantage of legal loopholes under the guise of so-called "creative financing" as much as regulators and their rules permit them to.

It's a new era, and it calls for new standards.

Thornton covers Wall Street from New York. Cohn covers financial issues from Washington, D.C.

Edited by Douglas Harbrecht

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