The last ones to react, in every case, were the credit-rating agencies, which downgraded companies only after all the bad news was in, frequently just days before a bankruptcy filing. Nevertheless, investors continued to trust the credit-rating agencies, and regulators continued to rely on them.
To any close observer of the changes in financial practices since the late 1980s, the collapse was not a surprise. New forms of risk and deceit now permeated every corner of the financial markets. Financial instruments had continued to develop in complex ways, and no one—including accountants, bankers, directors, regulators, or even plaintiffs’ lawyers—was in a position to exercise even a modicum of control. New instruments called credit derivatives enabled banks to transfer and repackage risks, making themselves safer and more profitable, but pushing trillions of dollars of risk into the dark corners of the financial markets. Individual investors, having jumped into stocks without understanding what they were buying, were now suffering unprecedented losses associated with these new instruments, often without realizing it.
There was one unexpected twist. Compared to the sophisticated financiers involved in the complex schemes of the 1990s—ranging from the nerds of Bankers Trust to the rocket scientists of Long-Term Capital Management, many of whom had attended the Wharton business school or had Ph.D.s in finance—the leaders of the companies involved in the major scandals of the early 2000s were uneducated in finance and had little experience in the businesses they ran. Consider Gary Winnick and Bernard Ebbers, the heads respectively of Global Crossing and WorldCom. Both graduated from college in the late 1960s, and took mundane first jobs. Both lacked advanced training in business or finance. Both knew little or nothing about telecommunications before they stumbled upon their respective companies.
And yet these two men were billionaires, and leaders of the telecommunications industry. By 2002, they also would be proof that you didn’t need a business degree from Wharton to watch over a billion-dollar financial fraud.
For Wall Street bankers, Winnick and Ebbers were the ideal clients: colorful, hands-off personalities who paid hundreds of millions of dollars in banking fees. Each of their companies was built around one simple idea. Winnick of Global Crossing sold a telecommunications network crossing under the Atlantic Ocean. Ebbers of WorldCom sold a low-cost, long-distance service. These plans seemed plausible enough during the stock-market boom of the late 1990s and, with the help of Jack Grubman, a respected analyst from Salomon Brothers, the stock prices of Global Crossing and WorldCom surged. The companies then used their highly valued stock to acquire more than 100 companies, each time paying hefty investment-banking fees.
Their business plans were simple enough for television sound bites, but they weren’t very good long-term strategies, especially given the difficulties of integrating so many different acquisitions. Nevertheless, as the telecommunications industry was collapsing, Global Crossing and WorldCom continued to perform well—at least on paper. Their earnings met analysts’ expectations and revenues continued to grow.
In late 2001, as investors finally discovered the truth about Enron, they began to question the financial statements of Global Crossing and WorldCom, too; and, by 2002, investors had learned of accounting gimmicks at these companies. Now, Enron was no longer the largest bankruptcy in history. If investors who had bought stock in Global Crossing and WorldCom had known the stories of those companies in any depth at all, they would have thought twice about trusting Gary Winnick and Bernard Ebbers with their money.
Gary Winnick was a native of Long Island, New York, and graduated from the C. W. Post Campus of Long Island University in 1969 with a degree in economics.3 C. W. Post had been founded a decade earlier, by the Post cereal family, to educate World War II veterans living on Long Island.
Winnick obviously loved the school. In remembering his C. W. Post days, he reflected, “I am a true Long Island boy, born and bred, and very proud of it. My experience at C. W. Post helped shape my success, and the school remains a very important part of my life.” Winnick and his wife gave $10 million to C. W. Post in 2001, and the school agreed to name the majestic Tudor revival style mansion that housed its center for academic, cultural, and administrative activities “Winnick House.”4
After graduation, Winnick began working as a furniture salesman for a store owned by his brother in-law.5 In 1972, he got his first break, and joined a New York securities firm called Burnham and Co. as a trainee. Winnick was relentlessly focused on making money, and the firm needed confidence and loyalty more than intelligence—a trader named Michael Milken supplied plenty of brainpower. After a 1977 merger, Burnham became Drexel Burnham Lambert, and Winnick became a part of Milken’s original twenty-man trading operation in New York. In 1978, Milken moved his closely knit group—including Winnick—from Wall Street to new offices in Beverly Hills.6
For the next seven years, Winnick worked by Milken’s side at his famous X-shaped trading desk. Winnick was brash—some called him a “blowhard”—but he was reliable, and was promoted to head of Drexel’s convertible-bond group, which led the industry. Winnick made millions of dollars, as did everyone in Milken’s inner circle.
Winnick left Drexel at the perfect time, in 1985, just before prosecutors began investigating the firm for securities fraud. Nevertheless, he remained at risk of prosecution and his record wasn’t entirely clean. For example, Winnick allegedly was involved in a questionable junk-bond deal involving Rooney, Pace, a defunct securities firm.7 But in December 1989, any questions about Winnick’s dealings at Drexel became moot, when prosecutors granted him immunity from prosecution after he agreed to testify against Milken. (They ultimately did not call him as a witness, in part because of time constraints imposed on both sides by Judge Kimba M. Wood.)8
With the taint of his Drexel experience, Winnick wasn’t a viable candidate for a senior position at a major corporation. Not yet, anyway. Instead, he decided to set up his own investment firm, called Pacific Asset Holdings—funded with a large investment from Milken. BusinessWeek called the firm a “Little Drexel,”9 and the ties to Drexel remained strong. Winnick did various financial deals with Drexel beginning in the late 1980s, including a bid to acquire Western Union. That bid failed in part because of Winnick’s connections to Drexel, which by then was under intense investigation.10 It was as close as Winnick came to running a telecommunications firm—before he joined Global Crossing a decade later.
Although Winnick was frequently credited as the genius behind Global Crossing, in fact the idea of building a network of telecommunications lines under the Atlantic Ocean was not his. Instead, some business partners suggested the idea, and Winnick agreed to invest $15 million of his own money.11 He was persuaded that, given the increased demand for global telecommunications networks, a company with a “global crossing” would have a valuable franchise. He bought an instructional video that showed how to lay undersea cable, and in 1997 Global Crossing was formed.
Winnick began relentlessly selling the idea of Global Crossing to anyone who would listen. Jack Grubman, who had been an executive vice president of AT&T’s consumer and small-business division, and was now an analyst at Salomon Brothers in New York, heard the message loud and clear. Global Crossing had a catchy name and a reasonably interesting idea, and it didn’t take much more than that to persuade investors to buy a stock during the late 1990s. Moreover, Grubman knew that if he became a close adviser to Winnick, he could persuade Global Crossing to make numerous acquisitions, and to direct investment-banking business to his firm.
Grubman was so successful that, thanks in part to Global Crossing, he made $20 million a year from 1998 to 2001, more than almost anyone on Wall Street except Frank Quattrone of CS First Boston. Salomon had guaranteed Grubman such huge bonuses to keep him from leaving to join Goldman Sachs as a partner; when that firm later did its Initial Public Offering, partners made tens of millions of dollars each. Grubman proved to be well worth Salomon’s money. For Salomon, and many banks, telecommun
ications advisory work was even more profitable than Internet IPOs. Overall, telecommunications firms paid Wall Street $13 billion in fees from 1998 to 2001. Of that amount, Global Crossing paid more than $420 million,12 twenty times more than a similarly sized company would pay in a typical year. A big chunk of those fees went to Salomon.
Salomon did Global Crossing’s Initial Public Offering in August 1998, along with Merrill Lynch, a few months before Henry Blodget’s prediction that Amazon.com would hit $400 per share. Compared to speculative Internet IPOs, Global Crossing was practically a sure thing: even continents filled with telecommunications networks still had to be connected to each other. And although Global Crossing’s undersea network had not been built, it was at least a real thing that could be built. The IPO was successful, and Winnick—who owned 27 percent of the company—was suddenly worth more than a billion dollars. Many of Winnick’s friends were also involved in Global Crossing’s management, and they also made millions of dollars, but Winnick made the most money and was obviously in charge. He and his friend Lodwrick M. Cook, a former CEO of ARCO, were ostensibly co-chairmen of the company, but Winnick’s official title was “chairman,” whereas Cook’s was “co-chairman.”
Now that Global Crossing’s shares were worth several billion dollars, Winnick could use them as currency to buy other companies. If securities analysts approved of the deals, Global Crossing’s stock would rise even more. Winnick went on a buying spree, acquiring dozens of telecommunications companies, with Jack Grubman advising on the deals, attending a critical board meeting, and promoting the stocks as an analyst—and with Salomon serving as the firm’s primary investment banker. With these acquisitions, Global Crossing was doing much more than building a fiber-optic line under the Atlantic Ocean; it was acquiring one of the largest land-based telecommunications networks, too.
With all of the acquisitions, it was becoming more difficult to interpret Global Crossing’s financial statements. Just as mergers had enabled Cendant to inflate its assets, dozens of mergers presented the same opportunity for Global Crossing. Moreover, for technology companies involved in large numbers of acquisitions—such as Cisco and Global Crossing—investors relied on analysts to interpret the detailed financial-statement data. For example, what should investors conclude from the fact that almost one-third of Global Crossing’s $22 billion in assets were recorded as goodwill—an accounting term representing the difference between the price Global Crossing paid for a company’s shares and the value that company previously had recorded for its assets in its financial statements. Investors looked to Jack Grubman to translate these numbers and, not surprisingly, Grubman gave Global Crossing his highest marks. Why wouldn’t he? Grubman had practically arranged the deals himself.
During this time, Winnick and other top executives milked Global Crossing for unprecedented perquisites and personal financial gain. Global Crossing engaged in Related Party transactions that made Enron look like a nunnery. It agreed to pay a subsidiary of Winnick’s Pacific Capital Group, PCG Telecom, a full two percent of its revenues in exchange for advice.13 It agreed to buy an on-line voice-transmission system from Withit.com, an Internet company—run by the son of the firm’s senior vice president for finance—which had no substantial clients.14 There were several questionable real-estate deals involving entities related to Winnick. Global Crossing even avoided paying taxes by incorporating outside the United States; although the firm’s headquarters was in Los Angeles, its corporate address was Wessex House, in Hamilton, Bermuda.15
And then there were the insider sales: in all, Gary Winnick cashed in $735 million of stock, and other insiders sold $4.5 billion, four times more than similarly situated people at Enron.16 Early investors in Global Crossing who later sold at a huge profit included former president George H. W. Bush, who took stock in lieu of a speaking fee, and Terry McAuliffe, the former chairman of the Democratic National Committee, who invested $100,000 in 1997 and cashed out for $18 million after the IPO. Many of these shares were sold when Global Crossing was near its peak in February 2000, when the market value of the firm’s shares was $47 billion, almost as much as Enron’s value.
In 1999, as Enron was exploring the idea of expanding into telecommunications, Global Crossing and Enron began discussing deals they might do together. In December 1999, Enron did its first trade of broadband fiber-optic capacity—a monthly contract between New York and Los Angeles on one of Global Crossing’s new networks.17 The relationship would last until just before Enron’s collapse; Gary Winnick and Jeff Skilling spoke about one end-of-quarter deal just before Skilling resigned in August 2001.18
Global Crossing and Enron were a natural fit. Fiber-optic networks were laid along the path of natural-gas pipelines, so there were reasons for Enron and Global Crossing to do legitimate business together. Enron was more interested in financial techniques than bricks-and-mortar projects, and Global Crossing’s executives quickly learned that financial engineering could be more profitable than any other form of engineering the firm had used. The dealings between the two firms quickly became focused more on accounting numbers than economic reality, just as Enron’s risk-management manual had instructed: accounting numbers were the important measure of performance.
As Global Crossing and Enron developed a relationship, Enron also was advising other companies about how to create phantom revenue and earnings. For example, in July 2000, Enron visited AT&T to pitch its expertise in various complex structured transactions. Enron’s pitch book was audacious: Enron claimed to have replicated its capabilities in natural gas and energy in the telecommunications sector, and said it would be “the world’s largest buyer and seller of bandwidth,” “the world’s largest provider of premium broadband delivery services,” and would “deploy the most open, efficient network with broad connectivity.” These were bold claims to be making to AT&T, which had long been the leading telecommunications company. But AT&T was dying, and although Michael Armstrong, the firm’s leader, had tried numerous financial tricks—from spinning off various divisions to issuing tracking stock, whose value was based on the performance of particular business lines—AT&T’s stock price was at a low. Enron officials thumbed their noses at AT&T’s hard assets, arguing that they could simply “swap” into fiber-optic networks, buying the rights to use other firms’ capacity, and thereby become a leading telecommunications firm overnight, without wasting the time and resources necessary to build its own network.
Enron offered AT&T a variety of complicated transactions designed to improve AT&T’s financial numbers. These were essentially turbocharged versions of the simple schemes Cendant and others had used to “borrow” profits from future years.
One idea related to AT&T’s practice of selling rights to its bandwidth in exchange for a prepaid amount from a customer. Customers did long-term deals with AT&T, and instead of agreeing to pay a fixed rate over time, they agreed to prepay a discounted amount up front. For example, if a customer bought 20-year rights to AT&T’s bandwidth, the cost might be $5 million per year, or $100 million in all spread over 20 years. Instead of agreeing to pay over time, the customer would agree to prepay some discounted amount up front—say, $40 million.
The problem with such a deal, according to Enron, was that accounting rules required AT&T to spread out the income from the $40 million up-front payment over the 20-year period, so that it reported earnings of just $2 million per year. That made economic sense, given that AT&T would incur costs from its obligation to provide broadband services during the 20-year period. But Enron claimed it could arrange a deal so that AT&T reported the full $5 million per year instead.
Here is how it would work. Enron created a Special Purpose Entity, and the customer prepaid $40 million to the SPE instead of to AT&T. AT&T then entered into an over-the-counter derivative with the SPE in which AT&T received a “loan” of $40 million and agreed to pay interest during the 20-year period. Enron then entered into derivatives with both the SPE and AT&T, in which Enron received the ful
l $5 million per year from the SPE and passed that amount on to AT&T. It was a complex daisy chain; but, essentially, AT&T borrowed money from itself, and recognized the additional borrowed amount—an extra $3 million per year—as income. According to Enron, AT&T arguably received $5 million in “income” per year from the SPE, and the “loan” with the SPE was an over-the-counter derivative that did not need to be reported (remember, such derivatives transactions were unregulated and fell outside the scope of traditional accounting rules).
AT&T had frittered away tens of billions of dollars of shareholder value through failed investments in telecommunications, and financial gimmickry, but this scheme was too much—even for AT&T. The company rejected Enron’s proposal, even though it seemed unlikely that regulators would detect these deals. Even if they did, they likely would not understand them. Still, the pitch book for the AT&T deal gave a picture of Enron’s overall dealings, and Enron sold similar products to other companies, reportedly including Lucent, Owens Corning, and even a handful of utility companies.
Then there was Global Crossing.
In March 2001, a little over a year after Enron’s first deal with Global Crossing, the two firms entered into a long-term swap. On the surface, the swap appeared to be a fiber-optic deal, in which Enron paid for eight years of access to Global Crossing’s fiber-optic network and Global Crossing purchased something called “network services” from Enron.19 Enron paid $17 million up front, whereas Global Crossing agreed to make monthly payments for eight years.
In reality, the fiber-optic and network-services rights roughly cancelled each other, leaving only a $17 million “loan” from Enron with monthly “interest” payments to be made by Global Crossing. Global Crossing reported earnings from selling rights to its fiber-optic network, but did not report the “loan” as a liability. Enron reported $5 million of gains from the sale of network services, but did not record the fact that Global Crossing owed it $17 million. Both companies benefited from the appearance of high volumes of transactions in network rights.20 It was exactly the same as the $8 billion of prepaid swap deals Citigroup and J. P. Morgan Chase had sold to Enron, except that now Enron was playing the role of a bank, arranging the deal on its own with Global Crossing.
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