Shattered Glass

by Ted on February 5, 2004

The New York Times Magazine had an excellent story this weekend on the fraud that brought the cable company Adelphia to bankruptcy. Most of the blame has to lie with the Rigas family, who managed to borrow three billion dollars, obligated the shareholders in their public company to cover it, and contrived to hide it from investors. They built a company with comically poor corporate governance- over half of the board were family members, and the audit committee may never have met.

Along the way, they had plenty of accomplices among the institutions that were supposed to be independent circuit breakers. Banks had no business lending other people’s money to the Rigases. Deloitte and Touche failed badly in their role as independent auditors. Despite the refusal of Adelphia management to disclose the loans, Deloitte still signed off on their 10-K. Adelphia attorneys did nothing to stop the loans, and most analysts did only a cursory job of inspecting the company’s structure.

In my mind, most of these problems don’t seem to be appropriate targets for public policy. No law can prevent incurious analysts, cowardly auditors, or shortsighted corporate management. (Conflicted auditors are another story, but that doesn’t appear to be a problem here.) I’d imagine that most laws that attempted to address these issues would do more harm than could.

But regarding banks, I’m not so sure. Specifically, I’m not sure about whether it was a good idea to overturn the Glass-Steagall Act, a Depression-era law prevented commercial banks from getting in the investment banking business until it was overturned in 1999 by the Financial Modernization Act. One of the concerns for the original lawmakers was that full-service banks would lower their standards for commercial loans in order to win lucrative underwriting contracts. According to the author, that’s exactly what happened in this case.

On Wall Street, the conditions for a capital-raising binge were ripe. The repeal of the Glass-Steagall Act, a Depression-era banking law, had paved the way for commercial banks like Citibank and Bank of America to get into the more lucrative business of underwriting. Adelphia’s Brown shrewdly exploited the banks’ greed. In a memo to bankers early in 2000, which cordially began, ”I hope your New Year is off to a great start,” Brown pitched the co-borrowing idea and pointedly observed, ”All of the lead managers and co-managers of each of these credit facilities are expected to have an opportunity to play a meaningful role in . . . public security offerings.”

In others words, if the banks lent the Rigases/Adelphia money, then Adelphia would spill some gravy onto their investment-banking divisions. When the bankers saw that, their mouths watered. This was exactly the sort of conflict that Glass-Steagall had been intended to prevent. The banks went for it. From 1999 to 2001, three banking syndicates, led by Bank of America, Bank of Montreal and Wachovia Bank, allowed the Rigases/Adelphia to borrow a total of $5.6 billion, a staggering sum. Citigroup, J.P. Morgan, Deutsche Bank and scores of other banks participated.

Adelphia, meanwhile, was true to its word. From 1998 to 2002, it went to Wall Street more than a dozen times to issue stock, bonds, notes, convertibles — every flavor in Wall Street’s pantry. It raised something like $10 billion, while shelling out $233 million in fees. And syndicate banks like Bank of America were rewarded with lucrative underwriting assignments for their investment-banking affiliates.

The banking organizations have declined to comment. Generally, they maintain that their two functions, lending and underwriting, were separated by a Chinese wall and that the underwriters were in the dark with regard to the loans (even though they were arranged by their own affiliates). This does not square with the facts. In February 1999, Brown bluntly informed a large group of bankers and investment bankers, ”The Rigas family intends to use the proceeds of this distribution to purchase equity securities from Adelphia.”

Anyone looking for mere gaps in the Chinese wall is missing the larger point: banks weren’t trying to separate departments but to integrate them. That was the whole reason they had lobbied for Glass-Steagall’s repeal. Thus, the banks would send teams of 8 or 10 investment bankers and commercial bankers — no distinction was evident, according to Tim Rigas — to Adelphia pitching every financial service under the sun.

Enron had a similar relationship with JP Morgan Chase. To quote the Financial Times, “Morgan was simultaneously Enron’s creditor, its counterparty in various complex offshore trans-actions, an arranger of third-party financing and a provider of investment banking advice.” The setup worked really well until, suddenly, it didn’t.

My instinct is that Glass-Steagall was a classic case of concentrated costs and diffuse benefits. A small number of bankers could see a tremendous opportunity for growth and profits if the law was repealed. Many investors benefited just a little from it. I’m actually a little surprised that the law stood for as long as it did.

But I could be wrong. The Economist says, more or less, don’t bring G-S back. I’ve come across this brief note suggesting that, since other countries have different practices, the law makes it difficult to compete with foreign financial services firms or to work smoothly with international offices. This paper argues that diversification in financial institutions would lower their total risk and lead to fewer defaults. But I don’t know how well this stands up to the evidence of the last few years.

In short, I’m in search of a point. Any thoughts would be welcome.



Maynard Handley 02.05.04 at 7:08 am

“The Economist says, more or less, don’t bring G-S back.”

And this is supposed to be an argument in FAVOR of abandoning GS? This from the same _Economist_ that will happily print article after article admitting that, yes, in this particular case (Enron, Parmalat, Boeing, whatever) corporate self-regulation didn’t work well, and, generally in the same edition, gives us editorials and other screeds on how interference in the behavior of corporations by anyone but the shareholders, be it activists, consumers, or government, is a horrible, terrible idea that will result in the destruction of capitalism and the poverty of us all.


Gavin 02.05.04 at 7:30 am

It’s quite hard to tell whether the extent of corporate malfeasance in the latest boom is significantly greater than in previous booms – relative to GDP for example.

But if it is, then the abolition of Glass-Steagall is a serious candidate for having made it worse. Although there are a number of other institutional changes that also matter – such as the way that auditing firms have been allowed to develop their consultancy businesses (as have law firms), and also the spread of Incentive Stock Option Plans. I’m not sure of the exact timing of the latter two events, although they certainly were important throughout the 1995-2000 stockmarket bubble period.

Although all the reforms mentioned had no doubt laudable goals, they also had the unintended consequence of raising the returns to corporate malfeasance, or reducing the ability of shareholders to monitor malfeasance. I’m not sure that the spread of compliance officers etc will actually achieve very much when set against those incentives.

Having said that, we shouldn’t be trying to replace caveat emptor with caveat vendor! If Adelphia’s shareholders let themselves be taken for a ride, well, it might be necessary pour encourager les autres. And if you’re worried about the Aunt Agatha’s who may have held Adelphia stock, then a simple solution might be the introduction of some kind of government guarantee of small shareholdings (similar to bank deposit insurance).


Chirag Kasbekar 02.05.04 at 7:33 am


Barry 02.05.04 at 1:08 pm

Why can’t we punish the people involved? When the auditors conduct phony audits, when the boards of directors are boards of crony accessories, when banks/investment firms aid and abet, the people involved should be punished, and punished harshly.

If I embezzled tens of thousands of dollars, I’d be kissing the judge’s *ss to get only probation. I’d probably end up doing a few years in prison. Those who embezzle/aid&abet the embezzlement of 100’s of millions of dollars should serve decades.

And I’ve heard the argument (advanced by these people) that harsh punishments will only make it harder to get directors, auditors and such. It’s probably true – I’d gladly take a job which involved free money for signing off on crimes with no personal liability, compared to having some personal liability.


nnyhav 02.05.04 at 2:20 pm

Glass-Steagall addressed the problems of commercial/investment banks being simultaneously principals and agents. The measure was adapted to prevent abuses/manipulation related to direct debt or equity stakes forming the banks’ capitalisation. US capital markets migrated to a system in which bank stakes were less direct (e.g., loan syndication) and in which companies could more directly access the securities markets, in part due to the piecemeal rollback of G-S (which certain foreign banks were grandfathered out of anyway — look where Gramm ended up). Globalisation of finance and of financial regulation certainly contributed to this particular legislation becoming increasingly anomalous. All this being well past, the abbreviation GS has passed on to the stock ticker of Goldman Sachs (where Rubin started out).


James Surowiecki 02.05.04 at 5:01 pm

Europe has never had anything resembling Glass-Steagall. European banks have always been able to be “universal” banks, and in at least some places — like Germany — have not only done both commercial lending and investment banking, but have also taken equity stakes in companies. So unless you think European economies have been fundamentally corrupted by universal banking, I think the connections between the repeal of GS and the scandals of the late 1990s has to seem very dubious. I think universal banking is a bad idea as a matter of strategy, but the case that it should be illegal is very weak.

Comments on this entry are closed.