Big Banks Prepaying The Piper

Forbes.com ^ | 7-24-02 | Dan Ackman

[Oldeconomybuyer]

NEW YORK - New York's biggest banks defended their dealing with Enron Tuesday at a Congressional hearing, but their own statements indicate what a tangled web they weaved. Their defense--essentially ignorance--seems almost worse than the wrong alleged.

At the hearing, Citigroup (nyse: C - news - people ) and J.P. Morgan Chase (nyse: JPM - news - people ) tried to spin themselves as victims of Enron's (otc: ENRNQ - news - people ) duplicity, but Congressional investigators said they were willing victims--who also helped Enron hide their debt from everybody else

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At issue at the hearing were a series of transactions known as prepays, in which a commodity trader promises to deliver a commodity in the future, but gets cash in advance from a financier. Normally when the trader gets paid for the commodity--whether it's oil, or electricity or anything else--he repays the financier. If there is a legitimate commodity deal, it's a standard arrangement, the bankers say. But in this case the commodity trader was Enron, so things got hairy.

Senate investigators say the banks helped Enron fake commodity trades so they could make what would ordinarily be billions of dollars in loans to Enron in ways that would let Enron avoid disclosing the debt to investors. Had Enron accounted for the loans properly, they would have shown roughly $14 billion in debt on its balance sheet rather than $10 billion. Had investors understood the true story of Enron's finances, they would have known to pull out of Enron stock much earlier, the investigators suggest.

The banks, for their part, say they were not responsible for Enron's accounting and that they relied on Arthur Andersen, Enron's convicted felon accountant, in various ways: "The transactions we entered into with Enron were entirely appropriate at the time based on what we knew and what we were told by Enron. We were assured that Enron's auditors had approved them and we believed they were consistent with accounting rules in place at the time," Citigroup said in a statement issued yesterday. It denies it had an oral side deal with Enron that would have made the prepay deals more clearly ordinary loans.

Statements like this one are an odd sort of defense. Aren't bankers supposed to know what's going on before they advance billions? Enron's guys may have been smart, but aren't Citigroup's guys supposed to be pretty smart, too?

As it happened, the two banks are now among Enron's biggest creditors and are collectively on the hook for roughly $4 billion--big money even for them. Their losses will dwarf the roughly $200 million in fees the bankers collected at a time when Enron was hailed as the seventh-largest company in America.

Meanwhile, the two big banks, along with others, are defendants in civil suits by Enron shareholders, are likely subjects of criminal probes and have seen their analysts embarrassed for their rank ignorance about what Enron was doing.

J.P. Morgan describes its dealings with Enron this way: "Our roles in the relationship included lender, trading counterparty, M&A advisor, structured finance provider and passive investor as a limited partner. " In other words, they did practically everything for Enron except wax Jeffrey Skilling's car. Still, they had no clue.

For J.P. Morgan, the same issue was vetted three months ago. At that time, a U.S. district court judge, Jed Rakoff, (the same judge involved in the WorldCom (nasdaq: WCOME - news - people ) case) ruled preliminarily in a dispute between J.P. Morgan and its insurers that J.P. Morgan's transactions with Enron appeared to be fraudulent: "These arrangements now appear to be nothing but a disguised loan--or at least have sufficient indicia thereof that the court could not possibly grant judgment to the plaintiff,'' Rakoff wrote in denying a motion by the bank. (See: J.P. Morgan Loses Round One.)

J.P. Morgan still says the deals were legitimate and that "We had appropriately limited our Enron exposure by mitigating our risk through surety bonds, letters of credit and collateral." The insurers, of course, have refused to pay for the bank's loss. The bank has said its total exposure to Enron is $2.6 billion and that it has already written off $500 million of that total. This exposure could, of course, grow substantially if the shareholder lawsuits are successful.

In the lawsuit between J.P. Morgan and its surety insurers, Judge Rakoff found that Enron was buying nearly the same amounts of natural gas from a company called Stoneville as it was putatively selling to another company called Mahonia. Stoneville and Mahonia appeared to be owned and operated by the same people. Therefore it appeared that the bank was giving money to Enron based on a sham natural-gas trade.

What remains unclear is who was behind Mahonia, Stoneville and the other offshore entities involved in the Citigroup deals. The banks denied yesterday that they controlled the companies.

If there is anyone out there who knows the full story, he's not talking.

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[TightSqueeze]

Time will tell but the government may in fact be between a rock-and-a-hard-place when it comes to the large money-center banks. This issue coupled with their massive derivative exposure could cause an economic crash that would make 1929 look like a day at the beach.

[Oldeconomybuyer]

Big bank exposure to derivatives and other financial gimmicks could make the 70-80's S&L fiasco look like small change.