FINANCIALHISTORY

of theUNITED STATES

FromEnron-Era Scandals to

the Subprime Crisis(2004-2006)

JERRY W. MARKHAM

dM.E.SharpeArmonk, New YorkLondon, England

Contents

FROM ENRON-ERA SCANDALS

TO THE SUBPRIME CRISIS ( 2 0 0 4 - 2 0 0 6 )

List of Abbreviations xixPreface xxiiiAcknowledgments xxvIntroduction , xxvii

Photographs follow page 188.

Part I. Enron and Corporate Reforms 1

1. Enron and Its Aftermath 3The Enron Scandal 3

Background 3Government Response 4

The Trials 7The Arthur Andersen Fiasco 7The Nigerian Barge Fiasco 10Broadband Services Prosecutions 13The NatWest Three 15The Lay and Shilling Criminal Trial 18Lou Pai 32

Summing Up the Enron Litigation 33The Prosecution's Scorecard ; 33Enron Bankruptcy Proceedings 34Class-Action Suits 35Dynegy 36

2. Other Enron-Era Scandals 37The Telecom Scandals—The Aftermath 37

Background 37Nortel 41Adelphia 42

vii

viii CONTENTS

Other Telecom Firms 43WorldCom 43

Other ̂ Scandals 47HealthSouth 47Tyco 51Cendant and AOL 53Computer Associates 55Grocery Store Accounting 56Pharmaceutical Companies 57Conrad Black 7 57Kmart 59Tax Shelters: Another Enron-Era Scandal 59Other Accounting Scandals 65

The Wall Street Scandals 66The Financial Analyst Scandals 66Other Financial Analyst Issues 68Frank Quattrone 69Spitzer's Downfall .- 71

3. Corporate Governance Reforms ...76Sarbanes-Oxley 76

The Enron Reforms 76Other Sarbanes-Oxley Reforms 78Small Companies 79

Loss of Competitive Advantage 80Competition from Abroad 80Blue Ribbon Reviews 80Government Concerns 83

The Executive Compensation Controversy 84Background. 84Fiduciary Duties 86Ovitz's Compensation 88Confiscation Through Taxes 89The Reagan and Bush Tax Cuts 91

Compensation Arrangements 93Golden Parachutes 93Class Warfare and the Criminalization of Executive Pay 95Richard Grasso's Retirement Package 97

SEC Full Disclosure 100Background. 100Disclosure Fails 101The SEC Tries Again 102

Compensation Concerns Grow 103Compensation as Politics 103

CONTENTS ix

Incentive Compensation 104Options 104Option Effects 106

More Scandals 107Option Backdating 107Prosecutions 109Other Abuses I l lTheWar on Perks 112

Corporate Reforms—Shareholder Voting 117Proxy Votes 117Election Proposals 120Majority Votes 122Staggered Boards 123Political Correctness 123Broker Votes 124Separation of Chairman and CEO 124Shareholder Bill of Rights 125

Other Reforms 126Class-Action Lawsuits 126Some Corporate Pushback 130Class-Action Lawyer Scandals 131

Part II. Financial Market Developments 137

4. Securities, Banking, and Insurance 139Securities Market Developments 139

Some History 139Regulation 141National Market System 142Specialists' Problems 143Information Technology 144More Automation 145The ECNs Compete 146NASDAQ 149Transformation ofNYSE 150Broadening Markets 154Overlapping Regulation 155

The Options Exchanges 156Some History 156Competition 157Subprime Crisis 159

Clearing and Settlement.. 159Securities Industry 159Additional Developments 162

CONTENTS

Transfer, Agents 164Treasury Report 164International Clearing 165Concerns over Cross-Border Settlement 166Equity Options Clearing 167

Custody and Payment Systems 167Free Credit Balances 167Collateral Arrangements 169Payment Systems and Central Banks.z.. 170CHIPS ." 171Fedwire 172Fixed Income Clearing Corporation 172SWIFT 172Payment System Concerns 173

Stock Lending 175Capital Requirements 176

Bank Capital Requirements 176Subprime Reaction 180

SEC Net Capital Requirements 180Background. > 180Drexel Burnham 182Consolidated Supervised Entities 183Insurance Capital Requirements 184

5. Commodity Markets 189Market Developments 189

Some History 189Regulation 190The Stock Market Crash of 1987 193Forex Fraud 194Other Over-the-Counter Derivatives 196Commodity Futures Modernization Act of 2000 197EnronOnline 199Energy Market Manipulations 200FERC Powers 204More Regulation 207Index Traders 208The Enron Loophole 209ECNs in the Commodity Markets 212Electronic Trading Delayed 213Competition from Abroad 214Competition and Consolidation 217

Futures Market Clearinghouse 218The Role of the Clearinghouse 218

CONTENTS xi

The Stock Market Crash of 1987 220Over-the-Counter Clearing 221Competition Concerns 221Cross-Margining 222Custody Arrangements—Futures Commission Merchants 224CFTC Capital Requirements 225

6. The Rise of the Hedge Funds and Private Equity 227Hedge'Funds , 227

Background. 227Mutual Fund Scandals 231The SECs Response 236Regulating Hedge Funds 241

Hedge Funds Expand 244Hedge Funds Go Public 244Hedge Fund Abuses 245

The Rise of Private Equity 249Some History 249Venture Capitalists 250Private Equity -....254Private Equity Renewed :.256Leveraged Loans 258CDOs 259Private Equity and Hedge Funds 261Private Equity and Privacy 263Union Objections 264Private Goes Public 266KKR 269The Carlyle Group 270Asset Managers 271Taxes : 274The Credit Crunch and Private Equity 275Sovereign Wealth Funds 276National Security Concerns 278

7. The Mortgage Market 281Mortgages 281

Some History 281Mortgage Lenders 282Residential Mortgage Providers 283Twentieth-Century Mortgage Markets 286Real Estate Bonds 288The Great Depression 290Residential Markets 292

xii CONTENTS

The Rise of the GSEs 294Federal Home Loan Bank Board 295Reconstruction Finance Corporation 296

Building a Mortgage Market 296Roosevelt Acts 296Home Owner's Loan Corporation 297Federal Housing Authority 298Reconstruction Finance Corporation—Expansion 302Fannie Mae „._. 302More Programs 303Postwar Boom 304The 1950s 305

The S&L Crisis 307S&L Business Plans 307The 1960s 308Studies 310More Legislation 311S&L Problems 312The S&L Crisis 315Deregulation .317Problems Grow 318Blame 321FIRREA 322Commercial Banks 324

8. A Critical Look at the Reformers 327Prosecution Abuses 327

The New York Attorney General 327Federal Prosecutors 328Justice Department as Regulator 332

Corporate Governance Reforms 334Punitive Legislation 334Compensation Issues 334Athletes and Entertainers 336Scalable Compensation 340Results 341Union Pension Funds as Reformers 341Newspapers as Reformers 344

Conclusion 351Notes 353Selected Bibliography 363Name Index 1-1Subject Index 1-17

CONTENTS xiii

FROM THE SUBPRIME CRISIS

TO THE GREAT RECESSION (2006-2009)

List of Abbreviations xiiiPreface xviiAcknowledgments xix

| Introduction xxi

Photographs follow page 622.

Part III. The Growth of the Mortgage Market 375

9. Securitization 377Government-Sponsored Enterprises 377

GSEs 377Securitization 379Collateralized Mortgage Obligations 381

Mortgage Market Growth 382Secondary Market 382Private Securitizations 384Asset-Backed Commercial Paper 385Student Loans 386

Subprime Lending 391Subprime Loans 391Consumer Protection Legislation 392Predatory Lending Practices 393Federal Preemption 396Fannie Mae and Freddie Mac 399Collateralized Debt Obligations 402Monoline Insurers 403Credit-Default Swaps 406Mortgage Brokers 407Nonbank Subprime Lenders 408

10. Prelude to a Crisis 412Panics and Bubbles 412

Some History 412The Stock Market Crash of 1929 413Inflation 414The Stock Market Crash of 1987 415Trouble Abroad 416

Run-Up to the Real Estate Bubble 418Breaking the Dot. Com Bubble 418Interest Rates 419

CONTENTS

More Interest Rate Increases 423Changing of the Guard 425First-Quarter Results 425Paulson Arrives 426

, Interest Rate Effects 427Third Quarter 428

i The First Cracks Appear 429The Dow Rises 429False Hopes , 430

The New Year—2007 ..'... 431Mixed Signals 431New Century Financial 432More Losses 433On to the Second Quarter 434

. Bear Stearns—The Struggle Begins 437The Credit Crunch and Private Equity 440Third-Quarter Problems 444Fair-Value Accounting 448The Fed Acts on Rates 449Subprime Problems Travel Abroad 451The Crisis at Citigroup 453UBS 457Money Market Fund Problems 459Asset-Backed Commercial Paper (ABCP) Problems 460Fed Policy 461Fourth-Quarter Results 463Fannie and Freddie 464Payday Lending 467Executive Compensation 468

Part IV. The Subprime Crisis 471

11. The Crisis Begins 473A Crumbling Landscape 473

The New Year 473Societe Generate 475Countrywide Financial 476The Crisis Continues 480Policy Developments 480Mortgages 482The Crisis Continues 485Auction Rate Security Market 486More Problems 490Bear Stearns Fails 495

CONTENTS xv

First-Quarter Results 499More UBS Problems 503

i.More Losses 504Economic Turmoil Continues 504Financial Services Results 507Investigations 508Broadening Problems 509Short Sales 510The Decline Continues 512IndyMac Fails 514Energy Prices 516Federal Housing Administration 517Third-Quarter Results 519Fannie Mae and Freddie Mac Are Nationalized 520

12. The Great Panic Begins 524The Financial Hurricane 524

Lehman Brothers 524Reserve Primary Fund 531The AIG Debacle ;, 534

More Failures ^.....546Merrill Lynch 546The Crisis at Morgan Stanley 554Washington Mutual (WaMu) 557Wachovia 558

The Bailout 561The Feds Face the Crisis 561The Bailout Bill 562Troubled Asset Relief Program (TARP) 565More Problems 565Government Reactions 566Market Volatility 567The TARP Bailouts 567Municipal Securities 570General Electric 570

13. The Crisis Continues 572The Contagion Spreads 572

Crisis Abroad 572Private Equity 577Hedge Funds 579Venture Capital 583

Dealing with Chaos 584The Crisis Rolls On 584

xvi CONTENTS

Greenspan 586More Market Volatility 587More Citigroup Problems 593Government Action 595More Losses 597

The Automakers Fail 600Problems in Motor City 600General Motors and Ford 601The Motor City Bailout Begins 603

The Madoff Fraud and Other Problems 608Fraud Continues 608The Madoff Fraud 609Suicides and Scandals 613

A Bad Year Finally Ends 615The Economy Continues to Struggle 615Year-End Results 618

Part V. The Crisis Abates 623

14. The Rise and Fall of the Subprime Crisis ,625The New President 625

The New Year—2009 625Trouble Abroad 627Inauguration Day 627Regulatory Proposals and Stimulus 629

The SEC 630Conditions Remain Uncertain 632

Executive Compensation 636A Populist Issue Returns 636Bonuses at AIG 638The Controversy Continues 640Compensation Abroad 644

The Bottom Is Reached 646The Market Decline 646Market Critics Emerge 648Market Volatility 649Government Interference 651Economic News 652

Sunrise in America 655The Second Quarter Begins 655TARP Cops 656TARP Funds 658Green Shoots 660The Struggle Continues 662

CONTENTS xvii

The Way to Recovery 667The Rocky Road 667

i. A Parting of the Clouds 669Fourth Quarter 675

A New Decade Begins 684Recovery Is Slow and Uncertain 688

15. Regulation, Reform, and the Subprime Crisis 696What Caused the Subprime Crisis?..,, 696

Subprime Affirmative Action 697CRA "Extortion" 698Down Payment Policies 700Safety and Soundness Concerns 700Freddie Mac and Fannie Mae Quotas 701Andrew Cuomo 703Bush Administration 704Interest Rate Policies 705Targeted Interest Rates 706Carry Trades 707The Fed's Liquidity Role .- 708"Helicopter Ben" and "Hank the Bazooka" 710Capital Requirements 711SEC Capital Requirements 714Fair-Value Accounting 715The Fair-Value Fight 716The FASB Reacts 720Real Estate Appraisals 721Appraisal of Income-Producing Property 723Risk Models 724

Regulatory Reform 725Financial Literacy of Regulators 725Functional Regulation 728Treasury Report 728Subprime Crisis Regulation Proposals 729Turf Wars ..730The SEC and the Goldman Sachs Case 731Dodd-Frank Wall Street Reform and Consumer Protection Act 736Elusive Systemic Risk 740The SEC, CFTC, and Derivatives 741Hedge Funds 747The Ratings Agencies—Shoot the Messenger 748Consumer Protection 755Consumer Financial Protection Bureau 756Compensation Issues Again 758

xviii CONTENTS

Federal Insurance 761Regulation Abroad 762

The-Financial Services Authority 762European Union 764

Conclusion 767iNotes : 769Selected Bibliography 777Cumulative Name Index 785Cumulative Subject Index 815About the Author 826