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Bubble banks pariahs { November 14 2002 } Original Source Link: (May no longer be active)
http://www.washingtonpost.com/wp-dyn/articles/A51598-2002Nov13.htmlhttp://www.washingtonpost.com/wp-dyn/articles/A51598-2002Nov13.html
Banks Go From Powerhouses to Pariahs
By Jonathan Krim
Washington Post Staff Writer
Thursday, November 14, 2002; Page A01
Fifth of six articles
On Oct. 8, 1999, a small software start-up in Silicon Valley called Interwoven Inc. took its turn at the bellows of the nation's stock market bubble.
In a story repeated hundreds of times during the technology boom, Interwoven started trading at $43 a share and ended the day up 141 percent from its IPO price of $17. And as usual with initial public offerings of stock, huge amounts of money were made, both by those who were able to buy shares ahead of time and by the investment bank that handled the offering -- in this case, Credit Suisse First Boston Corp., which earned $2.7 million in fees.
Frank Quattrone, the star technology banker who helped make CSFB the Valley's leading IPO bank, had a special interest in the success of the deal. Along with several other CSFB bankers, Quattrone, who at the time reportedly made $100 million a year, was able to buy Interwoven shares at an even lower, pre-IPO price: $8.49 a share, according to regulatory filings. A year later, when the stock had risen to $90 a share after splitting twice, the bankers sold their shares for $3.4 million, the filings show. An internal fund operated by the bank cashed in shares worth an additional $19 million.
That year, a CSFB research analyst touted Interwoven's stock, calling the market for Web-site-building software an "explosive, multibillion-dollar opportunity." CSFB maintained a positive rating on the stock into the spring of 2001. Today Interwoven trades for less than $3, but its performance has been remarkably consistent: It has never made money.
Celebrated in an earlier boom -- the 1980s -- as "Masters of the Universe" for their skill in leveraged buyouts and corporate mergers, Wall Street's investment bankers found lucrative new opportunities in the 1990s, an era whose hallmark was the extraordinary availability of capital.
Some sold new forms of derivatives, complex and high-risk investments that offer tantalizing returns if the buyer is willing to make a bet on, say, whether the value of the currency of Thailand will go up or down. Others advised corporations on "structured" financings that allowed companies such as Enron Corp. to raise billions in cash but also to avoid taxes and hide debt by using complicated partnerships, off-the-books transactions and related exotic investment products.
Still others pounced when the tech boom hit.
Although it was the venture capital funds that gave the tech start-ups the money to begin operations as fledgling private companies, it was the investment banks that took them to the big time -- the public stock markets -- enabling many unprofitable firms to raise billions of dollars from investors. This helped spawn a stock market boom that enriched many in the know but ended in losses for hundreds of thousands of less-informed Americans.
Today, several major investment banks -- including such storied names as Morgan Stanley, Goldman Sachs and Merrill Lynch -- are under investigation by regulators and face multimillion-dollar fines and lawsuits for banking practices over the past five years. One of the besieged, but less well known, is Credit Suisse First Boston.
It has paid $100 million to settle claims that it demanded kickbacks from investment managers in exchange for hot IPO shares. It is being sued by Massachusetts regulators for providing misleading or deceptive research to boost demand for stocks. Overseas, its bankers have run afoul of regulators in Britain, Sweden and Japan.
Quattrone, once a Silicon Valley celebrity, now stands vilified as an icon of Bubble excess.
In many ways, CSFB mirrored the times. Just as many tech start-ups sought to displace established industry giants through aggressive innovation, CSFB sought to topple its bigger, stodgier Wall Street brethren. It failed in that mission, but some of its bankers and tactics helped shape the industry.
CSFB "was as aggressive as it gets," said Michael Holland, a New York money manager who worked at the firm. "Wall Street is a very small place. In terms of competitiveness, these were the cowboys. It was no holds barred, take no prisoners."
Another former CSFB senior banker, who like most people interviewed for this account insisted on anonymity, said the culture at CSFB was that "you never turn down a deal."
"If the client has a problem, we can figure out a way to solve it," the banker said of the ethos.
Officials at CSFB refused to make Quattrone and other top bankers, including chief executive John J. Mack, available to comment for this story. They said that CSFB's practices were the industry standard at the time and that the bank should be judged on that basis, not unfairly singled out.
But they point to several changes Mack has instituted since joining CSFB last year. These include bringing in Gary G. Lynch, a former Securities and Exchange Commission enforcement chief, as general counsel; changing how the bank allocates IPOs; and giving research analysts more independence from bankers.
"Wall Street, like all of corporate America, is facing a crisis of investor confidence exacerbated by a protracted bear market and some shocking examples of corporate abuses," Lynch said in a statement yesterday. "In hindsight, it is easy to see that many investment banks -- together with most institutional investors, government and independent economists, the media and other market participants -- were overly optimistic about the anticipated performance of some high-growth sectors in the economy. To help restore investor confidence, our industry must now do a better job of assuring investors that we are properly managing any potential conflicts of interest and that our research meets the highest standards of independence."
Changing the Calculus
The New York Stock Exchange sits on Wall Street. Investment bankers are Wall Street.
In richly appointed, dark-wood-paneled offices they are investment advisers and portfolio managers for wealthy private clients. In branches around the world they facilitate corporate mergers and buyouts and underwrite IPOs. On raucous trading floors they buy and sell securities of every color -- basic stocks, junk bonds and derivatives.
These transactions, executed for clients and for the banks themselves, make the markets run. Bankers conceive complex financing deals that help companies raise money. Through their research arms they advise clients on the prospects of stocks. They lend money. There are hyperactive dealmakers who seek ever-higher fees with cutthroat zeal. And there are salesmen who earn hefty commissions selling high-risk investments.
Modern-day investment banks trace their roots to post-Depression reforms in the financial system, when regulators prohibited traditional commercial banks -- whose primary role was making loans and taking deposits -- from being involved in the securities-and-trading side of the business. But those lines blurred over time and would be formally wiped away with the repeal of the Glass-Steagall Act in October 1999.
By then, Morgan Stanley, Goldman Sachs and Merrill Lynch were entrenched as the heavyweights of Wall Street, the "bulge bracket" players. In 1998, Morgan Stanley netted $3.3 billion in profit; Goldman Sachs recorded $2.4 billion.
For years, CSFB had tried to break into the rarefied top tier.
It was just First Boston Corp. during most of the 1980s, a firm that, by one account, was the prototype of the aggressive suspenders-and-slicked-back-hair culture popularized in the movie "Wall Street." In 1988, First Boston was bought out by the Zurich-based financial conglomerate Credit Suisse Group. First Boston got a deep-pocketed partner from the deal, and Credit Suisse gained a strong foothold in the United States, particularly in mergers and acquisitions.
The combined CSFB went on an acquisition spree, adding smaller trading and banking firms around the world to fill holes in its areas of expertise or market share. In 1996 it had roughly 5,000 employees. By the end of 1999, that number had nearly tripled.
Leading the charge to become a global powerhouse was the bank's then-chief executive, Allen D. Wheat, a blunt-spoken expert in trading derivatives. Wheat was famous for raiding whole teams of professionals from competitors, and just as the technology sector began to hit overdrive in 1998, he hired Quattrone to run CSFB's technology banking group.
Philadelphia-born, Quattrone was educated at the Wharton School and Stanford University. He started work on Wall Street at Morgan Stanley. He was not a typical Wall Streeter, heading west in the early 1980s, eschewing the rough and tumble of New York for the embryonic center of technology growing in the apricot and prune orchards of Silicon Valley.
When Quattrone arrived on the West Coast, the personal computer was making its debut, and a handful of successful companies such as Apple Computer Inc. and chipmaker Intel Corp. were riding the first wave of the tech boom.
Quattrone cultivated relationships with venture capitalists and tech executives, dressing casually and grasping technology's growth potential before his colleagues back in New York. Eventually, he persuaded Morgan Stanley to underwrite tech-company IPO deals that by major-bank standards were still so small they would normally be ignored by the Wall Street giant.
Traditionally, banks did not take companies public until they had been profitable for at least two or three quarters. Instead, companies were expected to wisely spend and ration the private funding they had received until their businesses proved viable. Only then would they be offered to public investors.
Then, in 1995, Quattrone took Netscape Communications Corp. public. The stock soared 107 percent on the first day and helped change the calculus.
Unlike the computer hardware companies that provided appliances that would make work and life more efficient, the Internet threatened to scramble the foundations of commerce itself, not to mention those of its major players. The technology of the Internet and a networked world was in its infancy, but its potential seemed certain -- and limitless. And investors were eager.
A new kind of alchemy was born. The requirement for near-term profit -- Netscape, for example, was giving away much of its software and losing money -- was replaced by almost any measure of growth that hinted at the promise of domination later.
Enabling a large portion of the public to invest in these stocks minimized the risk for the financial institutions and early investors who helped launch the companies. Regardless of how a business fared, its stock usually soared high enough, and for just long enough, for many on the inside to cash out.
In the process, risk was transferred to investors who came in at later stages, ponying up for stocks at prices that would prove unsustainable, even as they were told by bankers' research analysts that prices could go higher still.
In 1996, emboldened by the success of Netscape and the dizzying array of Internet-related innovations, Quattrone began to get antsy, according to those who worked with him. By then a Silicon Valley fixture, he believed his bosses in New York still didn't understand tech's potential, didn't give him enough control and didn't pay him enough.
"As part of the Bubble, investment bankers got a lot of leverage with their employers," said one person who knew him. "In 1996, Frank put the screws to them pretty good."
Quattrone wanted control over the entire tech-banking universe at Morgan Stanley, including analysts who followed tech companies, according to several people familiar with his operation. Combining authority over banking functions and research was a novel idea; conventional wisdom held that analysts served as important checks against bankers whose compensation came from doing deals with companies regardless of their prospects.
But Quattrone, according to those who worked with him, believed the relationships needed to be integrated so that a potential client with an IPO would have some assurance that if the bank took the company public the bank would support it with research.
Other banks did the same, and, as several regulators have charged, stock research was compromised or deceptive. Decisions to take companies public were reinforced by the bankers' research units.
Quattrone's demands were turned down by Mack, who was then president of Morgan Stanley. Quattrone jumped to a firm that gave him a better deal and some of the control he wanted: Deutsche Morgan Grenfell, a German-owned bank with aspirations to grow in the United States. In 1997, Quattrone scored another major tech IPO: Amazon.com Inc. The following year, Wheat called and persuaded him to join CSFB.
Quattrone took so many members of his team with him in July 1998 that CSFB simply took over the offices they were in and changed the name on the doors. Bankers said he got control over tech banking, tech trading and tech stock research, as well as the commitment of at least $25 million from the bank to invest in internal funds that traded stocks for the bankers and other special clients.
Such was Quattrone's independence that a CSFB insider described it as having "a company within the company."
The results were remarkable. In 1998, CSFB handled six domestic tech IPO deals, valued at $269 million, putting it sixth among the banks, according to financial data from research firm Dealogic Inc. By the end of 1999, at the height of the Bubble, it jumped to first, handling 51 deals -- twice the number handled by Goldman Sachs or Morgan Stanley.
In 2000, CSFB again handled nearly twice the number of issues as its top competitors, although in overall dollar terms it was never able to topple its big rivals.
For two years, demand from companies seeking to go public was "insatiable," said one banker, and Quattrone "was feeding the market what it wanted to eat."
"Frank didn't care about anything else. . . . It was buyer beware. He got paid for the IPO," the banker said.
Quattrone was willing to let some people in on the action, through what became known in the Valley as "Friends of Frank" accounts. Quattrone promised shares of IPOs the bank was handling to wealthy potential clients, such as chief executives and venture capitalists, if they would open private bank accounts at CSFB, people familiar with the firm said.
According to the bank, the client could not cherry-pick among the offerings and had to decide whether to accept all IPO shares or none.
In a 1998 interview with Fortune magazine, while still at Deutsche Morgan Grenfell, Quattrone said that standards for bringing companies public had loosened, which he attributed in part to investor demand. Nonetheless, he maintained that the bank turned down a majority of the companies seeking to go public.
"Investors have become more aggressive because of the Internet," he told Fortune. "They're so afraid they'll miss something." A CSFB spokeswoman rejected the notion that the bank was less rigorous than its competition in its decisions about which companies to take public.
Working the Footnotes
In addition to getting the action he wanted in the tech arena, Wheat wanted to build up CSFB's capabilities in other areas that could earn the firm fees for supplying capital to companies in unusual ways. So he bought a second-tier competitor, Donaldson, Lufkin & Jenrette Securities Corp., better known as DLJ, in 2000. With it came a creative team of bankers in an esoteric area known as "structured finance."
"DLJ was way out there . . . more aggressive than CSFB" in areas such as structured finance and junk bonds, according to a former CSFB banker. DLJ had taken on many of the bankers from Drexel Burnham Lambert Inc., the infamous home of Michael Milken that imploded in scandal in the 1980s.
One prominent team leader at DLJ was Laurence Nath, known in Hollywood as a brilliant banker who, while working for Citigroup Inc., did innovative financing deals for the movie industry. In 1998, Nath's team developed a close working relationship with an energy company called Enron Corp.
Nath was one of a cadre of bankers in the industry who, steeped in the arcane rules of accounting, would be called in to help companies meet particular needs, such as raising cash, transferring debt or reducing taxes. At CSFB, the structured-finance experts executed dozens of complicated financings for several clients.
"These are very sophisticated people who are experts in taxes, experts in legal structures," said Jennifer E. Bethel, a finance professor at Babson College who served as chief economist for the SEC's corporate finance division. "They could make a deal that otherwise couldn't get done."
CSFB declined to make Nath or any banker on his team available for comment.
Structured finance can be a legitimate way for companies to get capital from sources other than their core operations, allowing them to invest more in their businesses.
This form of financing might, for example, allow a company to place an asset, such as a power plant, into a special entity such as a partnership, trust or subsidiary. By selling or transferring the asset to the entity, the company raises cash. To pay for the asset, the entity issues bonds to investors. Since the obligation to pay off those bonds resides on the balance sheet of the special entity, not of the parent company that got the cash, the company's overall debt looks smaller.
In some cases, especially Enron's, partnerships were wrapped up in subsidiaries owned by trusts in a seemingly endless maze. Some were incorporated offshore. Some were run by Enron employees, and Enron was able to take large deductions for entities "sharing" administrative costs and other expenses.
At the core of many of the structured deals, though, was that the primary company was ultimately on the hook for paying off bondholders. Depending on how much a company disclosed about these entities and how they worked, identifying how much that commitment to pay might affect a company's bottom line would be difficult even for experts.
Lynn E. Turner, a former chief accountant of the SEC, told Congress in July that "many of these structured or engineered transactions are done to circumvent existing accounting rules."
"I can't tell you, Mr. Chairman, how often . . . I heard the common refrain 'Where does it say in the accounting literature I can't do it?' " Turner said.
Nath and his team were not involved in some of Enron's most infamous off-the-books transactions, with names such as Chewco and Jedi, through which Enron executives allegedly enriched themselves. CSFB argues that Nath was a bit player, developing three partnerships out of thousands for Enron, and that they were transactions fully cleared by credit agencies and disclosed to the financial markets.
But a senior Enron official said that for the company, "CSFB was one of the go-to investment banks in terms of some of the more complex off-balance-sheet structures."
The Enron executive said that Nath and an associate, Dominic Capolongo, were deeply involved in structuring several deals for Enron, with Capolongo spending a great deal of time at Enron's Houston headquarters, working with top Enron executives.
CSFB was also an investor in one of Enron's many partnerships, was a significant adviser on Enron mergers and acquisitions, and handled $1 billon worth of Enron stock and bond underwriting.
Some experts say most disclosures of these kinds of deals are not adequate, especially because they often appear in footnotes to financial statements.
"The 'big-think' was that as long as disclosure was in the footnotes, the market would correct itself," said Frank Partnoy, a finance professor at the University of California at San Diego and a former derivatives trader. "That turned out to be totally false." The special entities, he said, "were explicitly designed in the mid-'90s to make the financial statements look better and push details off into the footnotes."
Paying the Penalties
The first rupture of the Bubble came in March 2000. And although many companies continued to go public that year, the markets began their relentless slide. By mid-2001, the banks were hurting.
That June, CSFB announced that it was firing three of Quattrone's tech brokers amid an SEC investigation into the bank's IPO-allocation practices. The bankers were accused of demanding kickbacks from money managers for allocations of hot IPO shares. Two of those fired subsequently sued CSFB for allegedly sacrificing them as scapegoats.
Under the scheme, the SEC said, money managers were required to pay inflated commissions to buy shares of other stocks through the bank's trading operation. The inquiry would prove to be an early insight into an array of industry IPO-trading practices that regulators say helped power the raging bull market and reinforce its momentum.
The most serious of these was a practice known as "laddering," in which clients were told that in exchange for IPO allocations, they had to agree to purchase shares of the stock after it opened for trading, thus heightening demand and driving the price higher.
CSFB denies it engaged in the practice, although it is accused in shareholder lawsuits of having done so. To date, the SEC laddering inquiry has focused primarily on Goldman Sachs and Morgan Stanley.
The banks are also being investigated for allegedly using IPO allocations as a reward for getting other banking business from companies.
A month after CSFB fired the three bankers, it fired Wheat. The SEC investigation was but the latest in a string of international embarrassments that resulted in regulatory action against the bank in Sweden, Britain and Japan.
In one case, a group of traders in London who called themselves the Flaming Ferraris -- after an exotic cocktail at a bar they frequented -- would loudly flaunt their trading riches at social clubs around the city. Then, one of them attempted to execute, by cell phone, a major trade on the Swedish stock market without a license.
In place of Wheat, CSFB hired Mack, whose stated intention was to restore the bank's integrity and improve its bottom line, which was suffering after the stock market's steady decline. Tech banking had essentially dried up.
One of the first issues Mack dealt with was the lucrative compensation contracts that had been given to Quattrone and other star bankers. Many of these bankers were the most highly paid on Wall Street, which was keeping CSFB's costs high even as revenue plunged, according to Rachel Barnard, a financial industry analyst at Morningstar Inc.
Mack tore the contracts up and rewrote them, saying the bankers could leave if they didn't like it.
Quattrone's control over tech research already had been loosened, after Wall Street's trade association recommended changes to industry practices.
This January, CSFB formally settled the SEC investigation by agreeing to pay $100 million in penalties. The settlement does not single out Quattrone, although former employees say he controlled virtually every activity of the tech banking group. About nine months later, the SEC fined and suspended two CSFB bankers in connection with the case. CSFB said it did not find sufficient cause to fire Quattrone or the other two bankers, although the firm reportedly increased the size of the fines and the length of the suspension of the two already disciplined by the SEC.
Quattrone remains head of global tech banking and was elevated to the bank's executive board late last year.
Mack, who was known as Mack the Knife at Morgan Stanley, has seen his reform plans complicated this year by the aggressive pursuit of the bank's research practices by Massachusetts regulators as part of a coordinated inquiry into the major investment banks.
In a series of embarrassing disclosures, internal e-mail from CSFB and Merrill Lynch has been released, showing how research analysts were pressured by bank superiors to tout stocks even when they knew the stocks were suspect.
"It was reckless," said William F. Galvin, the Massachusetts secretary of state who is heading the securities investigations. "They were very disinterested in fulfilling their fiduciary duty and totally driven by the need for profit," Galvin said of CSFB. "They were boastful about the deceptions and deceits."
The state has filed formal civil charges against CSFB. Bank officials deny the allegations, calling them riddled with inaccuracies. They argue that individual analysts had the power to reject banker pressure.
Bank officials also stress the many changes at the firm since Mack took over, including that analysts are now prohibited from owning stock in companies they cover. The officials say they are cooperating with the various investigations and have adopted changes recommended by New York Attorney General Eliot L. Spitzer, who has spearheaded the probes.
And they say they are prepared to follow whatever global settlement is reached between the industry and regulators, which is under negotiation.
Galvin said he filed his action separately because he isn't convinced by the claims of any investment banks.
"History has shown that they pay a big fine, make some personnel changes and then find a way to do what they are going to do," he said. "We need to make some real changes.
"You can't just say we have a few new people and then say, 'Are we okay now?' "
Staff researcher Richard Drezen contributed to this report.
© 2002 The Washington Post Company
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