Normalized Financial Wrongdoing: How Re-regulating Markets Created Risks and Fostered Inequality 9781503614468

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NOR M A L I Z E D F I NA NC I A L W RONG DOI NG

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NOR M A L I Z E D F I NA NC I A L W RONG DOI NG How Re-regulating Markets Created Risks and Fostered Inequality

Harland Prechel

Stanford University Press Stanford, California

Stanford University Press Stanford, California © 2021 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or in any information storage or retrieval system without the prior written permission of Stanford University Press. Printed in the United States of America on acid-free, archival-quality paper Library of Congress Cataloging-in-Publication Data Names: Prechel, Harland, author. Title: Normalized financial wrongdoing : how re-regulating markets created risks and fostered inequality / Harland Prechel. Description: Stanford, California : Stanford University Press, 2021. | Includes bibliographical references and index. Identifiers: LCCN 2020015480 (print) | LCCN 2020015481 (ebook) | ISBN 9781503602380 (cloth) | ISBN 9781503614451 (paperback) | ISBN 9781503614468 (ebook) Subjects: LCSH: Financialization—United States. | Corporations— Government policy—United States. | Corporation law—United States. | Corporations—Corrupt practices—United States. | Income distribution—United States. Classification: LCC HG181 .P74 2021 (print) | LCC HG181 (ebook) | DDC 332/.04150973—dc23 LC record available at https://lccn.loc.gov/2020015480 LC ebook record available at https://lccn.loc.gov/2020015481 Cover design: Christian Fuenfhausen

For Helen

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Contents

List of Figures and Tables  ix List of Abbreviations  xi Preface  xiii

1  The Contemporary Corporation and Private Property  1 2  Historical Transitions from Liberalism to Neoliberalism  20 3  Transforming Banks from Market Enablers to Market Participants  65 4  Converging Economic and Political Interests  101 5  Creating Risk, Engaging in Financial Malfeasance, and Crisis  143 6  A “Great Crisis” in the FIRE Sector  177 7  The Extent and Causes of Financial Malfeasance  200 8  Inequality in the Twenty-First Century  221 9  Emancipatory Social Change  269

Notes  313 References  317 Index  337

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Figures and Tables

Figu r es 2.1 Prototypical Multilayer-Subsidiary Form 5.1 Enron’s MLSF and Selected Corporate Entities 7.1 FIRE Sector Alleged Security and Exchanged Commission Violations 7.2 Percent of Corporations Restating Financial Statements by Multilayer-Subsidiary Form, 1994–2004 7.3 Percent of Corporations Restating Financial Statements by Total Number of Subsidiaries (Quartiles), 1994–2004

50 149 207 212 212

Ta bl e s 2.1 FIRE Sector Parent Company CEO Compensation, 2000–2007 5.1 Capital Raised at Enron and Selected Subsidiaries from Stock Issuances 5.2 Change in Enron’s Stock Values, 1997–2002 7.1 Statistical Model of FIRE-Sector Financial Malfeasance, 1995–2004 7.2 The Odds That an Event Will Occur 8.1 Expenditures on Dividends and Stock Buybacks, 2007–2016 8.2 The Largest FIRE-Sector Corporations’ Expenditures on Stock Buybacks, 2000–2007, and TARP Distributions

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64 160 164 208 213 247 248

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Abbreviations

ABS AFL-CIO AIG CFPB CDO CDS CFTC EPA ERTA EESA FASB FDIC FDICIA FEC FECA FHA FIRE FISIM FmHA FTC GDP GMAC GSE HUD IMF IPO MBSs MDF

Asset-Backed Securities American Federation of Labor and Congress of Industrial Organizations American International Group Consumer Financial Protection Bureau Collateralized Debt Obligation Credit Default Swap Commodities Futures Trading Commission Environmental Protection Agency Economic Recovery Tax Act of 1981 Emergency Economic Stabilization Act, 2008 Financial Accounting Standards Board Federal Deposit Insurance Corporation Federal Deposit Insurance Corporation Improvement Act Federal Election Commission Federal Election Campaign Act Federal Housing Administration Finance, Insurance, and Real Estate Financial Intermediation Services Indirectly Measured Farmers Home Administration Federal Trade Commission Gross Domestic Product General Motors Acceptance Corporation Government-Sponsored Enterprise Department of Housing and Urban Development International Monetary Fund Initial Public Offering Mortgage-Backed Securities Multidivisional Form xi

a bbr ev i ations

MLSF MMD MMMF MSV

Multilayer-Subsidiary Form Money Market Deposit Accounts Money Market Mutual Funds Maximizing Shareholder Value

NLRB OPEC PAC PPIP REIT REMIC SIV S&L SEC SNA SPE SSA TARP TILA VAR

National Labor Relations Board Organization of Petroleum Exporting Countries Political Action Committee Public-Private Investment Program Real Estate Investment Trust Real Estate Mortgage Investment Conduit Structured Investment Vehicle Savings and Loan Association Securities and Exchange Commission System of National Accounts Special-Purpose Entity Social Structure of Accumulation Troubled Asset Relief Program Truth in Lending Act of 1968 Value at Risk

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Preface

This book emerged from my concerns with the political and managerial behavior of the largest US corporations. Like many other people, I am troubled by the detachment of corporate and political leaders from the realities of most people. The political and economic conditions of our time give greater meaning to Max Weber’s response to the events and trends of his era that he described as riding on “an express train moving toward an abyss and not feeling certain whether the next switch has been set right.” The more I have examined the decisions made by corporate and political leaders, the more convinced I have become that the switches are not set right and must be reset to avoid an abyss. This concern over corporate-state relations motivated me to write this book because the American public deserves to understand the mechanisms that created the current state of affairs so they can mobilize politically, strengthen civic organizations to advance their interests, and elect political leaders willing to and capable of implementing policies that reduce class inequality and create a fair and just society. Chapter 1 provides a general overview of the book and the conceptual framework. Chapter 2 examines the transition from liberalism to neoliberalism and their effects on corporate property rights and corporate behavior. I examine the policy formation process that contributed to the current corporate-state relation in chapters 3 and 4, where I focus on how corporate actors exercised power to restructure the US political economy to their benefit. Chapter 5 examines how the emerging organizational and political-legal arrangements created opportunities for the energy and FIRE (financial, insurance, and real estate) sectors to engage in high-risk behavior and shift costs and risks from corporations to the American people. Chapter 6 focuses on the 2008 financial crisis and the response by political leaders, who shifted much of the cost of the crisis to American taxpayers. Chapter 7 moves from a historical analysis to a quantitative xiii

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analysis of financial malfeasance by the largest US corporations and the largest FIRE-sector corporations. Chapter 8 examines how the transition to financialization created organizational and political structures that contribute to high income and wealth inequality in America. In conclusion, chapter 9 begins with an examination of the current high levels of political polarization and the segmentation of the working and middle classes. I then shift to the potential reemergence of civil society and how to take back the political arena to make society work for all Americans. I thank the National Science Foundation for support through SES0351496 and SES-0351496-001, which funded data collection on financial malfeasance. Texas A&M University provided the institutional support, facilities, and other resources necessary to carry out this project. Members of the research team that collected most of the data include several highly dedicated undergraduate research assistants, including Jennifer Jameson (formerly Harvey), Hannah Harper, Leslie Herbst, Caroline Seegmiller, and Jessica Spitzer. I owe special thanks to two valued and highly capable colleagues who coauthored articles on the quantitative aspects of the analysis. Theresa Morris (previously at Trinity College) contributed to collecting and compiling data and conducting the analysis of financial malfeasance among the five hundred largest US corporations. Lu Zheng (now at Tsinghua University, Beijing) conducted the analysis of financial malfeasance in the largest FIRE-sector firms. I am indebted to many other colleagues and friends who contributed to this project in various ways, including forcing me to clarify my ideas, encouraging me to get on with writing the manuscript, and providing social and moral support. I am grateful to the Melbern G. Glasscock Center for the Humanities Research at Texas A&M University for the Internal Faculty Residential Fellowship that was crucial to getting the project started. I thank my department head, Jane Sell, for providing partial financial support during the time that I was at the Glasscock Center. I also thank Jane for her supportive routine question, “How is the book coming along?” My interactions with the many students who took my undergraduate course on class in contemporary society and graduate seminars in political sociology were valuable in developing and clarifying my ideas. I xiv

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had the good fortune to work with several highly skilled and motivated research assistants. Stephanie Kotick, an extremely proficient and diligent undergraduate research assistant, did much of the meticulous historical research locating historical documents on the policy formation process. Dadao Hou, my graduate research assistant, did an excellent job of finalizing the collection of the historical documents for a component of the research on the policy formation process. I received valuable help from other graduate students at various stages of the project, including Alesha Ignatius Bereton (formerly Istvan), Linzi Berkowitz, and Amber Blazek. Linzi read the entire manuscript and did an outstanding job of editing it. Colleagues from other universities who provided valuable support and feedback at conferences, colloquiums, and informal conversations include Fred Block, Royston Greenwood, John Harms (who read and provided feedback on chapter 8), Mark Mizruchi, Terrence McDonough, Don Palmer, Charles (Chick) Perrow, Robert Putnam, Peter Yeager, and Wayne White. I am sure that I inadvertently omitted some colleagues and offer my apologies to them. I am especially appreciative to two people. David Willer provided enthusiastic support throughout the project. Dave, who has an uncanny ability to identify central ideas that make a project cohere, identified an organizing idea during the early stages of the project that became a central theme in the book. Bob Antonio provided valuable feedback on the manuscript proposal, raised many important questions as the project unfolded, and was an invaluable bibliographic resource. Although he did not read the manuscript, he was an outstanding sounding board during our discussions, especially during our annual birding trips to the Rio Grande Valley when we had time to discuss the project in detail. Stanford University Press representatives were supportive from the inception of the project. I owe special thanks to Stanford University Press acquisitions editor Marcela Cristina Maxfield, who provided detailed comments on each chapter and raised important questions and provided direction throughout the process. I also thank Sunna Juhn, Tim Roberts, and Bev Miller, who provided valuable feedback preparing the manuscript for production. I am indebted to the anonymous reviewers of the xv

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manuscript whose detailed comments provided crucial insights into how to revise and clarify my ideas. I appreciate the policies of the publishers that permitted republishing parts of previously published material. The quantitative analysis in this book was previously published in the American Sociological Review and the British Journal of Sociology. Part of the historical analysis previously appeared in Organizational Wrongdoing, edited by Donald Palmer, Royston Greenwood, and Kristin Smith-Crowe and published by Cambridge University Press, and in The Oxford Handbook of WhiteCollar Crime, edited by Shanna R. Van Slyke, Michael L. Benson, and Francis Cullen, published by Oxford University Press. I am most indebted to my family and friends, who were supportive and encouraging through the project. My sisters, Karen Jensen and Diane Daines, have provided moral support throughout the process. Our annual family get-togethers were always reinvigorating and left me recharged when I returned to the manuscript. I have the good fortune of support from Dilma Da Silva, whose infectious smile and optimism were invigorating throughout the writing process. I am also indebted to my former spouse and good friend, Ruth Larson, for being a caring partner in raising our daughter, Helen Larson Prechel, who gives me more happiness than I thought possible to experience and continues to teach me to appreciate what is good in the world.

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chapter 1

The Contemporary Corporation and Private Property In September 2008, US financial markets lost more than 30 percent of their value in the crash that ranks as one of the worst financial crises in US history and second only to the October 1929 financial crisis followed by the Great Depression.1 This book investigates how the way in which political and corporate elites reconfigured organizational and politicallegal arrangements created incentives, opportunities, and dependencies for management to engage in the high-risk behaviors that resulted in financial crisis. In addition to better understanding the causes of the 2008 crisis by identifying the historical conditions permitting risk-taking behavior, I seek to provide scholars, policymakers, investors, enlightened corporate leaders, and the public with information for taking preventive measures to ensure against future occurrences. As the Great Recession demonstrated, the flow of capital depends on stable financial markets, and market failures have the most extreme and long-term adverse consequences for the poor and working and middle classes. Although some scholars, journalists, and politicians maintain that similarities exist between the 1929 and 2008 crises, there has been little systematic analysis on the extent of the similarities and differences of these two crucial periods in US history or their relevance for stable capitalist growth and development. Analysis of social structures and hierarchies has been displaced in recent years in organizational and economic sociology and related fields by cultural analysis, with a particular focus on institutional norms (Gray and Silbey 2014; Walker and Rae 2014) as the prevailing explanation of individual and organizational behaviors. My focus renews emphasis on structures and hierarchies and how changes in them come about.

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St ruc t u r es a n d Cor por at e-Stat e R el at ions Although Adolf Berle and Gardiner Means are widely known for their observation that managerial control of the modern corporation increased in the early twentieth century, crucial details of their now classic analysis are largely forgotten. In The Modern Corporation and Private Property, Berle and Means ([1932] 1991) examined how the property rights associated with the modern corporation increased the power of the corporation in relationship to the state: “The state seeks in some respects to regulate the corporation, while the corporation, steadily becoming more powerful, makes every effort to avoid such regulation” (313). They were particularly concerned with the implications of the late nineteenth- and early twentieth-century holding company that facilitated corporate consolidation and permitted financiers to establish control over corporations. In contrast to previous corporate structures where all parts of the company were combined into a single legal entity, this legal structure permitted the holding company to establish ownership control by acquiring just over 50 percent of other corporations’ stock and incorporating them as legally independent subsidiary corporations under the parent holding company. Many contemporary scholars overstate Berle and Means’s observations on the relationship between stock dispersion and the separation of corporate ownership and control by ignoring two mechanisms that permitted the rise of managerial control: (1) when holding company owners acquired other corporations, they typically paid the owners with holding company securities and hired them to manage operations, and (2) with few mechanisms to monitor operating management, holding company owners and managers had little choice but to allocate decision-making authority. That is, given the limits of internal organizational controls during this period, consolidation of multiple previously independent corporations as subsidiaries under a single giant holding company required capitalists and their top managers to allocate authority to operating and other middle managers. In fact, stock was not widely distributed during this period. Public investment in corporation securities increased from less than $1 billion in 1897 to approximately $6.8 billion in 1904 (Roy 1997). By 1927, only 4 to 6 million people, or 3.4 to 5.0 percent of the population, 2

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owned corporate stock (Burk 1988). To put these data in context, when J. P. Morgan created United States Steel Corporation in 1901, he issued $1 billion in corporate securities, a large share of the total stock issued in the entire country. As recently as 1952, only 6.5 million people, or 4.2 percent of the population, owned common stock. The early twentieth-century holding company permitted its owners and managers to engage in opportunism, high-risk behaviors, and financial chicanery and wrongdoing that weakened corporations and the banks that invested in them, which contributed to the Great Depression that followed the 1929 stock market crash. After these behaviors were exposed to the public, Franklin D. Roosevelt (FDR) and his New Deal coalition and Congress passed a wide range of social and economic reforms, including dismantling holding companies. These organizational and political-legal reforms represent the second stage of Polanyi’s ([1944] 2001) conception of the double (i.e., countervailing) movement. During the first stage of the double movement, political and economic leaders falsely assume that markets are self-regulating and dismantle market controls, which has devastating consequences for society, requiring a second movement to protect society from the market. Stimulated by the demand for manufactured goods during World War II, New Deal and post–New Deal political-legal arrangements created the conditions for stable economic growth and development in manufacturing, which became the dominant economic sector. In subsequent decades, manufacturing corporations cooperated with the federal government to develop policies designed to advance their capital accumulation agendas. During this period, unions expanded and provided a countervailing power to corporate power and succeeded in negotiating safer working conditions and higher wages and benefits for its members (e.g., the capital-labor accord), which were crucial to creating the middle and working classes. At the same time, the economically and politically weakened banking sector was relegated to providing capital to manufacturing corporations and mediating disputes among them (Mizruchi 2013). By the 1970s, the US manufacturing sector was experiencing declining profits associated with slow economic growth, global competition, the failure

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of corporations to keep pace with innovative technological change, and oil price increases by the Organization of Petroleum Exporting Countries (OPEC). In response, corporate elites became increasing critical of unions and New Deal and post–New Deal policies and mobilized politically to reconfigure these arrangements (Prechel 1990). Their political strategy was guided by neoliberal ideology, which asserted that government regulations restricted markets and undermined efficiency. Although the Carter administration eliminated some regulations, the 1980 presidential election of President Ronald Reagan, who opposed government’s responsibility to solve social problems, represented a retreat from society. The Reagan era tax policies provided massive cuts in corporate taxes, but the crucial component of the president’s agenda advanced corporate property rights. As the following chapters show, the organizational and political-legal arrangements that emerged provided the mechanism that created giant corporations that exercised market control, increased financial risk, and fostered inequality. By the late 1990s, corporate-state relations were transformed in ways to accelerate financialization: an organizational and political-legal strategy that emphasizes capital accumulation through financial transactions and financial controls to evaluate the performance of companies and corporate entities and their managers. Financialization represents a transition away from prioritizing value creation, that is, “ways in which different types of resources (e.g., human, physical) are established and interact to produce new goods and services” (e.g., steel, automobiles, textiles), to prioritizing value extraction: “activities focused on moving around existing resources and outputs, and gaining disproportionately from the ensuing trade” without creating new wealth (Mazzucato 2018, 6). Derivatives, which became a crucial mechanism of value extraction, are contracts between two or more parties whose value derives from the value of another underlying security. Historically, the underlying securities were real commodities such as wheat, corn, and hogs, but the financialization regime permitted the underlying commodity to include virtually anything that represents ownership: currency, mortgages, student loans, and stocks and bonds, for example (Levitt 2002).

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Derivatives are not real commodities. Instead, they are fictitious commodities that create profits from the performance of real commodities in another market. Although derivatives do not produce anything new except more securities and contracts, they can be the source of massive profits and losses because they permit investors to bet on future prices (Prechel and Harms 2007). The financialization social structure of accumulation (McDonough, Reich, and Kotz 2010) created multiple opportunities for managers to engage in high-risk behaviors that were not viable during the middle decades of the twentieth century. Participation in financial markets went beyond banks to include many nonbanks, such as hedge funds, insurance companies, mutual and pension funds, real estate, and nonfinancial firms in manufacturing and retail that set up financial subsidiaries. By the early 2000s, giant corporations including Enron, WorldCom, and Adelphia began to fail. Although these failures provided early warnings of the instability of the prevailing organizational and politicallegal arrangements, they were largely ignored by the political and economic elites who dismissed these failures by attributing corporate malfeasance to individual characteristics—“a few bad apples” (Prechel 2003). Then in September 2008, Lehman Brothers, one of the oldest and largest investment banks, filed for bankruptcy, and the subsequent events demonstrated that capitalism is a complex, dynamic, and interconnected system (Krier and Amidon 2015). The Lehman bankruptcy, the largest in US history, cascaded into the most severe financial crisis since the Great Depression. Within days, bankers became wary of the ability of other banks to repay their overnight debt and refused to make loans to each other. As credit markets became less liquid, corporate executives, government officials, and leaders of central banks feared a global market failure. Business and political leaders concluded that if this trend continued, it would be impossible for banks to remain open and for corporations to operate, which would bring the global economy to a halt. The threat of widespread corporate bankruptcies turned fear into panic, and political and economic elites decided to bail out banks and other corporations with taxpayers’ money. Among the many disconcerting issues that surfaced after the financial crisis is the fact that bank managers have continued to engage in high-risk behaviors, 5

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report high profits, and compensate themselves at record-high levels while unprecedented levels of inequality persist in the country. Why Focus on Organizational and Political-Legal Arrangements? After it became known that the underlying causes of Enron era failures entailed financial wrongdoing and chicanery, political and economic elites asserted that these failures were the outcome of the moral weaknesses and ethical flaws of individual managers. However, the systemic bank and corporate failures in the 2008 financial crisis delegitimized the thesis of the “few bad apples.” In response, many researchers shifted their focus from a breakdown of individual ethics to a breakdown of corporate ethics. Although the informal structures associated with cognition, ethics, norms, and values affect decision making, this focus does not explain why a decline in individual or corporate ethics occurred at this point in history. The answer to this question requires a focus on the formal organizational and political-legal arrangements—the opportunities and incentives they created and how individuals exploited them to their benefit. To address these items, my analysis in this book incorporates Edwin Sutherland’s (1949) seminal insight that differential social structures create opportunities to engage in wrongdoing. My historical analysis reveals how the political-legal arrangements in which corporations are embedded were transformed in ways that permitted high-risk behaviors that in some cases were previously illegal. This book also offers much-needed attention to the mechanisms that encouraged the middle and working classes to shift their assets from savings accounts, pension funds, and other relatively secure investments into high-risk corporate securities and financial instruments. There are three interrelated themes in this book. First, I examine how class fractions organized politically and exercised power to change the political-legal arrangements in ways that redefined corporate property rights and created opportunities and incentives to engage in financialization while enriching themselves. Second, I show how the embeddedness of corporations in these organizational and political-legal arrangements permitted managers to engage in financialization activities 6

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that sometimes included unscrupulous behaviors similar to those that arose in the 1920s when similar corporate structures existed. Third, I discuss how the new organizational and political-legal arrangements contributed to increased inequality. Why Focus on Corporate Property Rights? Corporate property rights define the outside parameters of legitimate business behavior, vary historically, and are defined politically. To illustrate, executives at Enron, WorldCom, Adelphia, and other corporations were convicted of crimes because they engaged in behavior that violated corporate property right laws. In contrast, despite widespread financial wrongdoing and chicanery by banks, which did much more damage to the economy than the 2000–2001 corporate scandals, relatively few executives of the largest corporations that perpetuated these behaviors were convicted of a crime. This leaves an important question unanswered: How were the political-legal arrangements of public corporations redefined to permit bank managers to engage in high-risk behaviors using the public’s capital without informing them? To answer this question, I examine who exercised power to transform corporate property rights in ways that put the entire economy at risk. My focus is on how the banking and energy industries, which were tightly regulated throughout the middle decades of the twentieth century, gained property rights that permitted them to engage in high-risk behaviors and how those property rights were extended to corporations in other economic sectors. W h y W r i t e T his Book? Despite the far-reaching effects of financialization on US and global economies, little systematic research exists on the social forces that created the prerequisite organizational and political-legal arrangements. Identifying the social structural causes that permitted risk-taking behavior is necessary for adequate remedies to be implemented that protect the public from future occurrences. Until these underlying mechanisms are understood, the necessary corrective policies to protect the public from future failures in financial markets cannot be enacted. 7

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Most analyses of financialization tend to narrowly examine the financial instruments directly associated with the 2008 crisis. Although these instruments are important, they represent only one dimension of financialization, a complex, dynamic, and interconnected dimension of capitalism that has far-reaching consequences for society. A primary objective of this book is to clarify the political origins of such organizational and political-legal arrangements. The few studies that give attention to the political origins of financialization tend to assume implicitly or explicitly that it was the outcome of the actions of an autonomous state—for example, that Congress and the executive branch facilitated the emergence of financial markets and high-risk financial instruments (Krippner 2011; Lavelle 2013; Jacobs and King 2016) or “pulled the banks into” this market and “did so trusting that banks understood what they were doing” (Fligstein and Goldstein 2010, 31, 63–64). Krippner (2011, 10–23) instead narrowly attributes the emergence of financialization to Federal Reserve Bank policies and monetary policy that encouraged the influx of foreign capital into the United States, and others examine a wider range of government policies (Lavelle 2013). However, all of these accounts assume an autonomous state and thus fail to address a central question: To what extent did political and economic elites exercise power to influence the policy formation process that brought about financialization? This book provides the American public with a framework to understand how long-term incremental social structural changes are working against them and future generations. Toward that end, I turn to critical theory, which is rooted in the Hegelian-Marxian tradition and was elaborated by the Frankfurt school. This method of immanent critique has its foundation in Hegel’s stress on “judging historical moments by their own internal norms and employing them to form one’s critical standpoint” (Antonio forthcoming). Its objective is therefore to demystify ideological distortions and thereby detect “the societal contradictions which offer the most determinate possibilities for emancipatory social change” (Antonio 1981, 330). Drawing on this theoretical tradition, my analysis juxtaposes the ideology of neoliberalism with concrete social structures in order to understand how neoliberal ideology conceals how the organizational 8

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and institutional arrangements I address (Mannheim 1936) emerged and created opportunities for corporations to accelerate financialization of the economy and engage in financial wrongdoing and chicanery to their benefit. This method emphasizes unfolding the historical logic (Roy 1997) that exposes neoliberalism’s flawed assumption that free markets exist in contemporary society (Mises 1949; Friedman 1962; Hayek 1991). My analysis draws on Polanyi’s seminal insight that exposed the flawed free market assumptions of nineteenth-century liberalism by showing that markets are culturally and politically constructed. This approach identifies the social actors that created and commodified (Offe and Ronge 1975; Offe 1985, 86, 245; Jessop 1982, 109) the financial instruments that disadvantaged many Americans dependent on financial markets. Understanding how financial instruments were commodified is critical to creating a more democratic policy formation process and institutional arrangements that provide opportunities for the poor and working and middle classes. Org a n i z at iona l Pol i t ic a l E conom y The organizational political economy framework, which incorporates concepts from a range of theoretical perspectives but moves beyond them, consists of several interrelated presuppositions. The core presupposition maintains that the social structure has multiple interrelated components— for example, states, markets, corporations and other organizations, and ideology—that are intertwined and therefore cannot be understood without examining the relationships among them (Marx [1867] 1977; Weber [1921] 1978; Polanyi [1944] 2001). The historically specific social structure of accumulation is affected by how these components are connected because some characteristics of the structure may appear only as a result of the way in which the components are assembled (York and Clark 2007, 720). The crucial component in this complex structure is corporate-state relations, not markets, which are always politically embedded in modern society (Polanyi [1944] 2001). The historically specific configuration of markets is the outcome of economic conflict that is manifested as political conflict and mediated inside the state. Political embeddedness of markets 9

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and corporations varies over time as political-legal arrangements are constructed to address historical capital accumulation constraints (e.g., the rise in oil prices and global competition in manufacturing in the 1970s). Therefore, political embeddedness and disembeddedness are best understood as ideal types located at opposite ends of a single continuum and are affected by historically specific corporate-state arrangements (Prechel 2003, 314). Political-legal arrangements that shifted markets toward the disembedded end of the continuum in the contemporary era have permitted corporate managers to engage in risk-taking behavior that shifts from fated risks in traditional societies, such as famines and plagues, to created risks in modern society, where the primary focus of technical knowledge is to facilitate economic growth and development (Beck 2009, 25). The primary social actors in this historical process are organizations, which depend on resources that other organizations control (Pfeffer and Salancik 1978). When corporations become more capital dependent, they mobilize politically to pressure governments to redefine their political embeddedness in ways that facilitate their capital accumulation agendas (Prechel 1990, 2000). 2 The capacity of corporations to pressure the state to advance their interests depends on their political power, the power of their organizational networks, and the degree to which capitalists are unified politically. In modern society, these activities are carried out by organizations, which are the mechanisms to exercise corporate and class power. Organizations are tools for shaping the world as those in control of them wish “it to be shaped” (Perrow 1986, 11). In other words, they are not controlled by all segments of society. Rather, they are largely the tools of elites, as Perrow points out: “The power of the rich lies not in their ability to buy goods and services, but in their capacity to control the ends toward which the vast resources of organizations are directed” (12). Organizational power is therefore the capacity of these elites to advance their agenda even when other social actors resist it (Weber [1921] 1978). Structural and instrumental power are two interrelated dimensions of organizational power (Levy and Egan 1998). Structural power, a component of the social structure, entails the extent to which 10

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organizational structures permit managers to place more resources under their own control. In contrast, instrumental power derives from the vast resources that organizations hold. Thus, structural and instrumental power are intertwined: an increase in structural power provides greater resources for those who control organizations to exercise instrumental power. The instrumental power of corporations is expressed as political capitalism: businesses’ exercise of power to gain control over public policies in order to facilitate their economic growth and development (Kolko 1963). Political capitalism is multidimensional; it entails the exercise of power (1) outside the state, where business interests attempt to control the political debate; (2) in the legislative process, where broad policy parameters are established; and (3) in state agencies that have authority over policy implementation and enforcement (Prechel 1990, 2000, 277). For example, in the mid-1980s, corporations used their instrumental power to pressure the state to redefine their property rights in ways that advance their economic agendas. This extension of corporate property rights facilitated the use of equity financing, which provided management with more capital resources to pursue consolidation that resulted in greater structural power (i.e., control over resources) increasing their instrumental power. Political capitalism typically entails the concerted effort of multiple corporations, which requires cooperation among them. However, the capitalist class is never fully unified because capitalism consists of competing class fractions: collectives of social actors that represent divisions among economic sectors that conform to the specific relationship each branch of capital has to the economy as a whole (Poulantzas 1978; Zeitlin, Neuman, and Ratcliff 1978; Aglietta 1979; Zeitlin 1989). Due to their structural location in the economy, each branch of capital has unique capital accumulation requirements that necessitate different political-legal arrangements to advance their respective economic agendas that may contradict those of other class fractions. The political interests of class fractions also vary historically as the conditions that facilitate capital accumulation change. Conflict within the capitalist class reaches its highest level during periods of economic decline as the respective relationship of each branch of capital to the economy as 11

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a whole requires a different solution, resulting in conflict that is manifested at the political level (Prechel 1990, 2000). 3 Nevertheless, capitalists’ competing economic needs and political interests do not preclude their developing a bloc with sufficient power to affect the transition to a new social structure of accumulation (i.e., phase of capitalism). It is not necessary for all fractions of the capitalist class to have the same interest or agree on the direction of economic policy to establish a power bloc. Instead, the political power to influence government policy requires only sufficient capitalist class unity to create a power bloc with adequate power to influence policy. Historical variation in the dominant power bloc is affected by the specific capital accumulation constraints and opportunities at that time and the structural location of economic sectors in relationship to the economy as a whole. When the rate of capital accumulation declines below a level necessary to ensure the long-term survival of corporations, the conflicting agendas of class fractions result in a political tug-of-war within the state, where politicians attempt to mediate conflict by implementing new policies. In other words, the economy does not have a unified logic of capital accumulation, so there is no unified capitalist class to dominate the political realm over the long term. Instead, fractions of the capitalist class form a new power bloc to dominate the policy formation process. During some historical conditions, for example, the dominant power bloc included fractions of the working class (Poulantzas 1978). The state therefore mediates inter- and intraclass conflict because capitalists themselves are frequently unable to resolve the contradictions that emerge in the economic sphere and the state’s legitimacy is dependent on maintaining economic growth and stability. During periods of relatively stable economic growth and development, conflict resolution takes the form of revising policy in ways that advance the capital accumulation agendas of the dominant power bloc. Organizational political economy theorizes that the state, the principal social control agent in society, is a complex organization. It is affected by its own agendas (e.g., maintaining economic stability and its own legitimacy) and by structures that include separate large supra-units (the executive, legislative, and judicial branches) and subunits such 12

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as the Treasury. The state also has resource-dependent relations with organizations external to it, such as corporations, and it mediates political conflicts that emerge inside and outside it because obtaining resources, such as tax revenues, is dependent on economic growth (Prechel 1990). When the state controls resources such as access to capital and markets that limit corporations’ capacity to realize their goals, corporations mobilize politically to restructure corporate-state relations in ways that favor them. The balance between corporate power and state power depends on the capacity of economic interests to use organizational resources to advance their economic agendas. Thus, corporations are a primary basis of collective action and constitute the primary means to exercise power in modern society (Offe and Wiesenthal 1980, 76–80; Roy 1997; Prechel 1990, 2000; Walker and Rea 2014). Corporations also provide a mechanism to forge political alliances with other organizations when their economic interests coincide, which contributes to their instrumental power. Explaining Historical Transitions: Social Structures of Accumulation The clearest exposition of the historically contingent character of the process of capital accumulation is articulated by social structure of accumulation (SSA) theory, which draws on long-wave theories of capitalist growth and development (Kondratieff 1935). The theory shows that capitalism goes through a cycle that is repeated over time, and variation in the rate of capital accumulation is the primary cause of historical shifts in the prevailing institutional arrangements of which political, economic, and ideological arrangements are primary (Gordon, Edwards, and Reich 1982; McDonough, Reich, and Kotz 2010; Wolfson and Kotz 2010; Kotz 2015). The cyclic characteristic of capitalism exists because corporate profits depend on institutional arrangements that are external to the firm. These institutional arrangements are designed to ensure conditions favorable to capital accumulation and the reproduction of class relations. However, periodic breakdowns in one dimension of the institutional arrangements in which corporations are embedded undermine capital accumulation, which initiates a shift to the next phase of the cycle. 13

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Each social structure of accumulation has three distinct stages: exploration, consolidation, and decay. In response to economic decay, the exploration phase emerges: politicians and capitalists experiment with restructuring the institutional arrangements in ways that facilitate capitalist growth and development. During this period, ideologies emerge to legitimate the superiority of certain policies over others. After the new institutional arrangements are enacted and the ideological, political, and economic arrangements are assembled in ways that facilitate capitalist growth and development, consolidation occurs. These arrangements provide the foundation for higher profits and contribute to stable capitalist growth and development that may last for decades. Each consolidation phase is characterized by a dominant power bloc (Prechel 2000). For example, during the consolidation period in the post–World War II era (1945–1973), manufacturing was the dominant power bloc. Throughout this period, most government policies (e.g., trade, tax depreciation allowances) provided greater benefits to the manufacturing class fraction. The state also mediated class conflict by facilitating the capital-labor accord that was designed to limit disruptions in the capital accumulation process caused by labor strikes and work slowdowns by raising pay and benefits for union workers. The accord also benefited non-union workers because corporations understood that the failure to provide a reasonable wage would create incentives for their employees to take jobs in unionized firms or mobilize to form unions. The last stage, decay, emerges when the prevailing institutional arrangements no longer ensure an adequate rate of capital accumulation. During this period, markets weaken and profits decline, resulting in slow economic growth and instability manifested as crisis. In response to crisis, corporations mobilize politically and pressure political elites to search for solutions, which begins a new exploration phase. The primary focus of this book is on the decay-exploration transition from institutional arrangements that facilitated capitalist growth and development in the manufacturing sector to institutional arrangements designed to facilitate capitalist growth and development in the banking and related economic sectors. The analysis will show that during early stages of the decay-exploration phase, class fractions within the banking and 14

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finance sector did not agree on policy because their respective locations in the economy were incompatible with the interests of other capitalist class fractions. However, as economic decline continued, these class fractions recognized that realignment of the institutional arrangements was dependent on their collective political power, and they unified to advance a political agenda designed to further their shared economic interests. Although capitalists perform a central role in the political process of reinvigorating capitalism, policies are negotiated inside the state because it is the only organization in society with the capacity to mediate conflict between classes and class fractions. The institutional arrangements that emerged extended the parameters of the political-legal arrangements in the energy and finance sectors that permitted corporate structures and financial instruments that were previous illegal or not viable. The reassembly of the parts of the social structure also created opportunities for corporate managers to engage in financial malfeasance. Structural Holes: Opportunities for Financial Malfeasance A central concern of this analysis is how parts of the social structure were reassembled in ways that created incentives and opportunities for individuals to engage in high-risk behaviors and, in some cases, corporate malfeasance. I use the term malfeasance throughout the remaining chapters because wrongdoing is often narrowly associated with lawbreaking. Malfeasance is a broader term that also includes deceptive behavior. Financial malfeasance entails acts that violate a law or the intent of a law established by governmental agencies responsible for ensuring the integrity of the financial system and the public’s understanding of the business code of conduct that consumers and investors use when making financial decisions (Prechel 2003,). Behaviors that are legal may still mislead investors, especially small investors, due to information asymmetry: parties to a transaction have unequal information in which an unfair exchange can result. Financial malfeasance is often organizational malfeasance that occurs in the context of complex relationships and expectations among shareholders, boards of directors, executives, and managers in parent companies, divisions, subsidiaries, and, more recently, off-balance-sheet 15

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partnerships (Clinard and Yeager 1980; Prechel 2003). This book focuses on malfeasance rather than wrongdoing or lawbreaking since the form of political embeddedness enacted during the study period legalized many behaviors that were previously illegal. I will show how the reassembly of the parts of the social structure decoupled corporations from the state in ways that created structural holes and opportunities for managers to engage in behaviors that put the entire financial system at risk. Structural holes, which are separations between non-redundant contacts (individuals who are part of a contract do not have direct contact with each other), show how an entrepreneurial managers who is connected to both parties obtains resource benefits to advance their careers by legitimately exploiting information—for example, a producer negotiating with a supplier. When structural holes exist, social actors have autonomy, and therefore no constraints, that translates into social capital and the opportunity to benefit from the relationship (Burt 1992). The capacity to identify and act on information entails human capital (e.g., knowledge and skills), but social capital (e.g., relationships with other social actors) is of primary importance because managers establish networks to bridge structural holes to gain benefits (Burt 1992, 8; Granovetter 1973; Corra and Willer 2002). The analysis here extends the definition of structural holes to include managerial behavior that illegitimately exploits information to gain resources and benefits—for example, violating the intent of an accounting rule or understood practice such that corporate balance sheets are inflated or risks are concealed (Prechel and Morris 2010). Because dimensions of the social structure are intertwined, structural holes are created when one part of the structure is changed without a concomitant change in another part, thereby decoupling corporations from third-party oversight. Decoupling takes place when changes occur in organizational arrangements without concomitant changes in political-legal arrangements or changes in political-legal arrangements occur without concomitant changes in organizational arrangements. Decoupling creates gaps between means and ends (Weber [1928] 1978; Antonio 1979; Bromley and Powell 2012). In this case, the means, which entail the day-to-day organizational decisions and practices of management, are decoupled from the state, the 16

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principal social control agent in society that seeks to safeguard society from catastrophic financial crisis. W h at Histor ic Logic T ells Us This book employs a historical logic to examine how financialization developed politically. This logic focuses on social actors who exercise power to transform the social structure in ways that expedite capital flows to specific parts of the economy. In contrast to functional logic, historical logic does not assume that the changes in the social structure that shift the flow of capital are socially beneficial, thereby confusing causes and consequences (Roy 1997, 21, 121). I use historical logic for three reasons. The first is to show that modern capitalism does not operate in accordance with a set of abstract market principles that produce efficient outcomes. Instead, markets are plagued by endemic and periodic crisis and embedded in institutional arrangements that are socially constructed, frequently by individuals pursuing their selfinterests. My focus on historical logic shows how empirical variation in capitalism is affected by socially constructed organizational and politicallegal arrangements that attempt to impose rationality on markets. Employing a historical logic captures the irrationality of capitalist markets that are prone to crisis as identified by Karl Marx and the application of formal rationality to impose order on markets as identified by Max Weber. For both classical social theorists, the state is the primary mechanism to impose rationality on an irrational system. The state attempts to overcome crisis by defining and redefining corporate property rights through the enactment of laws that set the outside parameters of acceptable behavior of corporations and their managers and owners. The second reason to use historical logic is to show that financialization is the outcome of class fraction politics where segments of capital mobilized politically to advance a particular set of institutional arrangements that give priority to financialization as a capital accumulation strategy. By focusing on the exercise of organizational power to define and redefine the policy formation process, the book makes transparent how specific social structures of accumulation emerge. This focus also permits an analysis of the conditions when 17

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social actors engage in malfeasance, chicanery, and lawbreaking, which occur with greater frequency when opportunities exist. Finally, I show that the current system was politically constructed: there is nothing inevitable about the current social structure of accumulation or the historic high levels of inequality associated with it. This objective is rooted in democracy, which depends on an informed public with the necessary information to engage in civil society, including knowledge of how competing policy proposals will change the social structure and affect their life chances. Pl a n of t h e Book To tell this story, I next examine how corporate leaders mobilized politically to assemble the interdependent parts of the social structure in ways that facilitated financialization. This transition included mechanisms for corporate managers to access more of the public’s capital by restructuring to the multilayer-subsidiary form, where a legally independent parent company holds ownership control over legally independent subsidiary corporations and other corporate entities. This corporate form permits management to make greater use of complex and high-risk financial instruments and disguise them from the public by locating them in legally independent corporate entities. We’ll see how corporations mobilized politically to pressure Congress to permit banks to shift their business strategy from market enablers to market participants. The economic interests of the banking and energy sectors coincided, resulting in a political coalition that pressured Congress and the executive branch to redefine their property rights in ways that allowed for expansion and participation in derivatives markets. Financialization decisions, I find, are made deep inside corporations, where managers have autonomy from outside influences. The case studies in chapters 5 and 6 demonstrate how prevailing political-legal arrangements created opportunities for corporations to use the multilayersubsidiary form to increase the size and complexity of the firm, making it easier to hide decisions and conceal losses from the investing public and government oversight agencies. Taking a quantitative approach, chapter

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7 then develops and tests hypotheses based on the social structural characteristics identified in the case studies. The organizational and political-legal arrangements that emerged shifted risks from corporations to consumers and contributed to recordhigh levels of durable inequality. This analysis exposes shortcomings in Piketty’s (2014a) thesis by showing that the historically high level of inequality in the United States is not the inevitable outcome of slower economic growth in advanced capitalist societies or tax policies alone. Although these components of the social structure are important, I show that the record-high levels of inequality are the outcome of politically reconstructed organizational and political-legal arrangements. We will also see how neoliberal ideology distorts the historical record regarding efficiency-enhancing innovations. I conclude by examining the prospects for civil society to organize politically and reduce the inequalities exacerbated by financialization that excessively rewards those who own or control capital and how mitigating the climate change crisis can be part of the solution.

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chapter 2

Historical Transitions from Liberalism to Neoliberalism

In response to alleged financial malfeasance in the 1930s for misusing the public’s capital at Middle West Utilities, Samuel Insull claimed that his actions were legal: “What I did, when I did it, was honest; through changed conditions, what I did may or may not be called honest. Politics demand, therefore, that I be brought to trial; but what is really being brought to trial is the system I represented” (McDonald 1962, 1–2). Insull’s exoneration raises an important question. How are systems created that permit social actors to engage in financial speculation and malfeasance with the public’s capital? The social system permitting risk-taking behavior that contributed to the Great Depression shares important characteristics with the system that resulted in the Great Recession. Social structures are constantly reconfigured over time, and in this chapter I give particular attention to the ideological, organizational, and political-legal arrangements. A core theme is how corporate property rights are redefined over time and how they affect the capacity of social actors to engage in risk-taking behavior and financial malfeasance. F ede r a l ism a n d Cor por at e Prope rt y R igh ts When the British colonized North America, they institutionalized the British legal system, which allocated authority to the government to define the rights and responsibilities of corporations (i.e., organizations), whose primary obligation was to advance the public good. After the United States formed a government, authority over economic activity inside state borders was allocated to the respective states. To ensure that they advanced the public interest, states granted few property rights to business enterprises (Thorelli 1955, 10, 36). The new country also adopted the limited liability corporation from British common law, which limited the liability 20

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of stockholders to the amount of their investment. Every business enterprise that applied for the legal status of a public corporation negotiated its charter with state legislatures. As the number of US business enterprises increased, the demand for corporate charters multiplied. By the early 1800s, many state legislatures had established uniform laws of incorporation and allocated authority to a government agency (e.g., the secretary of state) to negotiate charters with individual businesses (Haney 1920, 103–104; Berle and Means [1932] 1991, 126–128). Several states permitted some economic sectors to organize as holding companies (the holding company owns legally independent subsidiary corporations) because they were considered natural monopolies (railroads are an example) where single-firm production was considered more efficient than multiple firms competing in the same market. Given the tendency for corporations to expand and control markets, individual states closely scrutinized applications for certificates of incorporation to ensure that business enterprises did not create monopolies or oligopolies. Thus, most business enterprises were reluctant to risk exposing their consolidation strategies to elected officials (Chandler 1977, 319) and remained voluntary associations or partnerships. In 1801, only 317 business enterprises were incorporated (Blumberg 1990), and large enterprises remained private limited partnerships where a few partners owned and managed the business. Although economic booms and busts had occurred before Civil War, they became increasingly common after 1870. As the rate of profit declined, business elites viewed economic busts as caused by cutthroat competition: overproduction resulted in uncontrolled price cutting. To limit the adverse effects of market fluctuations, business elites mobilized politically and pressured the federal government to impose tariffs on imported goods. Although tariffs facilitated profit making, recessions and depressions remained common because the boom-and-bust cycles were caused in part by the behavior of businesses themselves: they would expand in response to economic booms to capture markets, thus creating excess production capability when demand declined. Crises of overproduction and underconsumption resulted in widespread bankruptcy when markets contracted because business elites were unable to repay 21

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the debt they had acquired while expanding their production capability during periods of market growth. To ensure a steady rate of capital accumulation, business elites employed consolidation strategies to control production capability and market prices. The first effort to organize against the irrationality of the system occurred between 1875 and 1895 when businesses developed pooling agreements: informal agreements to set prices and divide market share. Their informality made pooling agreements easy to organize but difficult to enforce. To maintain capability utilization rates (the portion of manufacturing facilities in use) at the level necessary to ensure a profit during economic downturns, pool members frequently broke their agreement by lowering prices to capture a larger market share. As a result, pooling agreements typically failed. They were an inadequate form of control because they created weak ties among network members. A related irrationality of the system is that many businesses invested in more capital-intensive technology to increase output, especially during periods of rapid economic growth. However, the increased capital intensity added to capitalists’ problems during economic downturns. Since labor-intensive technologies rely more heavily on labor, these costs constituted a high proportion of total capital investment. Historically, capitalists relied on laying off workers to cut their costs during economic downturns, but this flexibility declined as production became more capital intensive. The higher portion of fixed capital created two problems: it reduced capitalists’ capacity to shift the financial burden of economic downturns to the working class through unemployment, and it required more debt financing, which increased costs. After the third major economic depression (1873–1897), business elites began to strengthen the ties among competing enterprises by consolidating those competing for the same markets (Kirkland 1967; Gordon, Edwards, and Reich 1982). These stronger ties took the form of trusts: an organization of business owners in an industry that gave trustees authority to make decisions for the trust, including expanding production capacity and setting prices. Unlike corporations, trust agreements were typically made among privately owned businesses and did not require a state charter (Nevins 1953, 364). 22

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Abuses by trusts eventually generated opposition among workers, farmers, and merchants who were required to pay the higher prices for products controlled by the trusts. The Farmers’ Alliance was among the first to politically oppose the use of trusts. Later, the Populist Party solidified merchants, small industrialists, farmers, and the working class against the rising power of big business. These struggles were not simply about economic issues; they also entailed struggles over the meaning of democracy as corporate property rights expanded and eroded workers’ wages and small business profits (McNall 1988). Although the Populist movement did not stop businesses from expanding their economic and political power, they succeeded in bringing public attention to activities including the Distiller’s and Cattle Feeder’s Trust, the Sugar Trust, and the Cotton Trust and pressured government officials and the courts to examine them. Eventually several states adopted laws prohibiting certain forms of these organizations (Argersinger 1974; Schwartz 1976; Goodwyn 1978). Several obstacles also existed for public corporations pursuing consolidation strategies. Businesses located outside a state were considered foreign corporations: that is, they had no legal rights in states. This law was designed to ensure that businesses did not take the economic benefits realized in one state to benefit another state. Businesses were also prohibited from owning stock in others, and although they could petition state governments for special legislative approval to form holding companies and purchase stock in other business enterprises, they were reluctant to risk scrutiny from elected officials and make their consolidation strategies open to public criticism. Furthermore, industrial capitalists’ dependence on financial capitalists undermined their expansion strategy. Financial capitalists were uneasy with two dimensions of the prevailing political and economic arrangements, making them reluctant to underwrite industrial business enterprises. Although financiers viewed forming holding companies to pursue consolidation strategies as the best means to limit competition, they were uneasy with openly supporting this strategy to the public and state legislators who had to approve use of the holding company structure and mergers and acquisitions. Also, periodic recessions and depressions 23

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continued to create cutthroat competition in the industrial sector, where bankruptcy rates were high, resulting in financial losses for investors. Soci alizing Ca pital a nd Cor por at ion Consol i dat ion By the late nineteenth century, business elites considered the mechanisms to organize the business enterprise inadequate to pursue their consolidation strategies and mobilized politically to expand corporate property rights in ways that allowed them greater access to the public’s capital (Roy 1997). Two events created the conditions to transform the definition of the business enterprise that facilitated consolidation. The first change was the 1886 Supreme Court decision in Santa Clara County v. Southern Pacific Railroad Company, where a lawyer for Southern Pacific Railroad Company used the Fourteenth Amendment, which was added to the Constitution in 1868 to protect the rights of freed slaves, to argue that the railroad company should be exempt from paying certain taxes because businesses should be treated like natural persons. Although the Court never ruled on this particular issue, the court recorder wrote that corporations are persons as specified in section 1 of the Fourteenth Amendment and the error was never corrected (Korten 1995; Hartman 2002, 105). Business elites asserted that the Court record redefine business enterprises from an organization with narrowly defined property rights allocated by individual states to the legal status of artificial persons. Like natural persons, artificial persons are permitted to engage in behaviors that are not prohibited by law. To ensure that their interpretation became accepted legal doctrine, business elites hired more lawyers and other experts whose sole responsibility was to identify business activities that were not covered under the law. The new definition of artificial persons, however, also meant that business enterprises could be held responsible for illegal acts. Previously, only a natural person could engage in illegal acts and be held responsible for them. The second event is the Sherman Act of 1890, which established laws limiting the restraint on interstate commerce by trusts. Advocates of this legislation argued that monopolistic behavior such as price setting affected 24

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everyone by pushing prices up. This government strategy was reinforced by the unexpected assassination of President McKinley in 1892 and the inauguration of Theodore Roosevelt, who advocated for a “square deal”: consumer protection, conservation of natural resources, and control of corporations. Roosevelt accelerated enforcement of the Sherman Act by filing antitrust lawsuits against J. P. Morgan’s Northern Securities Trust and forty other trusts. Passage and enforcement of antitrust laws prompted John D. Rockefeller, whose Standard Oil Trust controlled most of the US oil market, to exercise instrumental power to spearhead the search for an alternative business structure. His lawyers maintained that the holding company would not be covered under antitrust legislation, so Rockefeller assigned his general counsel, J. B. Dill, to lobby the New Jersey governor and state legislature to enact laws that permitted businesses to organize as public holding companies. New Jersey was selected as the target state because of its ongoing fiscal crisis. Although the state was in desperate need of revenue to repay its Civil War debts, elected officials resisted raising taxes because of the risk of being unseated in the next election. Led by Dill, the business lobby convinced New Jersey politicians that laws of incorporation provided a mechanism to raise capital through fees and taxes, so in 1889, New Jersey passed the first state laws of incorporation. Business enterprises soon transformed trusts to public holding companies. These laws and subsequent modifications through 1896 radically transformed the political embeddedness of the business enterprise (Prechel 2000). The legal structure for holding companies had an important advantage over trusts by permitting firms to control other firms through stock ownership. Ownership control was established by holding more than 50 percent of subsidiaries’ stock. The “public” holding company laws also permitted corporations to raise capital by selling their own stock and up to 50 percent of subsidiary stock to the public. The holding company thus represented an important transition by allowing corporations to draw on the public’s capital (Hilferding [1910] 1981; Roy 1997). The political embeddedness of the holding company also permitted these enterprises to create a hierarchy of subsidiaries by controlling second-level subsidiary 25

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corporations through its first-level subsidiaries. This structure meant that the holding company could exercise ownership control by owning just over 25 percent of second-level subsidiaries’ stock and 12.5 percent of thirdlevel subsidiaries’ stock. This more tightly coupled structure gave holding company owners a mechanism to control the vast resources that many previously independent firms had held. To illustrate, when the United States Steel Corporation was created in 1901, it consolidated more than two hundred previously independent businesses as subsidiaries under the holding company to consolidate control over 60 percent of the nation’s steel production capability (Haney 1920). Many business enterprises soon adopted the holding company form to consolidate their control over previously independent companies. In 1904, just five years after the second New Jersey law was passed (1898), the number of companies listed on the New York Stock Exchange declined from 4,200 to 250 (Wallace 2017). This reassembly of the parts of the social structure created many of the giant corporations that dominated the US economy throughout the twentieth century. The increased organizational and financial flexibility of the holding company also increased the capacity of managers to engage in financial malfeasance and mislead the investing public. To illustrate, the holding companies could engage in internal capital transfers including shifting parent company debt to its subsidiaries, a practice that makes the holding company appear to be financially sound when it is not, which increased its capacity to issue more securities to the public. The holding company also creates opportunities and incentives for management to engage in stock overvaluation, that is, the corporation’s stock values exceed its assets. One mechanism of stock overvaluation entails setting the value of its wholly owned subsidiaries. Even a mild overvaluation in individual subsidiaries can have a large cumulative effect on the parent company’s stock valuation whose primary assets are its subsidiaries. Thirty years after reassembling the parts of the social structure, 85 percent (487 of 573) of corporations that were listed on the New York Stock Exchange, were organized as holding companies or mixed operating-holding companies (Berle and Means [1932] 1991, 184). This legal structure permitted one business enterprise to gain control over $2 billion 26

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in assets with an investment of $20 million (69). Holding companies could also diversify their assets by acquiring stock in affiliate corporations: business units in which the parent company owned less than 50 percent of the stock. The holding company provides a legal structure for business enterprises to raise capital by issuing stock in itself and its subsidiaries, protect holding company assets by distributing debt to subsidiaries, permit owners and top management to access managerial expertise in its subsidiaries, consolidate control over markets, and ensure the continuation of the business after the founder’s death (US Department of Energy 1993). One of the many insights of Berle and Means ([1932] 1991) is that while stock became widely dispersed in the modern corporation, the distribution of stock was not primarily through stock purchases by individual investors. Instead, stock dispersion occurred primarily by using the holding company to acquire other companies and paying the former owners with parent company stock. Holding company owners also hired former owners to manage subsidiary corporations and had little choice but to allocate to them decision-making authority over production, hiring, and other dimensions of corporate governance. A second often overlooked insight that Berle and Means (83) identified is that from its inception in the late nineteenth century, the holding company structure created opportunities for financial malfeasance by overvaluing holding company stock and for operating managers to skim profits from the subsidiaries they managed. Fina nce Capital a nd Fina ncial M alfeasa nce While the holding company provides a mechanism to facilitate corporate consolidation, much of it was orchestrated by financial organizations: intermediaries (i.e., middlemen) who use their own capital or collected capital from entities with a surplus and transfer it to holding companies and collect a percentage or fee for themselves (Greider 1987, 30).1 For example, the 1901 consolidation of more than two hundred previously independent business enterprises as subsidiaries under United States Steel Corporation was orchestrated by the investment bank J.P. Morgan & Co., also known as the House of Morgan. The consolidation included several already large business enterprises, including Carnegie Steel. 27

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Corporate consolidation within the holding company structure created opportunities for financial malfeasance. United States Steel Corporation was so overvalued that insiders such as Andrew Carnegie would not accept stock as payment and negotiated to receive payment in the form of bonds, which are instead paid before stock in the event of a bankruptcy. Similarly, Henry Frick, chairman of and investor in Carnegie Steel, received almost $50 million of United States Steel Corporation stock from this transaction that he immediately sold. In contrast, most owners of small enterprises that were consolidated were unaware of the overvaluation of United States Steel Corporation and accepted payment in stock. This massive consolidation attracted public attention that resulted in individual investors purchasing stock in the new company. As Carnegie, Frick, and other insiders anticipated, between 1901 and 1904 United States Steel’s stock declined from $55 a share to $9 a share, resulting in large losses for small investors. The reassembly of these parts of the organizational and politicallegal arrangements also reconfigured the capitalist class. Dependent on finance capital to underwrite their consolidation strategies, many manufacturing capitalists were required to give up partial ownership and control of the new firm. Furthermore, most investment banks organized as private partnerships: business associations of two or more people or companies sharing risks and profits. Unlike corporations, partnerships do not have the right to sell securities to the investing public and are loosely regulated because they do not use the public’s capital, which placed them outside the already minimal regulatory structure. Partnerships typically have several partners, no single partner has a controlling interest, and the contracts creating partnerships specify the extent of each partner’s liability. In the absence of laws limiting their business activities, investment bankers engaged in multiple financial arrangements with the same corporate client, including underwriting stock offerings, consulting on mergers and acquisitions, and issuing loans. These conditions create conflicts of interest and perverse systems, including incentives to overvalue acquisitions because they resulted in higher fees for the investment bank that were typically compensated with a percentage of the transaction. In addition, higher-valued acquisitions 28

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typically entailed larger loans, which were often obtained from the same investment bank underwriting the transaction. Financiers were not satisfied with allowing manufacturing capitalists to use their capital. In addition to the revenues generated from underwriting, loans, and financial services, investment banks like the J. P. Morgan partnership demanded partial ownership, seats on corporate boards, and input into corporate reorganization (Josephson [1932] 1962; Kolko 1963; Chernow 1997). To illustrate, in exchange for underwriting the McCormick and Deering consolidation, J. P. Morgan demanded a role in restructuring the new International Harvester Corporation (1902). Although Cyrus H. McCormick remained head of the company, by 1906, Morgan replaced him with one of his partners, George W. Perkins, and replaced members of the McCormick and Deering families with his own managers (DeLong 1991, 225–226). Morgan influenced the expansion and restructuring of AT&T in the early 1900s. Using his leverage as the primary underwriter, he forced AT&T to appoint Theodore N. Vail, a banker, as the president of the restructured corporation. At one point, J. P. Morgan’s partners sat on the board of directors of fifty-nine companies (Chernow 1997). The increase in corporate structural and instrumental power did not go unnoticed by fair-minded politicians. In his 1905 and 1906 addresses to Congress, President Theodore Roosevelt encouraged Congress to pass laws prohibiting corporations from contributing to political campaigns. In 1907, Congress passed the Tillman Act to regulate political campaign contributions, and in 1910, the Federal Corrupt Practices Act was enacted, and amended in 1911 and 1925, to strengthen the Tillman Act. These laws included provisions to fine corporations, managers, and corporate directors for violations and to sentence directors and executives to prison for illegal acts. The administration and Congress, however, failed to create an enforcement mechanism to deter corporate abuses. M i ddl e W e st U t il i t i e s One of the most infamous cases of exercising structural power to engage in financial malfeasance occurred in Middle West Utilities. Soon after the public holding company became viable, Samuel Insull and other business 29

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elites founded Edison General Electric, which later became General Electric. In 1889, Insull left the company and moved to Chicago to accept a top-level position at Chicago Edison Company, where he created several business enterprises and acquired others. Insull’s consolidation strategy strained the resources of Chicago Edison. To alleviate capital dependence, he restructured the firm to create Middle West Utilities, a holding company, and encouraged investors to purchase its stock. Using the revenues from these stock sales, he continued his consolidation strategy by acquiring more companies, including Central Illinois Public Service Company in 1910. Insull used the holding company structure to create a vast network of subsidiaries to both expand existing and create new energy markets in the United States and Canada. He financed much of this expansion by convincing residents in many cases to purchase stock in the subsidiaries before the infrastructure to supply electricity was constructed. By 1912, Middle West Utilities and its subsidiaries provided electricity to four hundred communities in thirteen states. Eventually it produced oneeighth of the country’s electricity, serving customers in thirty-two states (Munson 2005, 53). By 1920, Middle West Utilities was more than double the size of United States Steel Corporation with a stock valuation of $2.5 billion and reported annual revenues of $400 million (Ramsay 1937, 14). The organizational and political-legal arrangements that permitted the expansion of Middle West Utilities also created multiple opportunities for risk that most investors were unaware of. Because each subsidiary in the holding company is a limited liability corporation, in the event of a bankruptcy, the liability of the parent holding company is limited to its investment in subsidiaries and intermediary holding companies. These arrangements existed despite the fact that the managers and owners of the holding company, unlike small investors, had managerial control over the subsidiaries, which provided them with access to financial information not available to the public. Risks in holding companies existed because these arrangements create opportunities for corporate elites to engage in intracompany financial transactions that can inflate the parent company’s balance sheets. For example, holding company management issued stocks and bonds in Middle West subsidiaries that did not have equivalent assets to back these securities. 30

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Top management could also require subsidiary managers to take on debt and transfer the capital to the holding company. These capital transfers increased the operating capital of the parent company while increasing debt in the subsidiary. Furthermore, holding companies loaned capital to the operating subsidiary corporation at rates much higher than market rates, which increased parent company revenues but financially weakened its subsidiaries. In addition, the holding company often charged the operating companies excessive fees for consulting, engineering, construction, management, and financial services. Top management of the holding company also inflated the assets of its subsidiaries, which is especially viable in wholly owned subsidiaries where the holding company owns all of the assets and the market does not determine stock values. These internal financial maneuvers and capital transfers generate fictitious income, thereby misrepresenting the corporation’s financial strength and inflating stock values. Given that these financial manipulations occurred between the holding company and its subsidiaries, the deception remained unknown to the outside investors who purchased Middle West securities. Insull’s expanding monopoly over the nation’s utility markets attracted the attention of politicians and scholars who were concerned with the monopolistic tendencies, risk-taking behavior, and moral hazards of holding companies. To deflect opposition, Insull engaged in political capitalism by funneling money to politicians to oppose his critics in elections, including a $125,000 donation to Frank Smith when he announced that he would run against Illinois senator William McKinley who opposed Insull’s monopolistic behavior (Munson 2005, 57). Insull spent enormous amounts of capital attempting to sway other elections as well. Estimates are that he spent more than $30 million annually to influence public opinion to support use of the holding company form (Munson 2005), which is equivalent to more than $759 million in 2019 dollars. Despite increased suspicions by politicians of financial malfeasance at Middle West Utilities, the continued demand for electricity facilitated its expansion. As the corporation became larger and more complex, it created even more opportunities for financial malfeasance. For example, based on the promise of future earnings, the share price of its intermediary 31

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investment holding company, Insull Utility Investments, increased from $12 to $150 in the 1920s. Estimates suggest that during some periods, the securities of the corporation increased at a rate of $7,000 per minute (Norris 1945). Insull’s consolidation of energy companies and hostility to politicians who opposed his tactics eventually resulted in an investigation in 1932 by the Federal Trade Commission (FTC). The investigation concluded that 75 percent of Insull’s subsidiary companies inflated their assets and the sale of some subsidiaries to others, resulting in “fictitious income” (Munson 2005, 57). Governor Franklin D. Roosevelt of New York was among the most open critics of Insull’s use of the holding company: he said that it challenged “the power of the government itself” (Munson 2005, 57). Despite their concerns, politicians had little authority to curtail use of the holding company within the prevailing political-legal arrangements. Asy m m et r ic I n for m at ion These organizational and political-legal arrangements created information asymmetry: parties to a transaction have unequal information in which an unfair exchange can result. Information asymmetry existed because the social structure created opportunities for business elites to engage in high-risk behavior with no mechanism to transfer that information to the investing public. Although many of Middle West Utilities’ subsidiaries continued to prosper during the early stages of the Great Depression, its financial structure began to crumble in 1931 when England abandoned the gold standard (Munson 2005). In response to England’s decision, US investors panicked and began to sell their securities, including those in Middle West Utilities and its subsidiaries. In one week following the sell-off, the value of the securities of Middle West Utilities dropped $150 million. Its share value bottomed out at $1.25 per share from its previous share value of $570. Due to variation on how paper profits were calculated, the total decline in valuation was estimated at between $500 million and $3 billion. As the stock value of the highly leveraged holding company declined, Middle West Utilities was unable to issue more securities or borrow additional capital. With few liquid assets and no means to access 32

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capital, it was unable to make debt payments, and the Chicago banks began to call in their loans. Insull then appealed to the New York banks, which created an opportunity for J.P. Morgan & Co., which held a substantial amount of Middle West Utilities’ debt, to gain control over the company. During what Insull anticipated would be a routine meeting, Morgan, in collusion with other New York bankers, exercised his power by refusing to loan Insull additional capital and demanding payment on existing loans. Unable to meet its financial obligation, Middle West Utilities went into receivership, and Morgan gained control over the holding company and its subsidiaries for a fraction of their asset value. Morgan also arranged for an audit of Middle West Utilities’ finances to demonstrate that Insull had embezzled the public. Although the audit revealed insufficient evidence to support the charge, the lack of transparency by Middle West Utilities had catastrophic consequences for the investing public. Wealthy investors had been enticed to invest in the firm with the promise of future earnings, and farmers, small business owners, and the working and middle classes in rural America (clerks, schoolteachers, and shopkeepers, for example) invested in the corporation with the expectation of obtaining electrical energy to improve the quality of their lives (Ramsay 1937). Instead, the bankruptcy and takeover of Middle West Utilities wiped out most of its unsuspecting 600,000 stockholders and 500,000 bondholders (Seligman 1982). In the absence of laws prohibiting it, many banks had invested depositors’ savings in Middle West and other corporations without informing depositors of the risks. Declining corporate profits resulted in widespread bankruptcies, which weakened the banks, contributing to the failure of almost five thousand banks during the Great Depression. Despite the damage to society from organizational and politicallegal arrangements that permitted widespread financial chicanery and malfeasance, the behaviors of Insull and other economic elites who engaged in similar behavior did not violate the law. Although the courts tried Insull and thirteen other Middle West executives for alleged crimes related to their deceptive financial transactions, the court concluded their behavior was perfectly legal. 33

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F rom L ibe r a l ism to E m bedded L ibe r a l ism When Franklin D. Roosevelt (FDR) was elected to the presidency in 1932, he continued to criticize the holding company as a primary cause of the Great Depression. However, the corporate lobby and its supporters in Congress resisted his efforts to prohibit public corporations from using the holding company form. FDR and his New Deal coalition were more successful passing legislation to redefine corporate-state relations in ways that strengthened and restored confidence in the banking system. A crucial component of New Deal legislation was the Banking Act of 1933, which limited risk in the banking system by reducing the probability of conflicts of interest. A key provision in this legislation, the Glass-Steagall Act, separated commercial from investment banks. Although national commercial banks retained their holding company structure, the federal government regulated them. Most investment banks retained their structure as private partnerships, which are loosely regulated because they do not rely on the public’s capital. Individual states continued to have their own banking laws, which preserved the dual banking system. The new political embeddedness also included laws to reduce information asymmetry by monitoring corporate financial transactions. Congress passed the Truth in Securities law in 1933, which required corporations to provide the public with financial information prior to issuing stock, and the Securities Exchange Act of 1934, which created the Securities and Exchange Commission (SEC) to monitor financial transactions in public corporations. The reassembly of corporate-state relations also required holding companies to include their subsidiary corporations in a single consolidated financial statement. Because the holding company structure created risks and opportunities for financial chicanery and malfeasance that contributed to the 1929 stock market crash and the Great Depression, FDR’s New Deal coalition made several attempts to eliminate this corporate form. Predictably, capitalists opposed this legislation because incorporating subsidiaries into a single legal entity increased the cost of consolidation by requiring corporations to acquire 100 percent of the target firm and purchasing the remaining stock in its subsidiaries. Most holding companies did not have 34

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the capital to do either. To block this legislation, corporate elites argued that restructuring subsidiary corporations within a single corporation would devalue their investments. After several failed attempts, Roosevelt and his New Deal coalition persuaded Congress to pass a 1.5 percent tax on capital transfers between subsidiary corporations and holding companies. Although the tax increased the cost of using this corporate structure, its more important effect was to create a record of internal capital transfers among corporate entities. Following the enactment of these laws, financial transactions between the holding company and its subsidiaries declined. To reduce the probability of conflicts of interest even more, Congress later passed the 1956 Bank Holding Company Act, which placed restrictions on mergers between insurance companies and banks. These political-legal arrangements motivated management to dismantle the holding company form and restructure as a multidivisional form (MDF) by transforming the holding company into a central office and subsidiaries to divisions. By the 1960s, many large corporations had restructured as an MDF (Chandler 1962), and by 1979, 84.2 percent of the largest 120 corporations were organized in this way (Fligstein 1990; Palmer, Jennings, and Zhou 1993). A few corporations continued to organize some assets as subsidiaries in the largest automobile, food products, oil and gas, pharmaceutical, and steel industries. However, most of these subsidiaries operated independent of the central office with few capital transfers among them. The MDF also contributed to the transition to managerial capitalism (Chandler 1962, 1977). Because subsidiary corporations were no longer embedded in markets, management had to rely on internal generated information to ensure firms’ financial integrity. Although corporations experimented with cost accounting and financial control in the late nineteenth century, transformation to the MDF motivated owners to develop more precise accounting and financial controls (Chandler 1977; Temin 1991). The transition to the MDF also increased the division of managerial labor, delegated authority to management, and shifted control from the invisible hand of the market to the visible hand of management (Chandler 1977). 35

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New Deal and post–New Deal corporate-state relations represent the transition from market liberalism to embedded liberalism (Ruggie 1982), where some economic sectors are more embedded in political-legal arrangements to protect society from unregulated markets. Karl Polanyi ([1944] 2001) conceptualized historical transitions that necessitate protections from unregulated markets as the “double movement,” where the first movement represents “free” markets that damage society and the second movement as protections from the excesses of liberal “free” markets. By limiting the outside parameters of corporate behavior, embedded liberalism contributed to the next consolidation phase, characterized by stable capitalist growth and development and greater equality. This historical transition increased workers’ rights, union membership, and power that culminated in the capital-labor accord where workers gave up control over the labor process for higher wages and secure employment that reduced inequality (Edwards 1977; Griffin, Devine, and Wallace 1982) and created conditions to expand the middle class. Although embedded liberalism reduced the opportunities for corporate elites to engage in financial chicanery and malfeasance, critics raised new questions about the imbalance between corporate power and state power. A primary concern was the revolving door among corporate and political elites. Critics from C. Wright Mills (1956) to President Dwight Eisenhower (1961) maintained that these conditions created the potential for collusion and the centralization of corporate power threatening democracy and economic opportunities for the working and middle classes. C r e at i ng a Pol i t ic a l Spe n di ng M ac h i n e In the absence of adequate enforcement, the Tillman Act and subsequent legislation failed to keep business from exercising instrumental power to interfere with the democratic process. To enforce the Tillman Act, Congress passed the Federal Election Campaign Act (FECA) in 1971, requiring corporations to disclose contributions to federal government political candidates, political parties, and political action committees (PACs). Like previous legislation to limit corporations from interfering with democracy, the FECA failed to create an enforcement structure. 36

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The flow of corporate capital into the political process was accidently exposed during the 1972–1974 Watergate investigation of the Republican Party break-in at the Democratic Party headquarters. Investigators discovered that President Richard Nixon held a large amount of money for his next election with no legitimate explanation of where it came from. To regulate the flow of capital from corporations and the upper class to politicians, the FECA was amended in 1974 to permit stockholders’ contributions of $1,000 to a single campaign and $25,000 to all federal candidates. It also created the Federal Election Commission (FEC) to monitor campaign contributions. However, during this period, stockholders rarely made contributions to political candidates, limiting managements’ capacity to influence elections. To test the law, Sun Oil Corporation solicited donations from its employees to the corporation’s PAC, which forced the FEC to respond. In 1975, corporations succeeded when the SUN-PAC ruling was passed by the FEC allowing corporations to solicit PAC contributions from its employees and use corporate resources to manage their PACs. Legalizing contributions from employees had two immediate outcomes: the number of corporate PACs rapidly increased from 89 in the end of 1974 to 433 in 1976, and contributions increased from $9.2 million in the 1977–1978 election cycle to $27.2 million in the 1987–1988 election cycle. These new arrangements shifted political struggles over the principle of whether corporations should be permitted to make contributions to political candidates to the struggle over how much money corporations and managers could contribute (Clawson, Neustadtl, and Scott 1992, 29–33). In subsequent decades, corporate managers used existing laws and regulations to legitimate higher spending limits to increase their instrumental power. Between 1975 and 2009, spending levels increased substantially. Average spending on Senate races increased from $56,000 in 1974 to more than $1.3 million in 2008. In 2010, almost $174 million was spent on just ten US Senate races, $25 million of it in Massachusetts alone. By January 2009, there were 1,598 registered corporate PACs, including 995 corporate and trade organization PACs compared to 272 labor PACs.

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Although the level of spending on political campaigns in the United States was already much higher than in other democracies, corporate elites were not satisfied. To increase their political contributions to candidates even more, they connected the neoliberal idea of individual rights with the idea of corporations as artificial persons. This argument made its way to the conservative Supreme Court when, in the case of Citizens United v. Federal Election Commission (2014), the Court ruled that the First Amendment, on freedom of speech, prohibited spending limits on political broadcasts, which resulted in a rapid increase in spending on media advertising. This Court decision removed most limits on PAC spending and permitted corporations and unions to make political contributions through other organizations as long as it was not made directly to a candidate. The ruling also removed the requirement to disclose who funded these activities. The creation of super PACs, which are also known as sources of dark money, made it virtually impossible to trace the money back to the original donor. The conservative Supreme Court used a similar logic deciding McCutcheon v. Federal Election Commission (2014) when it ruled that placing limits on individual contributions is unconstitutional. Given that the First Amendment was adopted on December 15, 1791, as one of the ten amendments in the Bill of Rights and was passed a century before business enterprises gained legal status similar to natural persons, it is unclear how the Court concluded that the amendment was intended to equate free speech with corporate spending on political campaigns. These Court decisions subvert democracy by shifting power to corporate management and the very rich, whose political contributions influence elections. In 2017, super PACs reported more than $1.06 trillion expenditures compared to just over $27 million by labor unions. However, the law exempts reporting some expenditures, so these amounts do not account for all super PAC expenditures. These political-legal arrangements permitting a massive flow of corporate capital into politics dramatically increased the instrumental power of management to contact and influence political elites to reconfigure political-legal arrangements in ways that advanced their capital accumulation strategies. Between 1971 and 2014, the limits on individual spending increased from $1,000 to $5.9 million, and corporate PACs permit even greater 38

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limits. To illustrate, in the 2013 election, the Koch brothers’ advocacy organization, Americans for Prosperity, which represents the political and economic interests of David and Charles Koch, who own more than 80 percent of Koch Industries with annual revenues above $110 billion and 120,000 employees in sixty countries, spent more than $412.6 million compared to $153.5 million by the ten largest labor unions (Fang 2014). The Koch brothers spent approximately $20 million prior to the 2018 midterm elections to “convince voters that . . . [the Trump-proposed] tax cuts are good for the country and the middle class” (Kitson 2018, 17). It is estimated that the Koch brothers will save between $840 million and $1.4 billion in taxes each year from the 2017 Trump tax cut. A large share of these tax cuts is to subsidize the fossil fuel industry. In 2014, the Koch brothers’ net worth was estimated at $80 billion with investments in many industries, including fossil fuels; petrochemical complexes; refineries in Alaska, Minnesota, and Texas; and thousands of miles of pipelines. These holdings emit over 24 million tons of carbon pollution every year, equivalent to the carbon from 5 million cars. In additional, the Koch brothers spend massive amounts of capital to oppose legislation to curtail pollution controls. Their lobbying strategies include a campaign to discredit scientific research on environmental pollution and pressuring Congress to prohibit the Environmental Protection Agency from regulating greenhouse gases associated with global warming (Michaels 2020). 2 Contributions to political candidates are only one dimension of corporate influence. Prior to the 1970s, few corporations hired their own lobbyists, and their lobby activities were limited to protecting themselves from policy and legislative changes. During the 1970s, corporate management changed their strategy to pressuring elected officials to enact legislation to their benefit and began to view the government as a political ally. The increase in corporate structural power enhanced their instrumental power in other ways. Corporate lobbying expenditures increased dramatically, and in 2019, the number of professional lobbyists, whose sole purpose is to influence elected officials to pass policies that benefit the organizations hiring them, reached approximately fourteen thousand. Corporate and trade association lobby expenditures continue to dwarf 39

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those of other organizations; corporations spend approximately $34 for every $1 spent by all public interest groups and labor unions combined (Drutman 2015). Furthermore, by the early 2000s, retired politicians discovered that lobbying was a lucrative occupation and became lobbyists using their networks in the government to advance corporate interests. Whereas 3 percent of retiring members of Congress became lobbyists in the 1970s, in 2004, more than 59 percent of former senators and 42 percent of former House members who left Congress in the previous seven years (1998–2004) became lobbyists (Lessig 2015). N e o l i b e r a l i s m ’s I d e o l o g y v e r s u s H i s t o r y After it became clear that the manufacturing power bloc was unable to restore capitalist growth and development, corporate elites searched for a way to explain this economic decay without accepting responsibly for their own failures. They found the answer in neoliberalism, which blamed government interference in the markets for their poor performance. Neoliberals assert that political solutions to social problems are always temporary and that social, economic, and political problems can be solved with information provided by markets. Through price changes, markets, they believe, provide the most efficient means to distribute information to decision makers (e.g., managers, investors, consumers) that collectively benefits society; therefore, the neoliberalists say, government intervention in markets undermines efficiency (Hayek 1991, 12–13). Market fundamentalism, the extreme version of neoliberal ideology, entails the religious-like certitude that all social problems can be resolved by market forces (Soros 1998; Stiglitz 2002, 219; Somers and Block 2005, 260–261). Neoliberalism has its roots in the Australian school of economics, including Ludwig von Mises, whose writings focused on human choice and action. Libertarian economists began to organize in 1938 during the Great Depression and rejected embedded liberalism by claiming that government interference with markets is the cause of poor economic performance. They began to organize formally in 1947 when von Mises’ student Frederick Hayek formed the Mont Pelerin Society, which served as a forum for advocates of free markets who believed that market distribution of resources is both efficient and unbiased and the highest 40

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rewards go to those who work the hardest and take the most risk (Mises [1951] 2009); Hayek 1991). Milton Friedman and other economists at the University of Chicago further elaborated neoliberalism and succeeded in convincing political elites inside and outside the United States to employ its core principles to guide economic policy. Despite the claims to science by the field of economics, many core neoliberal presuppositions were speculative and never empirically tested. As a result, the assertions that markets fairly and efficiently distribute resources is more of a moral and ideological argument than a scientific theory. A central component of neoliberalism is supply-side economics, which asserts that production (or supply) results in economic prosperity. Although supply-side economics is often associated with academic economists like Milton Friedman, many of its core ideas were developed by economists engaged in politics. Robert Mundell, for example, served as an adviser to the European Commission and is credited with developing the euro. He also advised governments, including those of Canada and the United States, as well as the International Monetary Fund (IMF) and the World Bank. In the United States, Mundell advised the Federal Reserve Board and the Department of Treasury. Another politically engaged economist, Arthur Laffer, a member of Ronald Reagan’s Economic Policy Advisory Board (1981–1989), popularized Mundell’s ideas with the Laffer curve, which claimed that cutting tax rates increases government revenues by stimulating economic growth. Working for organizations such as the IMF and the World Bank, neoliberals experimented with policies in South America and other parts of the global economy. In many cases, neoliberal capitalism was given a high priority over democracy, often resulting in authoritarian governments (Yergin and Stanislaw 1998). In the United States, neoliberalism became highly influential in the 1980s during the decay-exploration transition when Ronald Reagan appointed many neoliberal economists to crucial positions inside the government. Business elites viewed this ideological shift as a solution to the country’s economic malaise and used their instrumental power to pressure government officials to implement neoliberal policies. The first 41

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major supply-side policy enacted by a receptive Reagan administration was the Economic Recovery Tax Act of 1981 (ERTA). Although Reagan presented this tax policy as benefiting the working and middle classes, the law provided large tax cuts for corporations and the wealthiest members of society by, for example, lowering the top marginal tax rate from 70 percent to 38 percent).3 In contrast to neoliberal claims, Reagan’s tax cuts resulted in the rapid increase in government debt to levels exceeded only by the debt accumulation from World War II. Although neoliberal policies are presented to the public as deregulation, this term is misleading because it implies that rules are eliminated. Re-regulation is more accurate: it captures the substantive changes that actually occurred, with previous rules replaced with new rules that benefit corporations and the upper class. Neoliberal re-regulation extended corporate property rights, reduced corporations’ responsibilities to society, permitted corporations to create new markets and enter existing markets, and legitimated managements’ risk-taking behavior to their own benefit. Neoliberalism is conceptualized here as an ideology for the following reasons: (1) it legitimates policies to advance the interests of corporate owners and managers, (2) many of its core presuppositions do not conform to empirical events, and (3) it has limited explanatory power of how markets emerge and operate. To illustrate, the history of capitalism is packed with periods where big business exercises structural and instrumental power to engage in political capitalism to limit market competition from entrepreneurs pursuing their interests. Once established, late nineteenth- and early twentieth-century business elites known as the robber barons, such as Andrew Carnegie, J. P. Morgan, John D. Rockefeller, Cornelius Vanderbilt, and Henry Villard, all opposed unrestrained competition associated with “free markets” and lobbied government officials to establish political-legal arrangements to permit them to control markets and limit market entry by competitors. The organizational and political-legal arrangements that emerged permitted capitalists to establish oligopolies, limit production, set prices, speculate, and engage in value extraction. Max Weber characterized the political and speculative practices of these “adventure capitalists” as irrational compared to rational industrial 42

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capitalism, which emphasized formal rationally calculated rules and bureaucratic management that contained an ethical component (Weber [1904–1905] 1958, 20–21; [1921] 1978, 1118; Swedberg 1998). “Adventure (robber) capitalism” is substantively irrational because “the market is not bound by ethic norms,” an orientation toward short-term profits prevails, and “constellations of interests and monopoly positions” are permitted to exploit formally free labor (Weber [1921] 1978, 637). For Weber, the irrational speculation of adventure capitalists such as the German immigrant Henry Villard is outside widely accepted pathways and conventions as it entails amoral ways to accumulate capital, often with risk and incalculable outcomes (Antonio 2019b, 3). Some adventure capitalists used charismatic powers of persuasion to convince Wall Street financiers to issue securities in corporations with few assets. Villard himself convinced financiers to issue $18 million in securities against only $3.5 million in physical assets (Josephson [1932] 1962, 240). The organizational and political-legal arrangements permitting the rise of the speculative high-risk behaviors of adventure capitalists contributed to the periodic recessions in the late nineteenth and early twentieth centuries that by 1929 moved into the decay stage, weakening firms and banks and contributing to widespread corporate failures that resulted in the Great Depression. By ignoring social structure and focusing on markets, neoliberals ignore a core characteristic of modern society: the power of the wealthy resides in their capacity to use the resources held in the organizations they control to their own benefit. As artificial persons that can live forever, corporations can accumulate massive amounts of capital that can be used to engage in political capitalism. Under the neoliberals’ idealized worldview, there is little to keep corporate managers from engaging in speculation, controlling markets, setting prices, limiting competition, and exploiting natural persons. Another flaw in neoliberalism is that many decisions are not made in markets, and thus efficiency cannot be assessed by the market. Instead, many decisions today are made deep inside large, complex corporations. These decisions are not evaluated by markets until after they are manifested in commodities that are sold in markets. Moreover, markets are incapable 43

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of determining if some commodities are the outcome of efficient decisions. For example, markets were unable to detect the massive fraud of emission systems in cars manufactured by Volkswagen (VW). Instead, government oversight agencies identified the problem and revealed that decision makers inside the corporation had created a mechanism for deceiving the public by engineering emission controls to register lower pollution levels when undergoing tests than emitted under normal operating conditions. Furthermore, the VW fraud was not exposed until long after massive resources were invested in designing, manufacturing, transporting, and selling these cars. Still more resources had to be invested in buying back these vehicles and disposing of them and then settling consumer lawsuits. Moreover, the adverse health consequences of the environmental pollution (e.g., particulate matter and nitrogen oxides) caused by these decisions add costs that are externalized to society (Wilmot 2019). Another flaw in neoliberalism is that it fails to acknowledge that value is politically defined to overestimate corporations’ contributions and underestimate government contributions to the gross domestic product (GDP), the primary measure of the health of national economies. The first formal rules to calculate national accounting from income, production, and expenditures were established in 1953 and compiled by the United Nations System of National Accounts (SNA), which defines GDP as “the amount of value added by production” and annual variation in value creation (Mazzucato 2018, 83). A standard measure of the amount of value a business contributes to the economy is operating profit margin, which is the amount of capital a business retains after expenses are deducted. This measure of GDP does not include things produced by the government, which is much harder to measure because these products, including national security and weather forecasts, rarely move through markets. Thus, their value cannot be determined by markets. Moreover, governments produce many products that are free to corporations. For example, the Internet and the satellitebased global positioning system were developed by the government, and their value is measured only by the extent to which they are incorporated into commodities. Without these government innovations, cell phones and many other devices would not exist or would generate much less value than current measures suggest (Mazzucato 2018). 44

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GDP also does not include the costs of environmental pollution. For example, toxic emissions take land out of production and increase health costs, and severe weather events caused by greenhouse gas (GHG) emissions increase a wide range of costs. These and many other costs are not measured but are instead defined by economists as externalities. In short, the way in which the SNA measures inputs makes it impossible to verify the efficiency assumptions that neoliberalism makes about markets. In short, many of the faulty assumptions of neoliberalism exist because its advocates do not acknowledge that markets are always politically embedded in modern society. The false narrative of neoliberalism contrasts with fundamental insights of modern political economy that begin with the presupposition that markets are embedded in cultural and politicallegal arrangements (Polanyi [1944] 2001). In precapitalist societies, markets are embedded in cultural arrangements, and exchanges are based primarily on normative considerations: societally accepted standards that create expectations concerning the occurrence of current and future events. In modern rational capitalism, markets are increasingly defined by political-legal arrangements. However, the behavior of “lawmakers, legal practitioners, and social groups interested in the law” is subject to normative considerations versus “law imposed by mere power” (Weber [1921] 1978, 866). Thus, in rational capitalism, in contrast to adventure capitalism, markets, normative considerations, and politicallegal arrangements are intertwined and cannot be understood in isolation from one another. In the absence of political embeddedness, some markets would not exist. Other markets exist because corporations mobilize political and exercise power to pressure the government to enact laws to create them. Mu t ua l Fu n ds: Ga i n i ng Access t o t h e P u b l i c ’s M o n e y Historically, corporate elites have attempted to socialize capital when the amount of their internally generated capital is insufficient to advance their capital accumulation agendas. The first major policy that socialized capital occurred in the late nineteenth century when corporations exercised instrumental power to create the legal framework for stock holding 45

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companies (Haney 1920; Hilferding [1910] 1981; Roy 1997). Socializing capital during this historical period took two forms: (1) individuals made direct stock purchases, and (2) bankers invested depositors’ capital into corporate securities. During the Great Depression, the low rate of public investment in corporate securities was considered an impediment to economic growth. To overcome this obstacle, corporate and political elites began to devise mechanisms to access the public’s capital. Mutual funds were among the first financial instruments to fill this void. Although they were created in 1924, they did not provide a substantial source of capital during the Depression. In response, Congress passed legislation in 1933 and 1934 to encourage the public to invest in mutual funds. Nevertheless, widespread distrust of big business—perceived by the working and middle classes as having taken control of the economy and mismanaging it—kept public investment in corporate securities low through the middle decades of the twentieth century, in part, because labor unions negotiated with corporations to develop pension retirement funds. Thus, mutual funds had to compete with pension funds for the public’s capital. Mutual funds gained more attention in the 1970s when it became apparent that corporations were in desperate need of external sources of capital to make the necessary investments to modernize their manufacturing processes to compete in global markets. The capacity of US firms to make value-creating investments by modernizing their facilities was hampered during the middle decades of the twentieth century by their strategy of value extraction via high stock dividend payments to investors. When global competition increased and profits declined in the 1970s, many corporations experienced capital shortages and were unable to make the necessary value-creating investments. The financial condition of the manufacturing sector worsened when the Federal Reserve Bank implemented policies to control inflation with interest rates that reached record-high levels in the early 1980s and made traditional sources of financing such as debt unobtainable for many corporations. In response, business elites lobbied Congress to redefine the politicallegal arrangements in ways that provided corporations with access to the public’s capital. Congress was receptive to this policy because 46

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it coincided with the state’s agenda to ensure stable economic growth and development. In 1971, in response to the business lobby, Congress enacted legislation to create money-market mutual funds, and in 1974, the Employee Retirement Income Security Act permitted individual retirement accounts (IRAs) for workers who did not have employee-funded pension funds. In 1978, legislation was passed that permitted employees to create 401(k) retirement plans. Then, in 1982, company-sponsored retirement accounts were approved by the Internal Revenue Service (Levitt 2002, 257). In the following decade, the Taxpayer Relief Act of 1997 created the Roth IRA, which permitted investment of pretax dollars. By creating incentives for the public to shift their savings from traditional bank saving accounts into high-risk retirement mutual funds, these political-legal arrangements provided corporations with access to more of the public’s capital. Later, in response to the recession in the early 1990s, Federal Reserve Bank chairman Alan Greenspan reduced interest rates, which lowered returns on savings account deposits, creating additional incentive for the public to place their capital in mutual funds. Despite the economic recovery, Greenspan kept interest rates low throughout the decade. This long-term policy encouraged the middle and working classes to invest more of their savings in corporate securities either directly or indirectly through mutual funds. Subsequent re-regulation in the early 1990s provided a range of banking and investing services that allowed customers to easily shift their savings into corporate securities (chapter 3). In 1980, 5.7 percent of households invested in corporate securities directly or indirectly through mutual funds, approximately the same as the estimate for 1927. However, by 1990, 23.4 percent of families owned shares in mutual funds, whose assets surpassed $1 trillion (Investment Company Institute 2013). The bull market of the early 1990s created additional incentives, and by 1993, 79 million people owned corporate securities, up from 42 million in 1983. Of the 79 million stockholders, 54 percent directly owned stock and 85 percent owned stock through mutual funds (Levitt 2002, 7, 245). This trend continued, and by 2001, 51.9 percent of American families directly or indirectly owned corporate securities through mutual funds (Kennickell, Starr-McCluer, and Surette 47

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2003). Although these organizational and political-legal arrangements made the public’s capital available to corporations, they also more tightly coupled the life chances of the working and middle classes to the successes and failures of corporations. T h e Mult il ay e r-Su bsidi a ry For m , A n t i t rus t, a n d t h e Gi a n t Cor p or at ion Although mutual funds held a significant amount of capital by 1980, the organizational mechanisms for manufacturing firms to access this capital did not exist. During the same period, analysts began to argue that securities markets undervalued large corporations and the sum of the parts was more valuable than the whole (Jensen 1984; LeBaron and Speidell 1987; Porter 1987). These claims were supported by the success of speculators such as T. Boone Pickens and Carl Icahn, who pioneered the use of hedge funds and made fortunes taking over corporations, breaking them up into parts, and selling the parts separately. The Multilayer-Subsidiary Form The success of hedge fund managers motivated corporate management to find a structure that allowed them to unlock capital in the firms they managed. One option was to use the holding company structure that prevailed in the late nineteenth and early twentieth centuries. However, with the exception of more tightly regulated banks and public utilities, this structure was deinstitutionalized when Congress taxed internal capital transfers between legally independent entities. This 1930s legislation was important not because of the cost of the 1.5 percent tax, but because the tax provided a means for government oversight agencies to monitor corporations’ internal capital transfers (Prechel 2000, 78). In fact, some companies retained their subsidiaries, but they operated independent of divisions restructured into the MDF. To gain access to capital held in mutual funds, the still-dominant manufacturing power bloc exercised instrumental power to dismantle the capital transfer tax. The strategy was led by the Tax Reform Action Coalition, which was created in June 1985 by 250 large, mostly nonfinancial corporations. Corporate lobbyists justified this policy change 48

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with the neoliberal idea that markets are the most efficient means to guide business decisions and the capital transfer tax functions as industrial policy that interfered with market incentives. This political coalition succeeded by convincing Congress to add provisions to the Tax Reform Act of 1986 (TRA86) and the Revenue Act of 1987 that repealed the 1930s capital transfer tax between legally independent entities (e.g., subsidiaries and holding companies) while continuing the corporate subsidies from previous tax policies. After it became clear that Congress would include this provision in the TRA86, capital-dependent corporations restructured using the multilayersubsidiary form (MLSF) and negotiated initial public offerings (IPOs) with investment banks in their newly formed subsidiaries. In this MLSF, the parent company replaces the general office of the multidivisional form, and divisions are replaced by legally independent subsidiary corporations (figure 2.1). Like the early twentieth-century holding company, the MLSF parent company provides consulting, financial, and other services to the operating subsidiary corporations. Although its structure is similar to the early holding company, with accounting and computerizing information processing technology, it is capable of a much higher degree of control of subsidiary management by parent company management (Prechel 1994). Whereas subsidiary management in the early twentieth-century holding company had a high degree of autonomy (Berle and Means [1932] 1991), this is not the case with the MLSF. By the early 1990s, financialization inside the corporation included setting the outside parameters of decisions to control costs and achieve financial goals in subsidiaries. This dimension of financialization entails investments in sophisticated computerized information gathering and processing that allowed financial managers in the parent company to monitor whether subsidiary management remained within predetermined cost standards and achieved their financial goals. Financial controls of the MLSF permit top management with the flexibility to acquire or merge firms as subsidiaries with little or no change in their management structure, while parent company managers make strategic decisions and monitor the portfolio of its subsidiaries. Thus, the parent company operates like a financial management company, including engaging in 49

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Figure 2.1. Prototypical Multilayer-Subsidiary Form. Source: Adapted from Prechel 2000.

financial transactions with its subsidiaries and third parties, such as banks and financial services firms (Prechel 1991, 2000). The MLSF provides the flexibility to organize small companies as well as giant “multi-tiered multinational groups of parent and subsidiary corporations” (Blumberg 1990). It is also particularly conducive to globalization where business operations in foreign countries that have different laws and regulations must be organized as legally independent entities. This corporate form also provides a means for corporations to organize product lines under a separate first-level subsidiary with operating subsidiaries organized under it (Prechel 2000). A crucial characteristic of the MLSF is equity financing. Like the early twentieth-century holding company, it permits parent company management to sell stocks and bonds in their subsidiary corporations while retaining ownership control: holding more than 50 percent ownership 50

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of subsidiary stock. Restructuring to an MLSF typically occurred in conjunction with an IPO of stocks or bonds. Management frequently issued stock in the new parent company and subsidiary using the same legal maneuver as restructuring. IPOs are managed by investment banks—one or more than one—that decide on the parent company’s and subsidiary’s value. To illustrate, when American Steel (a pseudonym) restructured as an MLSF in 1986, investment banks managed an IPO of 3.75 million shares in its newly created first-level subsidiary corporation. This transaction raised approximately $90.6 million, of which $85.6 million was transferred as tax-free dividends to the new parent company. In 1987, the parent company raised an additional $97 million by issuing 2 million shares of its own preferred stock. In subsequent years, additional securities were issued in subsidiaries, and in 1994 alone, management transferred $225 million from a subsidiary to the parent company as tax-free dividends (Prechel 2000, 221–222). A large share of these securities were purchased by institutional investors who managed the mutual funds made viable by the political-legal arrangements created in the previous decade. Unsurprisingly, in 1986, the same year that restructuring to the MLSF became viable, the number of IPOs more than doubled from 166 in 1985 to 355 in 1986. The level of IPOs remained high the following year at 244 (Gao, Ritter, and Zhu 2013). Given that mutual fund investors purchased a large portion of the corporate securities, these organizational and political-legal arrangements shifted some of the risk from the upper class to the middle and working classes. The MLSF also accommodates diversification strategies through other legally independent corporate entities such as affiliate corporations and partnerships. Affiliate corporations are legally independent firms in which a parent company owns less than 50 percent of their stock, which permits parent company management to diversify without the responsibility of managing these companies. In addition, the parent company is typically not required to report entities in which it owns less than 50 percent on its consolidated financial statement. This financially and organizationally flexible MLSF permits managers in the parent company to buy and sell other corporations as the parent 51

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company’s financial needs vary. Parent company management can also change its product line by acquiring or spinning off subsidiary corporations. After this structure was in place, many corporations sold their noncore product lines to raise capital via stock transaction. Later, after profits were restored in the 1990s, large parent companies diversified by acquiring more than 50 percent of other companies and incorporated them as subsidiaries (Prechel, Morris, Woods, and Walden 2008). For example, in 2016, General Electric (GE) acquired ownership control of the giant oil field services company Baker Hughes for $23 billion by acquiring 62.5 percent of the firm and incorporated it as a subsidiary while retaining much of Baker Hughes’s management. Less than two years later, in 2018, when GE reported losses and needed capital to strengthen its balance sheet, parent company management announced that it would sell over 12 percent of Baker Hughes’s stock. Thus, the flexible structure of the MLSF allowed GE to raise capital through equity sales while retaining ownership control of Baker Hughes. Under certain conditions, the MLSF creates a liability firewall between the parent company and its legally independent subsidiaries, which protects the parent company from liabilities that occur in its subsidiaries (Krendl and Krendl 1978). For example, in 1963, a passenger in an Opel Rekord automobile was injured in an accident and sued General Motors (GM) and its wholly owned subsidiary, Adam Opel (AG), for damages. In its decision, citing legal precedent, the court acknowledged that GM owned 100 percent of Opel but held that this “fact is not sufficient to fuse the subsidiary into the parent company for the purpose of establishing an agency relationship”; the court also stated that “a duplication of some or all of its directors, or officers or an exercise of control that stock ownership gives to stockholders” is not sufficient to establish parent company liability (US Court of Appeals 1978). Although subsidiaries may be found liable by the courts, parent companies typically require subsidiaries to transfer their profits via dividend payments to the parent company. Thus, subsidiary corporations hold few assets that plaintiffs can recover. In some cases, the liability firewall requires that plaintiffs sue and win each lawsuit at the subsidiary level until they reach the parent company.

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In most cases, the cost prohibits individual plaintiffs from pursuing litigation against corporations organized as an MLSF. The MLSF also mitigates the problem of bounded rationality— the limited cognitive abilities of decision makers—associated with large, complex firms organized using the MDF where all assets are located in a single corporation. Within the MDF, top management is dependent on internal accounting controls to evaluate organizational entities’ performance. By transforming divisions into legally independent subsidiaries, these corporate entities are embedded in the market, which provides additional measures of their performance, such as profits or stock values. These changes in the internal organization of corporations occurred without concomitant changes in their political-legal arrangements, thereby decoupling these corporations from oversight agencies. To illustrate, eliminating the need for management to report internal capital transfers to the IRS decouples the corporation from this crucial oversight agency. The lack of financial transparency in the MLSF also motivated parent company management to devise financialization strategies to advance their capital accumulation agendas, including transferring capital among their domestic and foreign subsidiaries in order to lower their tax obligation. Over the long term, the political disembeddedness of the corporation created multiple opportunities for managers to engage in risk, deception, and financial malfeasance. Redefining Antitrust Rules Corporate elites also exercised instrumental power to redefine antitrust enforcement. In response to political pressure from corporations and neoliberal economists who asserted that antitrust laws undermined efficiency and prohibited corporations from competing in global markets, the Reagan administration revised the formula that triggers antitrust violations. Whereas the previous formula was based on market share of the largest four firms in an economic sector, the new formula included all of the firms in the market (Oesterle 1991). At around the same time, the Federal Trade Commission, which collects data on corporate concentration, suspended

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data collection. This executive branch decision made it difficult for the public to know the extent of corporate control over markets. After the antitrust changes were enacted, the still-dominant manufacturing power bloc increased its market control by merging with or acquiring other corporations in the same industry. These combinations placed large corporations in the same industry under the financial control of a relatively small number of parent companies located at the apex of the MLSF, dramatically increasing parent company structural power. According to the Government Accountability Office, there were 2,600 mergers in the oil and gas industry alone between 1991 and 2005. Some of these mergers and acquisitions consolidated some of the largest US corporations: Texaco acquired Getty Oil, Chevron acquired Gulf Oil, Mobil acquired Superior Oil, and then Mobil and Exxon merged. By 1993, the largest ten oil refining companies controlled 55.6 percent of the market (Slocum 2006). Consolidation also contributed to a rapid increase in corporate size. Whereas the largest fifty Fortune 500 industrial firms held less than thirty times as many assets as the smallest fifty firms between 1958 and 1977, this ratio increased to more than sixty times by 1993 (Prechel and Boies 1998, 323). Unsurprisingly, consolidation of the oil and gas industry was followed by an increase in the cost of gasoline, and by 2008, prices and profits began to skyrocket. Profits were so high in the petroleum industry (e.g., $39.5 billion for ExxonMobil in 2006) that corporate executives were required to appear before the US Congress on at least three occasions to defend their pricing behavior. However, Congress did nothing to make defiant corporate elites change their behavior. To summarize, because subsidiary corporations are embedded in the market, which provides measures of subsidiaries’ performance, the prevailing organizational and political-legal arrangements made it viable to create larger and more complex corporations to control a larger share of the market. Although increased size and complexity typically contribute to bounded rationality and undermine efficiency, the market embeddedness of subsidiaries, together with implementing computerized information processing systems, provided top management with financial controls to monitor subsidiary operating managers. At the same time, the capacity 54

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of external oversight agencies to monitor the internal operations of these larger and more complex corporations declined, further decoupling corporations from government oversight. The New Era of Giant Corporations Many Americans associate giant corporations with the turn of the twentieth century when Standard Oil, US Steel, and other corporations used holding companies to consolidate production in a few corporations. However, the emergence of the MLSF in the late twentieth century ushered in another era of consolidation and giant corporations. Despite this historical transition, the size and complexity of the modern corporation is concealed from the public because the prevailing politicallegal arrangements do not require subsidiaries to have names that reflect their connection to the parent company. As a result, parent companies’ market control is not transparent to the public. To illustrate, Unilever holds ownership control over Ben and Jerry’s; Restaurant Brands has ownership control over Burger King, Popeyes, and Tim Hortons; Clorox has ownership control over Burt’s Bees; Williams-Sonoma holds ownership control over Pottery Barn and West Elm; Nestlé has ownership control over Gerber and Purina; TJX owns HomeGoods, Marshalls, T.J. Maxx, and Sierra Trading Post; and Yum Brands holds ownership control over Kentucky Fried Chicken, Pizza Hut, and Taco Bell. However, these corporations are relatively small compared to Alphabet (YouTube and Google’s parent company), Amazon, and Facebook and other corporations whose control of markets permits them to behave like or nearly like monopolies. Consolidating ownership under fewer parent companies also provides a mechanism to shift control of business from local communities, towns, and midsized cities to large cities where the parent companies are located. This geographic shift disenfranchises local communities, towns, and cities and marginalizes citizens from decisions that affect them, often with adverse consequences for the community. Consolidation of banks is particularly problematic because policy decisions are often made by financial managers in the parent company located in large metropolitan areas who have little interest in or understanding of the needs of communities dependent on them for capital. 55

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C r i si s i n t h e M a n u fac t u r i ng S e c t or a n d Fi na nci a l iz at ion of t h e Cor por at ion The value extraction strategies of the oligopolistic manufacturing sector that provided high dividends to investors left them poorly prepared when global competition accelerated in the 1970s, economic growth slowed, and energy costs increased. Firms’ financial condition worsened when the Federal Reserve Bank implemented a policy to control inflation with high interest rates. These historical conditions made traditional sources of financing such as bank debt unobtainable for many corporations. Capital Dependence and Decay Dependent on external sources of capital with little means to access it, manufacturing transitioned to the decay phase of the capital accumulation cycle. This transition was partially due to their strategy to reward stockholders instead of investing in new manufacturing technologies during the middle decades of the twentieth century that in the long term undermined their ability to compete with European and Japanese industrial facilities on cost or quality. During this decay-exploration period, the still-dominant manufacturing power bloc explored multiple options to restore the rate of capital accumulation. In the absence of external sources of financing, corporations turned inward and hired more financial managers and placed them in key decision-making positions. To illustrate, in the mid-1970s, American Steel (a pseudonym) created a new position: assistant vice president of finance. When the previous vice president of finance, who had a background in accounting, retired, the firm promoted the recently hired executive, a former investment banker, to this position (Prechel 2000, 217). This banker had the human capital (skills and knowledge) and the social capital (contacts with social actors) to negotiate external financing (stock and bond offerings) with investment banks. As one top executive told me, this change in the leadership signified that top management recognized the need for greater expertise in finance if the corporation was to survive the “heavy weather” in the near future. While management recognized the need for internal organizational changes, they also engaged in political capitalism to restore the rate of 56

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capital accumulation. In 1972, manufacturing corporations created the Business Roundtable to develop a unified political strategy to pressure Congress and the executive branch to pass legislation to overcome constraints on capital accumulation. At the same time, the informal Carlton Group addressed a wide range of business interests (Akard 1992). In 1975, the group consisted of representatives from the Business Roundtable, National Association of Manufacturers, the American Council for Capital Formation, the Committee for Effective Capital Recovery, the Retail Tax Committee, and the US Chamber of Commerce. In 1980, the American Business Conference also joined the Carlton Group. A primary objective of these organizations was to address falling profits by revising corporate tax policies to increase capital flows in the still-dominant manufacturing power bloc. Their early successes included the business component of Reagan’s 1981 tax policy, the Economic Recovery Tax Act. Together with tax credits, the accelerated cost recovery system in the bill provided massive corporate tax cuts in the form of shortened depreciation periods (Prechel 1990). Based on its advocates’ own claims, these tax cuts to corporations and the wealthy failed to stimulate economic growth and increase government revenues and instead contributed to deficits that forced the government to borrow more money than any other period since World War II. The increase in deficits had devastating consequences for manufacturing. Skyrocketing government debt together with an international floating exchange rate caused by President Nixon’s decision to end the Bretton Woods system resulted in a rapid rise in the value of the US dollar, causing a decline in the price of virtually all commodities imported into the United States and higher prices of US goods abroad. Despite lobbying by the automobile, heavy construction, steel, textile, and other manufacturing industries, the Reagan administration refused to revise its tax policies. Although Federal Reserve chair Paul Volcker pressured US trading partners (e.g., Germany, Japan) to sign the Plaza Accord in the mid-1980s to revalue their currencies relative to the dollar, it was too late for most industries. The United States lost global market share, resulting in plant closings and the loss of millions of jobs. Employment in the steel industry 57

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alone declined from 457,000 in 1975 to 164,000 in 1990. The rising value of the dollar pulled European currencies with it, weakening its manufacturing sector. At the same time, the windfall profits from OPEC oil price hikes, together with high US interest rates, attracted capital from OPEC and other countries, which deposited it in US banks, increasing the flow of capital into financial markets (Appelbaum 2019, 239–245). Using capital from the massive Reagan tax breaks, the manufacturing sector underwent widespread restructuring. The substantially smaller manufacturing sector restored profits by investing in new technologies to centralize decision-making information and distribute it on a need-toknow basis, computerized control systems such as a statistical process to incorporate decisions directly into the manufacturing process, and reducing inventories on the input and output ends of production (e.g., just-in-time; Prechel 1994). Although these mechanisms increased profits, the much smaller manufacturing sector lost much of its political power and created an opportunity for the banking and financial sectors to assert their political power. The first signs of the emerging power of the financial sector occurred when it warned that the rapid escalation of government debt would destabilize financial markets and successfully pressured Congress to rescind some of Reagan’s tax cuts. Political Capitalism and Off-Balance-Sheet Financing Reagan’s corporate tax cuts were so lucrative that low-profit firms could not use them all; after deductions reduced their taxes to zero, they still had not used all of their deductions. To maximize their benefit, financial managers in manufacturing firms engaged in political capitalism to revise Treasury Department rules governing off-balance sheet financing, which at the time was an obscure financial technique used primarily by banks (e.g., contracts on currency exchange rates). Qualifying for off-balancesheet treatment requires that the assets are securitized, transferring risk to a third party. After receiving initial approval, corporate managers worked with officials in Treasury to develop a mechanism to securitize their unused tax deductions (Prechel 2000, 218–219). The mechanism governing this innovative form of securitization was known as leaseback arrangements or lease-lend, which entails packaging 58

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physical assets (e.g., computers, blast furnaces, office equipment) in offbalance-sheet partnerships and leasing them to profitable third parties that used the tax deductions to reduce their tax bill. Leaseback arrangements do not entail any physical movement of the assets, permitting the owner to continue using them. This form of financialization benefited firms on both sides of the contract. Whereas the owner of the assets leased them at a discounted price to high-profits that could use their tax deductions to reduce the firm’s tax bill, revenues paid to the lessor improved their cash flow. These arrangements benefited corporations but lowered tax revenues and therefore contributed to higher government debt. Corporations justified these off-balance-sheet partnerships because the securitized assets are not actively managed and represent a steady and predictable flow of revenue. If the intent of the political-legal arrangements is followed, these financial instruments have a limited effect on risk because changes in the value of these assets are predictable. That is, a physical asset such as a steel mill is not actively managed like commodities that flow through markets, which introduces a degree of unpredictability and risk. Securitization provides a clear benefit to corporations. Instead of waiting for the firm to return to profitability and then use the tax deductions, securitization permitted management to have immediate access to revenues from leasing physical assets. The purported intent of these organizational and political-legal arrangements was to modernize and improve the efficiency of firms’ operations without taking on additional debt. However, the rule changes placed few requirements on how management could use the revenues. As a result, some corporations used revenues from these partnerships to pursue diversification strategies into more profitable product lines. Partnerships are the preferred corporation entity for securitizing assets as they are loosely regulated and easily created and dismantled. These partnerships are given the designation of special-purpose entities (SPEs), a specialized type of partnership created to carry out a specific financial purpose or activity (Financial Accounting Standards Board 1959; Powers, Troubh, and Winokur 2002, 38). Most important, companies are not required to report partnerships that qualify for off-balance sheet status on their consolidated financial 59

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statement. In general, an asset is placed on a balance sheet if the company owns or is responsible for it. However, responsibility for an asset is complex and often entails a degree of judgment by management. Because government oversight of corporate finances is underfunded, only the corporation and their auditor know if the asset is truly passive. Thus, the legitimate use of SPEs is largely dependent on trust. By the late twentieth century, many kinds of SPEs were used, including master trusts, owners trusts, grantor trusts, real estate mortgage investment conduits (REMICs), and financial asset securitization investment trusts (chapter 3). SPEs organized as trusts are typically created for tax purposes. SPEs are of two general types: pass-through SPEs, which are passive tax vehicles that pass the principal and interest payments of assets to the investors and do not pay taxes, and pay-through SPEs, which allow reinvestment of cash flows, restructuring of cash flows, and purchasing additional assets. After manufacturing corporations realized the benefits of SPEs and other forms of partnerships, financialization strategies quickly spread throughout this sector. Off-balance-sheet partnerships exist at the edge of the regulatory system, which makes them virtually impossible for oversight agencies to monitor. Furthermore, securitization is complex, with hundreds of pages of rules on how to securitize assets. Given the complexity of these rules, following the intent of the law is largely dependent on trust. Although there is nothing new about corporations employing lawyers, accountants, and financiers to discover ways to circumvent the intent of rules and laws, off-balance-sheet partnerships create new incentives for corporations to hire experts to aid them in circumventing the intent of the law to advance their capital accumulation agendas. Off-balance-sheet partnerships quickly became a core component of the shift to the financial social structure of accumulation as they can be used to conduct a wide range of business activities. By 1990, approximately 600,000 partnerships existed. The number of partnerships continued to increase in the 1990s (Levitt 2002; Gladwell 2007). By 2002, there were approximately 2 million partnerships in corporate America holding hundreds of billions of dollars and reporting almost $3 billion in income and $2.5 billion in tax deductions (Johnston 2003). 60

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Despite the massive decline in the size of the manufacturing sector, the organizational and political-legal arrangements permit the extreme concentration of wealth and power. To illustrate, in 1970, when adjusted for inflation, US Steel was valued at $5.98 billion. Despite its near bankruptcy in the 1980s, the corporation lives on. In 1986, when the MLSF became viable, management restructured its product line by merging and acquiring some subsidiaries and spinning off others and renamed the corporation USX. By 2014, USX generated $17.5 billion in revenues. Despite its size, USX is not among the largest US manufacturing corporation. In 2014, Chevron, which was part of the monopoly created by John D. Rockefeller in the nineteenth century and broken up in 1911 for anticompetitive behavior, returned to a top spot in corporate America when it became the third largest US corporation, with $103.784 billion in revenues. The second largest company, Exxon Mobil, also part of Rockefeller’s monopoly, expanded to become the second largest corporation with revenues of $384.6 billion. As the concentration and centralization of capital continue, so do the income and wealth of its major stockholders. Mu t ua l F u n d M a nage rs’ C h a ll e nge to M a nage r i a l Con t rol Redefining the organizational and political-legal arrangements to expand the mutual fund market and the MLSF realized management’s goal to socialize capital even more. What management did not anticipate is that these organizational and political-legal arrangements expanded the structural and instrumental power of mutual fund managers and other institutional investors. Institutional Investors and the Spread of Stock Options By the 1980s, institutional investors exercised their power to pressure CEOs and boards of directors to maximize shareholder value (MSV): firms’ worth as measured by dividend payments and growth in stock value (Useem 1996). To create incentives to MSV, they compelled top management to make greater use of stock options as a form of executive compensation. After a predetermined waiting period, managers have the 61

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option to buy and sell the stock in a single transaction. Thus, stock options provide only benefits, and no risk, to the manager. If the stock does not increase in value, the manager does not exercise the option to buy it. Large institutional investors assumed that a larger ownership share would encourage managers to behave more like owners and make decisions that increased shareholder value. Although CEOs initially opposed this form of compensation, they soon realized that stock options could be used to increase their own compensation (Boyer 2010). Despite this success, institutional investors continued to assert their instrumental power to increase their influence over management by focusing their lobbying efforts on regulatory agencies. Their trade association, the Council of Institutional Investors, succeeded in redefining investormanager relations in 1992 when the SEC and Financial Accounting Standards Board (FASB) relaxed the rules governing communication between managers and investors.4 This change was followed by a rapid increase of the number of corporations with institutional relations departments, creating opportunities for large investors to communicate their interests to corporate executives (Krier 2005). The organizational and political-legal arrangements have several interrelated adverse consequences. First, the rapid increase in stock options diverted capital into executive compensation and away from productivity investments. Second, because stock options have value only if stock prices increase, they create incentives for managers to focus on short-term profits instead of making long-term productivity investments. Third, stock options encourage corporate consolidations because mergers and acquisitions typically increase share price. Fourth, stock options create perverse incentives for managers to engage in highrisk, high-profit behaviors that sometimes include financial malfeasance (chapter 5 and 6). Fifth, stock options accelerate income and wealth inequality (chapter 7). Emergence of the Managerial Class Stock options increased incrementally over the following decades and soon represented the primary form of executive compensation, surpassing executives’ salaries. Together with redefining the rules governing 62

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communications between corporate management and institutional investors, these arrangements contributed to the creation of a managerial class of not only CEOs but other top-level managers such as chief operating officers (COOs), chief financial officers (CFOs), and chief risk officers (CROs). They owned a substantial share of corporate securities typically in the companies they were managing (Prechel 2019). This class has interests different from those of top managers during the middle decades of the twentieth century when managers owned relatively few corporate securities (Lewellen 1971). Then, a clear separation existed between management and ownership, and owners allocated authority to managers (Chandler 1977). Those in the managerial class today often negotiate their own compensation and the compensation of their subordinates with the board of directors, who are typically compensated with stock and stock options themselves. During the years preceding the 2008 financial crisis, top managers became substantial shareholders. Table 2.1 shows that between 2000 and 2007, the average annual compensation for just eight bank and financial firm CEOs was $32.125 million, with a total compensation of $2.1576 billion during that period. By 2018, CRO Geoffrey Greener owned 583,000 shares of Bank of America, CEO Brian Moynihan owned 1.14 million shares, and the largest inside shareholder was COO Thomas Montag, who owned almost six million shares (Maverick 2018). Stock ownership by top managers continued to increase throughout corporate America after the 2008 financial crisis, and by 2017, many parent companies required their CEOs to own stock worth six times their annual salary (Pierce 2017). Over time, many nonfinancial parent companies increased their stock ownership guidelines, and by 2017, corporations such as Avery Dennison, BB&T, Chevron, Duke Energy, and GlaxoSmithKline had similar executive compensation policies. The creation of the managerial class resulted in a fundamental shift in the power structure and the dynamics of US capitalism. The managerial class has a deep commitment to neoliberalism and market fundamentalism, especially dismantling social policy and most forms of regulation. Although the manufacturing sector was the first class fraction to mobilize politically to restructure their political embeddedness, 63

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Table 2.1. FIRE Sector Parent Company CEO Compensation, 2000–2007 Average Annual CEO Compensation (Millions)

CEO Compensation (Millions)

AIG

$20.0

$160.0

Bank of America

20.7

165.6

Bear Stearnsa

29.0

203.0

Citigroup

42.3

338.4

Countrywide Financial

51.4

411.2

Lehman Brothers Holdings

69.2

553.6

Merrill Lynch

29.5

236.0

Washington Mutual Average Annual Compensation, 2000–2007 a

11.3

90.4

32.125

2,157.6

2000–2006. Source: Forbes Annual Evaluations in Public Citizen (2009).

permitting them to engage in financialization, the following chapters demonstrate that members of the managerial class in the banking sector were among the most aggressive in exercising power to restructure the political-legal arrangements in ways that permitted them to participate in financial markets to their personal benefit.

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chapter 3

Transforming Banks from Market Enablers to Market Participants The inability of corporations to overcome economic crisis on their own required state intervention to restructure the economy during the Great Depression. However, the federal government was constrained by the federalist structure of the government that distributed certain powers to states, including control over economic and banking activities inside their borders. The objective of this dual banking system was to ensure that local businesses and homeowners had access to capital. Whereas statechartered banks were incorporated in and regulated by the state where they were located, national bank holding companies and their subsidiaries were regulated by the Federal Reserve Bank. Other national banks were controlled by the Office of the Comptroller of Currency, organized within the Treasury Department. As a result of this structure, the United States had a decentralized and pluralistic banking system (Greider 1987, 27). As the economy weakened in the 1920s, Congress passed the 1927 McFadden Act, designed to limit disruption of capital flows in local communities by prohibiting national banks from branching into state bank markets unless permitted by state law. Because most states did not permit branch banking, the McFadden Act prohibited national banks from operating in these markets. Three New Deal banking laws also were designed to stabilize banks. First, to limit competition and the potential for bankruptcy, the Banking Act of 1933 gave the Federal Reserve Bank authority to set limits on bank interest rates. Second, to encourage community members to deposit their money in banks, Congress established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. Third, the Glass-Steagall component of the Banking Act of 1933 separated commercial from investment banking. Forced to give up deposits, investment banks lost their primary source of capital and power (Mizruchi 1982; Mintz and Schwartz 1985). 65

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Although the Roosevelt administration attempted to limit mergers between banks and nonbanks, these efforts were unsuccessful until Congress passed the Bank Holding Company Act in 1956 (CQ Almanac 1999), which created barriers to mergers between banks and insurance companies. The Douglas Amendment to the 1956 legislation further limited bank powers by tightening restrictions on out-of-state banking established by the 1927 McFadden Act. By limiting banks to market enablers that provided capital for other economic sectors, these political-legal arrangements established the foundation for the US banking system throughout much of the twentieth century. This chapter identifies three policy periods that reconfigured the parts of the social structure in ways that transformed banks and other financial organizations from market enablers to market participants. A crucial component of this change in organizational and politicallegal arrangements is the spread of high-risk forms of securitization: the process of taking illiquid assets or contractual debt such as home mortgages, commercial mortgages, auto loans, or credit card debt and, through financial engineering, transforming them into securities that are transferred to third parties. Securitizing typically takes the form of asset-backed securities (ABS) to provide liquidity (i.e., capital) to the holder of these assets. Prior to the 1980s, most securitization of assets, especially the category of ABSs known as mortgage-backed securities (MBSs), was limited to government agencies. The analysis that follows shows that capitalist class fractions engaged in political capitalism to gain access to the securitization market and how these organizational and political-legal arrangements shifted risk from banks and nonbank financial organizations to society. The Federal Reserve Bank places securitization into three categories: government securities, which are bonds, including savings bonds and treasury bills, issued by a government; government agency securities, which are bonds issued by government agencies and governmentsponsored enterprises, publicly traded companies with government support; and private label securities, which are created and sold by banks and corporations. In the early 1980s, private label securities were almost nonexistent. By 2007, they were distributed throughout the global 66

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economy, with federal bank holding companies controlling almost 70 percent of this market (Cetorelli and Peristiani 2012). T he Feder al R eserv e Ba nk f rom H a m ilton to Today The Federal Reserve Bank was established as independent from both Congress and the executive branch but with limited powers. By the 1980s, the Fed had become increasingly ideological and political, a shift that was instrumental in reconfiguring corporate-state relations in ways that created opportunities for banks and other financial organizations to become market participants and engage in high-risk behaviors. This section provides a brief account of how this quasi-government organization changed from an entity with limited authority to one with the authority to redefine banks’ political embeddedness in a way that permitted them to engage in behaviors that in some cases circumvented Congress. The Federal Reserve Bank was founded during George Washington’s presidency by the first secretary of the treasury, Alexander Hamilton, who maintained that a central bank was necessary to ensure economic stability throughout the new nation. However, the federalist-state structure resulted in conflict between the Fed and individual states, many of which had already established their own banking systems. A turning point occurred when state banks were unable to stop the panic of 1907 and J. P. Morgan organized several private banks to become the lender of last resort. This crisis generated concern among corporate and political elites over the capacity of the federal government to control subsequent panics. Many elites were also concerned with the power associated with private banks if they remained the lender of last resort. In response, Congress enacted legislation to create the Federal Reserve System and the Federal Reserve Bank in 1913 and 1914, respectively. Created to serve the public good by heading off or resolving economic crises, the Federal Reserve’s authority increased as it responded to subsequent economic crises. Its first charter established the Federal Reserve as a quasi-government organization with power and autonomy to enact policy without executive branch approval. This corporate-state relation was enacted because political elites feared that party politics would interfere with objective 67

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decision making regarding monetary policy. To ensure that multiple political interests were represented, Congress retained oversight of the Federal Reserve Bank. As the economy increased in size and complexity, subsequent charters expanded its power and autonomy. The first significant expansion of the Federal Reserve Bank’s power occurred during FDR’s first administration. The Fed’s organizational power increased during subsequent crises in the Truman, Eisenhower, and Nixon administrations when the chairmen defied presidential authority. Like other bureaucracies, expansion of the Fed’s power is correlated with the increased number of expert appointees (Weber [1921] 1978). However, unlike the past, when the Fed appointed experts from a range of areas relevant to its policies, it became increasingly influenced by economists beginning in 1970. With the exception of George Miller’s short appointment in 1978, all Federal Reserve chairs were economists: Arthur Burns (1970–1978), Paul Volcker (1979–1987), Alan Greenspan (1987–2006), and Ben Bernanke (2006–2014). The Fed also created alliances with academic economics departments by funding research, creating visiting faculty positions, and organizing conferences (Jacobs and King 2016, 77–80). The Fed, especially the powerful Federal Reserve Bank of New York, also established ties to finance capital. As the power and autonomy of the Fed increased, its employees began to distrust elected officials, and their decision-making process became more secretive. The Fed’s power increased sharply during the Reagan administration when Volcker was given the authority as chairman to solve a new problem, stagflation, that is, high inflation and slow economic growth. Ignoring labor unions and consumer advocates, Volcker implemented monetary policy in the form of high interest rates. These policies succeeded in lowering inflation, but at a high cost to the working and middle classes, especially in the construction, farm, and manufacturing industries, which experienced wage stagnation and high unemployment—up to 10 percent in some regions. After Volcker’s chairmanship, Fed policies continued to focus on ensuring return to capital (e.g., stock market) over return to labor. This bias reached an extreme level under Alan Greenspan as chair, who stimulated trading by lowering interest rates. By lowering the cost of borrowing capital, this policy created incentives for traders to 68

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borrow money to invest in more high-risk financial instruments. Over time, traders expected the Fed to intervene in capital markets during crises. Thus, instead of implementing policies to stabilize the economy during crises, Greenspan enacted policies to stabilize the stock market. Commonly known as the “Greenspan put,” these policies created incentives for investors to retain or purchase stocks during crises and buy a put option on them, which is a financial instrument to protect the price. This practice of lowering interest rates to limit stock market swings created a moral hazard by encouraging excessive risk taking during periods when intervention was needed to stabilize the economy as a whole instead of just protecting the wealthy, who own most stock. Thus, policies to stabilize the stock market took priority over stabilizing the economy, which subsequent Fed chairmen continue. As a result, in the post-2008 crisis period, the stock market grew at record-high rate while the economy grew at an anemic rate. In 1998, Greenspan also shifted the Fed beyond its traditional role of overseeing banks when it rescued LongTerm Capital Management, a giant hedge fund (Jacobs and King 2016), creating an even greater moral hazard. The Fed’s agenda to serve the interest of capital is in part an outcome of the revolving door. Many of the Fed’s top-level appointees are previously employees of banks or financial firms or hold a doctorate in economics and finance. If top-level appointees are promoted from within the Federal Reserve, their promotions are contingent on accepting neoliberal ideology and market fundamentalism. Pol ic y Pe r iod I: C r e at i ng t h e Secon da ry Hom e Mortg age M a r k et to Ov e rcom e Econom ic Cr ises Already weakened by corporate bankruptcies that followed the periodic recessions throughout the 1920s and 1929 stock market crash, the Great Depression further eroded the housing market. Because state banks held a substantial number of home mortgages, the prolonged economic downturn devalued their assets, weakening banks. By the early 1930s, state bank failures became widespread, leaving many parts of the country with no mortgage lenders (CQ Weekly 1989a). To restore bank assets, slow the 69

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declining rate of bank profits, and stimulate economic growth through job creation in housing construction, the federal government enacted a comprehensive housing policy to create more affordable long-term mortgages. A core component of this policy created the secondary mortgage market. In 1932, the Federal Home Loan Bank Act created eleven regional Federal Home Loan Banks to funnel capital to community development financial institutions, cooperative banks, homestead associations, insurance companies, and savings banks (Lavelle 2013). It also insured depository institutions to finance home mortgages and created the Federal Home Loan Board to charter and oversee federal saving and loans.1 In addition, the Homeowners Loan Act of 1934 created federally chartered savings and loan associations (S&Ls) to refinance home mortgages. Congress also passed the National Housing Act in 1934 to create the Federal Housing Administration (FHA) to insure mortgages, thereby limiting risk to the S&Ls that financed home mortgages (McCoy and Renuart 2008). In 1938, Congress amended the National Housing Act to create a new government agency, the Federal National Mortgage Association, which became known as Fannie Mae. This quasi-governmental organization was authorized to create the secondary mortgage market: a mechanism to acquire home mortgages from banks. The secondary market increased the flow of capital to banks, which enabled them to sell more home mortgages in their respective communities. This legislation also included government guarantees to cover losses in Fannie Mae and authorized the Treasury Department to provide it with low-interest financing to purchase FHA-insured mortgages. Concerned that the economy would spiral into recession at the end of World War II, the federal government passed the Servicemen’s Readjustment Act of 1944, commonly referred to as the GI Bill. This legislation further increased the role of banks as market enablers by authorizing the Veterans Administration to insure home mortgages and extend Fannie Mae’s authority to purchase these insured mortgages. State intervention in the economy to create the secondary mortgage market offset the declining rate of profit by accelerating the turnover rate: the time capital spends in the valorization (i.e., value-creating) process beginning when capital is invested in production and stays in circulation until it 70

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returns in form of a profit (Marx [1894] 1981, 235). Accelerating the turnover rate is a means to limit the falling rate of profit. In this case, by returning capital to banks more quickly, the secondary mortgage market permitted them to make more loans to consumers, thereby increasing profits within a specific time period (e.g., monthly, quarterly, annually). Fannie Mae remained the only participant in the secondary mortgage market until the 1960s when President Johnson’s Great Society programs expanded homeownership. However, budget deficits associated with the Great Society programs, the escalating cost of the Vietnam War, and declining government revenues during the 1960–1961 recession stretched the state’s fiscal capacity in this era of limited government deficits. Pressured by lobbying organizations representing home builders, real estate brokers, mortgage bankers, labor unions, insurance companies, and local and state governments, Congress passed the Housing and Urban Development Act of 1968 to stimulate economic growth (CQ Almanac 1968). This legislation ended Fannie Mae’s thirty-year monopoly in the secondary mortgage market by splitting the old Fannie Mae into the “new” Fannie Mae and creating the Government National Mortgage Association (Ginnie Mae). Organized under HUD, Ginnie Mae continued to carry out Fannie Mae’s original mandate to increase liquidity in the secondary mortgage market by buying government-insured mortgages. This legislation also extended Ginnie Mae’s property rights by authorizing it to securitize mortgages. Ginnie Mae issued its first mortgage-backed security in 1968 (Lavelle 2013, 64). Mortgage-backed securities (MBSs) (or mortgage pass-throughs) are a type of derivative. In this case, the underlying assets are home mortgages (Levitt 2002, 311; Partnoy 2004, 170). These securities are created by transferring a package of mortgages to a corporate entity such as a trust, partnership, or subsidiary. These financial instruments represent future streams of income for investors from payments of the mortgage principal and interest. Ginnie Mae increased the turnover rate of capital by purchasing home mortgages from banks, pooling them to create bonds, issuing securities in the mortgage pools, and selling them to large investors. By reducing the capital turnover time, these MBSs permitted banks to sell more home mortgages. Investors in these financial instruments included 71

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large institutional investors such as pension funds and insurance companies (CQ Weekly 1993; CQ Almanac 2003). Historically, market-traded derivatives consisted of futures and options on commodities such as such as corn, soybean, wheat, lean hog, live cattle, stock and treasury bond futures, and currency futures and options (Oxford 2006, 164). Legalizing securitization in the home mortgage market created a new social frontier in the realm of finance. Once established, other organizations engaged in political capitalism to participate in this market. During slow economic growth in 1969 and 1970, the housing sector was again identified as a means to stimulate economic growth and offset the declining rate of profit. However, political coalitions inside and outside the state disagreed on the mechanisms to accomplish this goal. Much of the debate focused on whether to provide Fannie Mae with property rights to acquire conventional mortgages, which are not insured by government agencies. Disagreement inside the state emerged between the secretary of housing and urban development, who supported this policy, and Federal Reserve administrators who argued that the absence of government-underwriting protection of conventional mortgages would erode congressional support for low- and middle-income credit programs (CQ Almanac 1970). Later, the Federal Home Loan Bank Board also supported this policy. A wide range of organizations outside the state representing banks and financial and real estate firms that would benefit from Fannie Mae’s increased property rights created a powerful political coalition to support the policy. These organizations include the National Association of Home Builders, National Association of Real Estate Boards, Home Manufacturing Association, American Bankers Association, United States Savings and Loan League, and the Life Insurance Association of America (CQ Almanac 1970). In response to political pressures from this political coalition and to advance its own agenda to stimulate economic growth, Congress passed the Emergency Home Finance Act of 1970 (CQ Almanac 1970), which partially privatized the new Fannie Mae by transforming it from a government agency into a government-sponsored enterprise (GSE). The authority of the new Fannie Mae was enhanced by permitting it to 72

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purchase insured mortgages from the Farmers Home Administration (FmHA) and conventional mortgages, that is, those not insured by the FHA, VA, and FmHA (CQ Weekly 1998; Madrick 2011:354: Lavelle 2013). To carry out this agenda, Fannie Mae continued to have access to low-interest-rate credit from the Treasury Department (CQ Weekly 1989c). This legislation also created a third mortgage-related GSE, the Federal Home Loan Mortgage Corporation, later known as Freddie Mac. Like Ginnie Mae, Freddie Mac was authorized to purchase conventional mortgages, pool mortgages into bonds, and sell securities in them (i.e., MBSs) (CQ Weekly 1989a, 1998). Oversight for Freddie Mac was given to the Federal Home Loan Bank Board, which was also responsible for overseeing S&Ls. Freddie Mac issued its first MBS in 1971. Congress again extended Fannie Mae’s property rights during the back-to-back recessions in the early 1980s to increase capital flows to the housing market by permitting it to issue MBSs, thereby increasing the capital turnover rate and liquidity in the home mortgage market (CQ Weekly 1989a). Fannie Mae issued its first MBS in 1981. Fannie Mae, Ginnie Mae, and Freddie Mac thus all had property rights to issue MBSs. These public policy experiments during decay-exploration phases of the capital accumulation process increased the circulation of capital, thereby stimulating economic growth. Insured by the federal government, these policies shifted more risk from banks to taxpayers. They also created additional risk by creating incentives for real estate brokers and bank managers to sell mortgages to consumers with limited capacity to repay them. The increased risk in this market did not go unnoticed. With support from consumer organizations, Senator William Proxmire (D-WI) introduced legislation to create the Truth in Lending Act of 1968 (TILA). This legislation required lenders to disclose the terms of home mortgages, including all fees and interest; increasing transparency; and reducing the potential for abusive practices by lenders (McCoy and Renuart 2008) who profited by selling greater numbers of home mortgages. Throughout this first policy period, securitization of home mortgages provided an effective means to stimulate economic growth. It also created 73

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a new market niche that was filled by nongovernment mortgage companies like Countrywide Credit Industries, which was renamed Countrywide Financial Services. Together, these organizational and political-legal arrangements created additional market risk. Transforming Fannie Mae from a government agency to a GSE and creating Freddie Mac and Ginnie Mae as GSEs created the government’s own off-balance-sheet entities because they were not included in the federal government budget. GSEs are decoupled from congressional oversight, creating structural holes that provided financial managers with the autonomy to lower their MBSs’ underwriting standards as they later did in the mid-2000s when the housing market bubble grew. Organizing oversight of Fannie and Freddie under HUD also increased the regulatory complexity of this economic sector, which was already regulated by a complex mixture of federal and state agencies. While these policies all increased risk, they also withdrew the federal government guarantee of principal and interest payments on MBSs in the event that homeowners defaulted. Now, GSEs themselves guaranteed the principal and interest on the mortgages they acquired from banks. Risk in the MBS market was increased even more as third-party rating agencies (e.g., Moody’s Investor Services), which evaluate the risk of securities, assumed an implicit government guarantee and gave GSEs high securities ratings on their MBSs. These securities were sold to investors, many of whom incorrectly assumed that they were guaranteed by the government In the absence of concomitant change in government (i.e., thirdparty) oversight, these organizational and political-legal arrangements created more structural holes and opportunities for financial risk and malfeasance. However, the risk level in GSEs during the earlier years of their development remained moderate compared to the risks of privatelabel mortgage-backed securities that emerged later. Pol ic y Pe r iod I I: E conom ic De cl i n e , Pol i t ic a l C on f l ic t, a n d E x pa n di ng F i n a n c i a l M a r k e t s The extension of GSEs’ property rights soon turned into conflict as bank managers recognized the capital accumulation opportunities in MBS markets and mobilized politically to access them. Throughout the middle 74

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decades of the twentieth century, banks were a low-profit, low-risk economic sector. However, economic downturns in the 1970s and early 1980s, globalization of the economy, and the loss of competitiveness of the dominant manufacturing power bloc created an opportunity for national banks to advance their economic agenda politically. These events coincided with the 1970s legislation that legalized political action committees (PACs), giving corporations the legal right to make contributions to election campaigns, creating more opportunities to present their economic interests to government officials (Clawson, Neustadtl, and Scott 1993). Like previous periods of slow economic growth, business leaders focused on revitalizing the economy by stimulating the housing sector. However, banks were unable to attract enough capital to meet consumer demand (Garten 1991; Morris 2005) and argued that providing the capital necessary to stimulate economic growth required redefining banking laws. State banks, S&Ls, financial services firms, and insurance firms all joined national banks and lobbied Congress and the executive branch to expand their property rights. However, these sectors had different capital accumulation needs that resulted in political divisions because extending the property rights of one sector encroached on markets in other sectors. These differences can be organized into four categories: 1. National banks wanted to access local and state mortgage markets, which meant competing with state banks, credit unions, and S&Ls. National banks maintained they could better serve potential homeowners in these markets because they could draw on national pools of capital and distribute it to regions where capital shortages existed. These banks also wanted to dismantle the Glass-Steagall Act so they could expand into the securities markets (Reinicke 1995). Instead of selling home mortgages to GSEs, they wanted to use the mortgages they held to create their own MBSs, sell securities in them, and collect the profits themselves. Although the American Bankers Association represented thirteen thousand banks of various sizes, it tended to advance the interests of large national banks. 2. State banks, S&Ls, and credit unions wanted to preserve their market niche as the primary providers of home mortgage loans and 75

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argued that eliminating the Glass-Steagall Act would permit consolidation of national (commercial) banks with investment banks and give these large banks unfair advantage in most markets. However, the ability of S&Ls to meet the demand in the home mortgage market was hampered by high inflation in the 1970s and interest rate ceilings established under Regulation Q of the Banking Act of 1933, which was designed to stabilize the banking industry by limiting competition among banks for deposits. Another concern of smaller banks was that merging national commercial banks with investment banks would permit banks to establish nonbank subsidiaries to create financial instruments unregulated by banking laws that offered higher interest rates that would encourage customers to move their deposits from smaller, more tightly regulated banks to these larger bank conglomerates. The seven thousand small banks were represented by the Independent Bankers Association of America (CQ Weekly 1984b). 3. The financial services industry, which included investment banks and approximately 650 money market mutual funds, wanted to expand into traditional bank markets. The Investment Company Institute represents their political interests. 4. The insurance industry wanted access to financial markets. Extending their property rights required dismantling the 1956 Bank Holding Company Act prohibiting bank and nonbank mergers. This economic sector was represented by the American Council of Life Insurers. Creating the Subprime Mortgage Market After decades of arguing that banking laws limited economic growth, the protracted recession in the mid-1970s provided an opportunity for commercial banks to align their political agenda to revise banking laws with thrifts (banks that are required to commit most of their loans to homeowners and other consumers versus businesses) and other sectors, including the still dominant manufacturing power bloc sector. Banks maintained that overcoming the recession depended on increasing liquidity in financial markets. Their first target was Regulation Q, which set interest rate ceilings for banks and thrifts, making it difficult to compete with nonbanks. This 76

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political coalition was strengthened by state banks that argued that state usury laws created interest rate ceilings, which were obstacles to economic growth and undermined their ability to compete for deposits and supply capital to local mortgage markets. An exception to Regulation Q was money market mutual funds (MMMF), which required a minimum deposit in denominations of $100,000. MMMFs were developed in 1971 and managed by investment banks and other financial services firms. This political coalition was strengthened by consumer groups that maintained that these organizational and political-legal arrangements discriminated against less wealthy savers. Estimates suggest that Regulation Q cost the working and middle classes several billion dollars in interest (Pyle 1974). In response, in 1978, bank and thrift regulators permitted money market certificates (MMCs) with a minimum domination of $10,000. Consumer groups argued that this policy did not solve discrimination against small savers, forcing regulators to permit commercial banks to issue interest-bearing checking accounts and, in late 1979, small-saver certificates (SSCs) with low minimums (Gilbert 1986, 30). Banks realized a significant victory in their effort to phase out Regulation Q when, with support from the Carter administration, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980. Title V of this legislation eliminated state interest ceilings on deposits and home mortgages. It also permitted state banks, S&Ls, credit unions, and small investment companies to charge interest on loans 1 percent above the Federal Reserve discount rate and created the Depository Institutions Deregulation Committee (DIDC) to phase out interest rate ceilings by 1986 (Gilbert 1986). Authorization of the DIDC to dismantle Regulation Q set in motion a series of changes that permitted banks to develop other financial instruments. Although negotiable order of withdrawal (NOW) accounts were first established by the Consumer Savings Bank in Worcester, Massachusetts, and permitted in New Hampshire in 1974 with a 5 percent interest rate ceiling, in 1981, the DIDC permitted NOW accounts nationwide. These organizational and political-legal arrangements paved the way for higher interest rates

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and adjustable-rate mortgages where interest rates varied and qualification for a loan was often determined by the lower initial interest rate. At the same time, stagflation continued to constrain capital accumulation in the economy as a whole. Although it had emerged in the 1970s, its effects became increasingly severe in the early 1980s as businesses were unwilling to invest in new production facilities because inflation caused these assets to decline in value. To control inflation, Federal Reserve chairman Paul Volcker raised the prime interest rate, which reached a record high of over 20 percent in June 1981. High interest rates dramatically increased the cost of new construction, which brought the construction and housing industries to a standstill. In response, the National Association of Home Builders and the AFL-CIO’s Building and Construction Trades Department formed a political coalition that lobbied the Reagan administration and Congress to enact policies to stimulate growth in the housing market. These conditions created an opportunity for Reagan to reassert his agenda to permit commercial banks to enter the real estate, securities, and insurance markets. Although the Senate offered substantial support for Reagan’s proposal, the House did not because it entailed dismantling the Glass-Steagall Act and the Bank Holding Company Act, which would adversely affect small banks that existed in virtually every district in the House of Representatives. As stagflation continued and corporate bankruptcies escalated, reaching 24,900 in 1982 (Greider 1987, 455), the bank lobby increased its pressure on Congress. Senate Banking Committee chairman Jake Garn (R-UT), a supporter of Reagan’s neoliberal agenda, and House Banking chairman Fernand St. Germain (D-RI) proposed legislation to resolve this crisis. An early version of their bill permitted banks to enter financial markets by underwriting revenue bonds and offering MMMF accounts. However, state banks opposed this legislation, arguing that it would give large banks an unfair advantage over smaller banks competing for deposits. One of the most vocal critics of the bill permitting banks to enter the bond market was Senator Al D’Amato (D-NY) whose state was home to many of the nation’s largest investment banks and securities firms, The final version of the Garn–St. Germain Act of 1982 expanded the power of the DIDC by authorizing it to create mechanisms to dismantle 78

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Regulation Q. The DIDC responded by authorizing a range of new bank products including money market deposit (MMD) accounts. The securities industry agreed to this change because MMDs, unlike the MMMF, did not compete directly with investment banks. However, because MMD accounts carried higher risk, they were not considered a bank product. To circumvent banking laws, banks were permitted to organize MMD accounts in nonbank subsidiaries. These organizational and politicallegal arrangements rapidly increased capital flows to depository institutions from $5.3 billion in 1978 to $159 billion in 1985. Commercial banks were the primary beneficiaries of these new arrangements: their share of interest-bearing deposits increased from 46.9 percent in 1978 to 71 percent in 1986. Under certain conditions, the bill also permitted national banks to merge with S&Ls and thrifts, which provide services to consumers, giving national banks access to local markets. The final version of the Garn–St. Germain Act of 1982 permitted state banks to sell adjustable-rate mortgages (CQ Weekly 1984d). Banks also lobbied to weaken the Truth in Lending Act (TILA) by removing credit disclosure requirements. Despite opposition from consumer-rights organizations and House Banking Consumer Affairs Subcommittee chairman Frank Annunzio (D-IL), Congress eliminated the requirement for banks to provide an itemized disclosure statement that included crucial information such as interest rate hikes. Now, consumers had to request mortgage disclosure statements describing the details of their loans (CQ Almanac 1980). Unfortunately, many consumers trusted that their real estate brokers and bank managers would provide them with the necessary information to make well-informed decisions. The weakened disclosure requirements under the revised TILA further decoupled banks from regulatory agencies, thereby providing bank managers with more opportunity for financial malfeasance, including selling adjustablerate, higher-profit mortgages to consumers who may not have been able to meet their payments after the teaser low-interest rates expired. Among the most important changes in banks, political embeddedness occurred in 1983 when the Senate Housing and Urban Affairs Committee approved bill S1821, which permitted banks and nonbanks to participate in the secondary mortgage market. Now corporations competed with 79

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Fannie Mae and Freddie Mac in this increasingly lucrative market. This expansion of corporate property rights paved the way for corporations to create increasingly murky financial instruments. In 1984, banks received national media attention when failures broke the post–Depression era record and one of the largest state banks, Continental Illinois National Bank and Trust of Chicago, failed to meet its capital adequacy requirements (i.e., available capital). Although Continental Trust was a state bank, it received a $4.5 billion federal government bailout. The Reagan administration justified the use of federal funds to rescue a state bank for fear that allowing it to fail would result in a run on the bank’s $41 billion in assets (CQ Weekly 1985a, 1985b). This decision represents the first “too big to fail” policy that became the backbone of the 2008 taxpayer bailout of banks and nonbanks. It also increased political conflict between large and small banks. Small banks argued that this bailout represented the creation of a two-class bank system where small banks would be permitted to fail and big banks would be bailed out by the federal government (CQ Almanac 1984b). Expansion of Nonbank Subsidiaries To circumvent Congress, President Reagan pursued his neoliberal agenda through the revolving-door tactic of appointing bank executives to key government agencies. Among the most important early appointments was Donald Regan, former chairman of investment bank Merrill Lynch, to the powerful position of secretary of the treasury. Reagan also appointed C. Todd Conover, a banking and management consultant, to comptroller of the currency. This agency is responsible for regulating forty-eight hundred national banks and approving applications for bank charters, branch offices, mergers, and new services such as discount brokerages. Political momentum for bank reform increased as more corporations viewed financial markets as lucrative profit-making opportunities and lobbied for access to them. However, diversification into financial markets required that corporations circumvent the primary purpose of the Bank Holding Company Act: separating bank from nonbank activities. A major breakthrough in this political stalemate occurred when corporations identified a loophole in the Bank Holding Company Act’s definition of 80

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banks as organizations that offered commercial loans and demand deposits such as savings and checking accounts. Corporations argued that a firm that engages in only one of these activities is not a bank and is not subject to federal banking laws (CQ Weekly 1984b). To exploit this loophole, several large corporations in retail, real estate, insurance, and investment banking applied for bank charters. Despite continued opposition from the national bank lobby, the neoliberal comptroller of the currency granted these charters. Taking advantage of the loophole was typically done by creating legally independent nonbank subsidiary corporations. Sears, Roebuck and Co. was one of the first nonbanks to diversify into finance. In 1985, the parent company created Sears Financial, which later became Discover Financial Services. Sears’s strategy represented a fundamental shift in finance from narrowly focusing on providing services to the wealthy to opening financial centers at its three thousand retail outlets and providing credit services to the working and middle classes (Greider 1987, 37). Through this subsidiary Sears provided a range of financial products, including credit cards, insurance, money market accounts, bank transactions automated teller machines, and buying and selling of real estate, stocks, and bonds (CQ Almanac 1984b). When nonbanks set up these accounts, consumers often assumed that they were insured when in fact they were organized in nonbank subsidiaries and thus uninsured. With little credit-qualifying restriction, financial services in nonbank subsidiaries quickly signed up consumers they had accessed in their retail outlets. For example, when Sears introduced its credit card in 1985, it had no annual fee and a higher credit line than most other credit cards. Although I had virtually no credit history when I accepted my first academic job in the mid-1980s, I was asked to apply for a Sears credit card as I purchased an item in an upstate New York store. My application was approved within minutes, and I paid for the purchase with my new Sears credit card. Banks’ Political Response to the Loophole After corporations obtained the right to enter financial markets, national banks exploited the Bank Holding Company Act loophole to their own 81

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benefit by creating more nonbank financial services subsidiaries and gaining a larger share of these markets. In the absence of action in Congress to close this loophole, some states, eager to attract business during this protracted economic downturn, viewed ambiguity in the law as an opportunity to generate revenue. South Dakota, which already had liberal interstate banking laws, was the first state to create a loophole permitting national banks to create nonbank subsidiaries in their state. In 1983, its legislature authorized national bank holding companies to circumvent the 1956 federal law by allowing them to enter insurance markets through South Dakota subsidiaries. A second law gave South Dakota banks authority to own insurance firms that operated out of state. Together these laws permitted South Dakota chartered banks to engage in all aspects of the insurance industry. The “South Dakota loophole” initiated a race to the bottom among states. To attract investments from national banks, other states passed similar laws that provided national banks with the right to enter state financial markets not permitted under federal law (CQ Weekly 1984b). After the comptroller of the currency approved national bank applications to enter nonbank financial markets, political conflict escalated as the insurance industry intensified its lobbying effort to protect its markets. Insurance companies were supported by Federal Reserve chairman Paul Volcker, who maintained that the actions of national banks were blatant attempts to circumvent federal law and refused to approve these bank charters. In response, national banks filed lawsuits against the Federal Reserve in the US Circuit Court of Appeals and Supreme Court (CQ Weekly 1984b). Both courts ruled that the Federal Reserve’s actions were illegal, which paved the way for more states to follow the South Dakota model. In response to the expansion of national banks into state markets, several state banks and regulators argued that these arrangements allowed national banks to siphon capital away from communities and invest it in more lucrative national and global markets.2 Although Maine and Alaska were the only states that allowed state banks to open interstate branches prior to 1984 (CQ Weekly 1984b), many states followed 82

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the South Dakota model to avoid losing investments from big national banks. However, some states refused to grant state charters to national banks and protected their markets by developing pacts with other states to permit branch banking across state lines (CQ Weekly 1984g). National banks in turn accelerated their political strategy at the federal level, maintaining that these organizational and political-legal arrangements gave unfair advantages to financial firms and insurance companies by permitting them to enter bank markets. National banks argued that leveling the playing field required dismantling Glass-Steagall and the Bank Holding Company Act (CQ Weekly 1984c). Senators Al D’Amato (R-NY) and Daniel Patrick Moynihan (D-NY), whose home state was the corporate headquarters of several large national banks, argued that the current political-legal arrangements unfairly allowed state banks to form regional agreements and open out-of-state branches while restricting national banks from entering state bank markets (CQ Weekly 1984e, 1984f). Although disagreements continued to exist among insurance companies, securities firms, and small banks, they unified politically on this issue and maintained that dismantling Glass-Steagall and the Bank Holding Company Acts would result in a few giant banks with control over bank, financial, and insurance markets. Despite opposition in Congress, neoliberals in the administration continued to pursue their agenda to dismantle Glass-Steagall. As conflict escalated between the Reagan administration and Congress, the administration threatened to grant more charters to financial firms to engage in banking activities and allow national banks to open out-of-state nonbank subsidiaries. These threats raised concerns among some members of Congress and the Federal Reserve chairman, Paul Volcker, who argued that doing nothing would create two banking systems with one removed from federal regulatory control, thereby increasing risk of a financial crisis. Volcker stated, “I can well visualize the day, if we don’t act and all the states go their own way and all the loopholes are exploited, that in a few years, we’ll be back here and we will have a great crisis  [emphasis added]” (CQ Almanac 1984b).

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Creating the Financialization Commodity Chain in the MBS Market After a protracted debate, members of Congress withdrew their bill to overhaul the bank and financial sectors by dismantling Glass-Steagall. However, investment banks were not deterred, and with the support of the Reagan administration, they continued their strategy to access financial markets, especially the MBS market. To pressure Congress to act on the Reagan agenda, the executive branch presented the Secondary Mortgage Market Enhancement Act of 1984 as a benefit to the public by stimulating the housing industry. This legislation removed many restrictions on MBSs, permitting federally regulated banks and financial firms to enter the MBSs market (CQ Almanac 1984a; CQ Weekly 1984c, 1984h, 1984i; Gotham 2006, 260). By permitting banks and nonbanks to participate in this market, this pivotal legislation “sanctioned the securitization of mortgages on the secondary market” (Smith 2012, 224) and affirmed a June court ruling that permitted banks and nonbanks to acquire a subsidiary to broker securities to organized their MBS activities (CQ Weekly 1984i, 1985b, 2005; CQ Almanac 1984a). The legislation also decoupled some financial firms from government oversight by exempting issuers of MBSs from registering with the SEC (CQ Weekly 1984a, 1984e). This bill is also important because it signifies President Reagan’s tactic of blatantly permitting business interests to write their own regulatory legislation: the primary author of the bill, Lewis Ranieri, was a trader for the investment bank Salomon Brothers. This legislation decoupled securitization in the housing market from Congress and the SEC. These corporate-state relations created more structural holes that gave managers unprecedented autonomy in issuing MBSs and placing them in off-balance-sheet entities. Whereas the manufacturing sector began to create asset-backed securities from physical assets (e.g., steel mills, computers) and placing them in off-balance-sheet entities in the early 1980s, corporate-state relations permitted securitization of home mortgages by banks by the mid-1980s. Although these changes increased the turnover rate of capital, thereby increasing profits, they made this financial market vulnerable to fluctuations in housing values 84

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without a clear determination of whether houses are passive assets and eligible for off-balance-sheet treatment. Many MBSs became incorporated into the financialization commodity chain consisting of multiple links that make it impossible to know the risk associated with these fictitious commodities. The commodity chain begins with real estate brokers who connect a buyer to a builder or real estate agent. After the buyer selects a property and qualifies to purchase a house, a financial company, which may be a financial subsidiary of the builder itself, arranges the loan and underwrites the mortgage. Under the revised TILA, real estate agents and mortgage companies are not obligated to disclose the terms of the mortgage to the buyer. After the transaction is completed, the bank or nonbank subsidiary that approved the mortgage bundles it with other mortgages that it sells to another bank or corporation that creates an MBS (e.g., bond) and sells securities in it to investors throughout the global economy. The financialization commodity chain does not always end here. The MBS is often transformed into other more complex financial instruments such as collateralized debt obligations (CDOs) that create tranches or slices of the MBS that correlate with investors’ risk tolerance. Investors encompass a wide range of individuals, and organizations include school districts, municipalities, retirement and other mutual funds, and foreign governments. MBSs are called passthrough entities because the interest and payments from homeowners are passed through the MBS to the shareholder in the fictitious commodity. Each transaction produces revenues for the firm, and employees receive commissions and bonuses that motivated them to sell more mortgages and ABSs. These organizational and political-legal arrangements create multiple conflicts of interest that have the potential to cause even more risk in this market. Whereas the builder has an interest in maximizing profits by selling houses at the highest price, the real estate broker has the same interest because a higher selling price results in a higher commission. In addition, the real estate broker has an interest in selling buyers a subprime mortgage because brokers receive higher fees on them but have no legal obligation to inform buyers if they purchased a variable-rate mortgage with higher payments in the future. 85

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Risk in financial markets also increased in the 1970s due to the shift from investors paying securities rating agencies to issuers of securities paying securities rating agencies (Lavelle 2013, 181). This interorganizational arrangement created conflicts of interests and incentives for corporations to terminate contracts with the rating agency that gave them low securities ratings. Soon, rating agencies shifted from protectors of financial markets to sanctioning and concealing risks in MBSs markets. These structural arrangements created more information asymmetry, giving banks and financial firms the capacity to pass more high-risk securities onto investors. The problem of accurately assessing the value of parent company stock became more difficult after corporations adopted the multilayersubsidiary form (MLSF). Given that many subsidiaries are organized under the parent company, even minor inaccuracies in rating subsidiaries’ risk levels and stock values can create large inaccuracies in parent company risk and stock valuation. Furthermore, these organizational arrangements created more opportunities for managers to transfer capital among corporate entities to bolster their balance sheets, making it difficult for rating agencies to keep current on the changing value of subsidiaries. In addition, corporations are not required to place assets and debt held in SPEs on the consolidated financial statements. The Tax Reform Act of 1986 also increased risks by including a provision legitimizing the use of real estate investment mortgage conduits (REMIC), another type of SPE organized as a partnership, trust, corporation, or association that pools mortgages into MBSs. Although investment banks benefited the most from this financial instrument, commercial banks and S&Ls used REMICs to shift risk in their fixed-rate mortgages, which lose value if interest rates increase (Johnson and Kwak 2010, 73), to investors. REMICs were similar to real estate investment trusts (REITs), which were created in the 1960s to increase the flow of capital into commercial real estate. REITS are a type of mutual fund that provide investors with opportunities to invest in income-producing assets and are organized as corporations, trusts, or associations. They became popular with investors and rapidly expanded because they must pay 90 percent of their taxable income as dividends. These financial instruments were 86

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marketed outside the United States and became one of the mechanisms to spread MBSs to global markets. In 1987, Reagan replaced Paul Volcker with Alan Greenspan to head the Federal Reserve. Greenspan, who was committed to neoliberal ideology, wasted little time exercising his authority. In the first year of his appointment, he abrogated the provision in the Glass-Steagall Act that prohibited bank affiliates from underwriting asset-backed securities. A year later, when banks were making little progress convincing Congress to eliminate Glass-Steagall, Greenspan re-interpreted the legislation in a way that allowed bank holding companies to create nonbank subsidiary corporations to underwrite and sell securities (CQ Weekly 1989b). Despite the increased complexity of bank and nonbank corporations and the financial markets they operate in, Greenspan and other neoliberals repeatedly stated the risks in this market were well understood and did not threaten economic stability. The Savings and Loan Crisis: Conflict Resolution and Increased Risk Dissatisfied with limited success in Congress, national banks shifted their political strategy and launched an extensive media campaign to convince the public that current regulations undermined the ability of US banks to compete with foreign banks and thereby threatened long-term economic growth. As the S&L crisis dragged on, the national bank lobby used it as an opportunity to argue that S&Ls were inherently unstable. By contrast, national banks maintained that their access to national pools of capital gave them the capacity to bring stability to local markets. In response, Treasury Secretary Nicholas Brady proposed allowing banks to enter financial services and insurance markets. However, the insurance lobby mobilized against market encroachment and was joined by consumer organizations that continued to argue that bank consolidation would create more risks and costs to consumers. The Main Street Coalition, for example, consisted of small banks, farmers, small-business owners, and consumer groups that emerged to oppose national banks’ political and economic agenda (CQ Almanac 1991). Together with the powerful insurance industry lobby, this political coalition convinced Congress to 87

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prohibit banks from entering insurance markets (CQ Weekly 1994b). In response, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991. Although it was narrower in scope than national banks’ initial proposal, it eliminated restrictions of the Garn–St. Germain Act of 1982 giving national banks greater freedom to take over S&Ls, which achieved their long-term agenda of gaining access to the home mortgage market. Securitization continued to be one of the primary mechanisms to increase the circulation of capital necessary for economic growth. However, it became increasingly risky during this second policy period (1970–1991) when banks and financial firms were decoupled from government oversight in ways that created opportunities for financial malfeasance. Unlike the first policy period, when most of the changes in securitization were an outcome of changes in political-legal arrangements, in the second policy period, both organizational and political-legal arrangements contributed to the spread of securitization and the risks associated with these financial instruments. Political-legal arrangements, for example, made the MLSF viable and permitted nonbank corporations to enter the home mortgage market through their legally independent subsidiary corporations. General Electric’s finance subsidiary became one of the largest participants in the home mortgage market. As CEO Jack Welch stated, whereas GE Credit held ten businesses with $11 billion assets in North America in 1980, in 2001, when the subsidiary was renamed GE Capital Services, it held twenty-four businesses in forty-eight countries with $370 billion in assets (Madrick 2011, 199) that generated $58.4 billon, constituting 46.3 percent of the parent company’s revenues (Gryta 2017). Another crucial change in this second policy period was abrogating a provision in the Banking Act of 1933 that prohibited bank holding companies from acquiring S&Ls and state banks. Now, bank holding companies could acquire smaller state banks, which gave them more access to the home mortgage market. The changes in banks’ political embeddedness occurred without concomitant changes in the political-legal arrangements responsible for oversight. Therefore, no third-party state agencies had the authority or responsibility to assess the financial integrity of the entire bank or financial conglomerate. This social structure created multiple structural 88

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holes that provided managers with the autonomy to engage in financial malfeasance, which included shifting high-risk MBSs into off-balancesheet entities that were intended to hold low-risk passive assets. Pol ic y Pe r iod II I: Mor e Con t e st e d T e r r a i n a n d Cr e at ion of t h e Fi na nce , Insur a nce, a nd R e al Estat e Sec tor Despite court rulings and executive branch decisions that forced a reluctant Congress to enact legislation providing banks with greater access to financial markets, many members of Congress continued to express concern over systemic risk and “too big to fail.” Unwilling to give up on gaining access to financial markets, banks accelerated their media campaign and appealed to neoliberal advocates in the executive branch asserting that government interference undermined market efficiencies. Two historical conditions strengthened banks’ political strategy. First, despite protectionist trade policies and massive tax breaks for manufacturing corporations (Prechel 1990, 2000), it became clear that this economic sector would not return to its dominant position in the global economy. Second, financial markets, especially derivatives markets, were considered a new growth area in the global economy. To advance their mutual interests, banks and financial firms formed a political coalition and pressured Congress to enact interstate banking laws to give national banks even more access to financial markets controlled by state banks. This agenda received support in Congress because it coincided with the government’s goal of facilitating economic growth. Although President Clinton focused his election campaign against incumbent George H. Bush on policies to benefit working Americans and appeared to be less interested in bank policy, he opposed revising banking laws that allowed national banks to become participants in state and local markets. However, in 1993, he appointed Robert Rubin, a former co-chairman of Goldman Sachs, to head his newly created National Economic Council that provided advice to the president. In 1995, Rubin was promoted to secretary of the treasury, where he had even more power to change the political embeddedness of the banks and financial services firms. Like Greenspan, Rubin endorsed the neoliberal ideology of market efficiency and became one of most vocal advocates 89

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for expanding bank property rights. Together, Greenspan and Rubin maintained that expanding the secondary mortgage market would facilitate economic growth. With these allies in the executive branch, national banks exercised their instrumental power to pursue their agenda in Congress. Their lobbyists asserted that eliminating restrictions on bank mergers would encourage financially stronger national banks to acquire weaker state banks, thereby creating stability and efficiency in the banking system as a whole. National banks also opposed two other political-legal arrangements designed to stabilize financial markets. They argued that the requirement to capitalize subsidiaries engaged in interstate banking drained capital away from investment in productive economic activity. They also argued that providing states with the right to regulate bank subsidiaries located in their state was complex and costly because banks were required to report to regulatory agencies in several different states. Both arguments appealed to neoliberals, who continued to assert that government regulations undermined market efficiency and markets provided the necessary decision-making information to reduce risk and increase efficiency. Although consumer organizations and small banks continued to oppose further consolidation in the banking industry, their efforts were dwarfed by the well-financed national bank lobby, which developed widespread support in Congress for interstate branch banking (CQ Almanac 1994). The long-standing political conflicts within the financial sector over nonbank activities were resolved in 1994 when senators dropped two key parts of the proposed legislation, later named the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. First, Senator Christopher Dodd (D-CT) withdrew his provision that restricted banks from selling insurance (CQ Weekly 1994a). This compromise satisfied national banks that objected to political-legal arrangements permitting insurance companies to enter bank markets but restricted banks from entering insurance markets. Second, the bill dropped the restriction against creating new branch banks across state lines. This provision signified the defeat of smaller state banks, which would now be acquired by larger national banks or forced to compete with them. If passed, this law would achieve national banks’ long-term agenda of expanding geographically 90

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with branches versus capitalized subsidiaries. Despite these defeats, the final version of the legislation reaffirmed the part of the federalist structure that authorized states to decide whether national banks could open branch banks inside their borders. Although Clinton continued to oppose this legislation, he needed congressional approval for his social agenda and campaign promise to create one hundred community development banks. Thus, Clinton compromised by supporting the provision that permitted national banks to merge with or acquire out-of-state S&Ls and organize them as branches instead of capitalized subsidiaries (CQ Weekly 1994a, 1994c). The final versions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 created two mechanisms for banks to expand into new markets. First, in 1995, national bank holding companies could acquire banks in any state. Second, in 1997, national banks were permitted to convert their state subsidiaries into branches. According to the Federal Reserve Bank, Wells Fargo had approximately fifty-eight hundred branch banks across the nation by 2018 (Levitt 2018). In short, this law permitted banks to open branches with no capital to balance the risk of operating in these financial markets. By limiting the amount of capitalization required, national banks had more capital available to pursue their consolidation strategies. Unsurprisingly, they took advantage of these political-legal arrangements and created giant bank conglomerates with organizational entities in many locations and selling many financial products in many markets, which added even more risk. By 1996, a Federal Reserve Bank decision permitted bank holding companies to diversify into investment banking and earn up to 25 percent of their revenue in this high-risk financial market (Lendman 2011, 116). Market participation in high-risk markets was not limited to banks. Like General Electric’s subsidiary GE Capital, many large corporations, including Du Pont, IBM, and Toyota, entered financial markets through subsidiaries; during the 1990s, Du Pont, for example, issued more than $1 billion in structured financial instruments (Partnoy 2004, 71). Most shareholders were unaware that corporate managers were using highrisk financial instruments because disclosure laws did not require parent 91

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companies to make these behaviors public as long as they occurred in their subsidiary corporations. Structural holes were created as one part of the social structure was changed (i.e., banks) without a concomitant change in another part that ensures third-party oversight. Decoupling banking activities from government oversight also permitted managers to bridge these holes and engage in risk-taking behavior using corporate money without informing investors. In contrast to neoliberal ideology of market efficiency, these complex organizational structures restricted information flows and increased the problem of bounded rationality. Information flows in this complex structure were hampered because critical information was buried deep inside the corporation. For example, national banks typically have multiple subsidiaries and an unknown number of off-balance-sheet entities. Much of the information in these corporate entities does not flow from organizations to markets to be distributed to consumers so they can make informed decisions. Information symmetry increased the autonomy of corporate entities and the managers and traders in them. If traders in corporate entities lose money, they may be able to conceal what happened from the parent company. In some cases, traders were able to recover losses before the parent company management was even aware of it. In other cases, their bets resulted in even greater losses. Exempting Managers from White-Collar Crime As risk in this social structure increased, corporations mobilized politically to weaken consumers’ and investors’ rights even more by making it more difficult to bring class action lawsuits against corporate managers and related positions for engaging in or collaborating on financial malfeasance. The first major legal victory in this policy arena occurred in 1991 when the Supreme Court ruled that shareholders must bring legal actions within one year of discovering a violation and not more than three years following a potential fraud. And in 1994, a Supreme Court ruling limited the capacity of investors to hold lawyers liable for giving advice that aided and abetted white-collar crime (US Congress 1995). In addition, a political coalition led by the financial services industry maintained that securities and racketeering laws permitted unwarranted 92

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and meritless securities fraud litigation and pressured Congress to protect managers, lawyers, and financial advisers from frivolous investor lawsuits (US Congress 1991, 1995). When the Republican-controlled Congress passed this legislation, Democrat president Clinton vetoed it, but Congress overrode Clinton’s veto. This law, the Private Securities Litigation Reform Act, further decoupled corporations from government oversight agencies by substantially weakening the shareholder and consumer protections specified in the Securities Exchange Act of 1933, the Glass-Steagall Act, the Securities Exchange Act of 1934, and the Racketeering Influence and Corrupt Organizations Act of 1970. These new corporate-state relations made it more difficult to use securities laws to bring lawsuits against managers, accountants, lawyers, and consultants who made speculative statements about corporate finances (CQ Weekly 1995), which created more incentives for managers to misrepresent banks’ financial strength. The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 After two decades of political pressure from banks and financial and insurance firms, the courts, Congress, the Federal Reserve Bank, and the executive branch no longer enforced or dismantled key provisions in the Glass-Steagall Act and the Bank Holding Company Act. However, banks were concerned that a new executive branch could reverse these decisions. Knowing they had support from the executive branch and key members of Congress, Citibank and Travelers Insurance illegally initiated a merger to create Citigroup in April 1998. Then Travelers committed another unlawful act by acquiring the investment bank Salomon Brothers. If successful, the $70 billion combination would form the largest banking, financial services, and insurance conglomerate in the world (Lipin 1998). The Citibank-Travelers proposed merger coincided with a political strategy to legalize mergers among financial, insurance, and real estate corporations. Inside the federal government, this effort was led by a neoliberal, Senator Phil Gramm (R-TX), chair of the powerful Senate Financial Services Committee, and Secretary of the Treasury Robert Rubin. Both legitimized this legislation by claiming that expanding bank access to capital markets was necessary to increase US competitiveness in global 93

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financial markets. After resolving disagreements on oversight, Congress passed the legislation in November 1999 (CQ Almanac 1999). Although changes by the Federal Reserve Bank and other parts of the executive branch in previous decades had dismantled core components of the GlassSteagall Act, the Gramm-Leach-Bliley Act made these changes permanent and no longer subject to interpretation by future administrations. In addition to permitting consolidation, this legislation allowed the one hundred largest US banks to create subsidiaries to engage in securities underwriting if the parent company met predetermined debt rating requirements. This provision exacerbated the conflicts of interest between the rating agencies and the corporations they rated. The Gramm-Leach-Bliley Act was the outcome of a twenty-nineyear political strategy (1970–1999) by national banks to gain access to financial and insurance markets, which included the lucrative home mortgage market. Mediation of conflict among the class fractions by government officials extended property rights for most banks and financial services firms. These neoliberal corporate-state relations allowed most corporations to provide multiple financial services, including home mortgages, securities underwriting, insurance underwriting, advising on mergers and acquisitions, stock analyses, and investment advice. This legislation was followed by a merger movement including the merger in 2000 between the bank holding company Chase Manhattan, with assets valued at $396 billion, and the investment bank J.P. Morgan, with assets of $266 billion, to create JPMorgan Chase. Although consumer organizations lobbied to preserve insurance industry oversight by states, which they perceived as more consumer oriented, the bill shifted partial oversight to federal regulators (CQ Almanac 1999). This legislation also transferred regulatory power from the Federal Reserve over nonbank subsidiaries to the SEC because some foreign governments required SEC oversight. These changes contributed to the patchwork of oversight agencies to monitor these large, complex organizations. In the absence of concomitant changes in oversight, there was no mechanism to ensure that all parts of the regulatory system fit into a coherent system. Although the Federal Reserve retained regulatory control over federally insured national banks, 94

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it did not have the authority to impose capital adequacy requirements on bank subsidiaries and affiliates. Authority over capital adequacy of these entities was allocated to their functional regulator, usually the SEC or the state where the banks and their subsidiaries were located. Moreover, the SEC had been underfunded since the Reagan administration cut its budget in the 1980s and lacked the resources to oversee these bank and corporate structures. The absence of adequate third-party oversight created more structural holes and opportunities for financial malfeasance. For example, in 2003, JP Morgan Securities settled a case with the SEC and multiple oversight organizations alleging its investment bank subsidiary influenced Chase H&Q, its equity analyst subsidiary. JP Morgan agreed to pay $50 million in penalties for this liability firewall violation without admitting or denying guilt (US Securities and Exchange Commission 2003a). Violations of securities laws also occurred at the investment banks Bear Stearns, Salomon Brothers, Goldman Sachs, Merrill Lynch, Lehman Brothers, and Morgan Stanley. In short, despite corporate executives’ and lobbyists’ assertions that management would eliminate conflicts of interests among its subsidiaries and other corporate entities by creating internal firewalls, management did the opposite in the absence of adequate third-party oversight: they bridged these structural holes and engaged in financial malfeasance. Defining Value Extraction as Value Production After the System of National Accounts (SNA) was established in 1953 to standardize how countries account for GDP, this measure became highly politicized. The fundamental problem was that no rigorous theory exists to define how economic activities contribute to value creation or how a “value creator” is defined. As a result, decision makers combined a range of criteria that include marginal utility theory, statistical feasibility, and common sense to define value creation (Mazzucato 2018, 100). One problem confronting decision makers who were establishing the SNA was accounting for how the output of banks and other financial intermediaries, which do not create outputs like enterprises that produce commodities, contribute to GDP. For this reason, financial intermediaries 95

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were defined as rentiers: in contrast to profits, which are classified as value production that contribute to GDP, rent was classified as unearned income or value extraction (Mazzucato 2018, 97, 110). Classical political economists including Ricardo, Smith, and Marx all focused on the distinction between profits and rent. However, Marx went beyond Ricardo and Smith by providing a theoretical logic that differentiates types of capital. He began with the distinction between industrial capital and commercial capital: whereas industrial capital creates surplus value, which remains after society reproduces itself, commercial capital realizes surplus value by ensuring the sale of commodities. Because value is the outcome of labor activity, commercial capital does not produce value; however, it has a claim on surplus value because it is necessary to realize the value produced by industrial capital. Like commercial capital, financial capital, which charges interest on loans, is unproductive capital, but it too has a claim on surplus value because it is necessary to ensure investment in plants and equipment that together with labor power create surplus value (Marx [1867] 1977; Mazzucato 2018, 47–56). This distinction creates a dilemma for measuring the productivity of the financial sector because it is a market enabler that other markets depend on to produce value. To solve this problem, the 1953 SNA defined the financial sector’s contribution to GDP as interest differentials: the difference between borrowing and lending rates (Mazzucato 2018, 106). This measurement was justified by the argument that money loaned by banks cannot be invested to make a profit elsewhere, banks take the risk that loans may not be repaid, and transferring money to other sectors in the form of loans is necessary to produce value. When the SNA was revised in 1968, it used the same basic definition of value production. However, the 1968 SNA included the phase “own funds” in reference to returns from other financial activities (Zieschang 2012). This seemingly minor change had important implications because it legitimates expanding the definition of value production to include financial services. The financial services sector took advantage of this opportunity. When the SNA was reviewed in 1993, the financial sector successfully lobbied to include financial intermediation services indirectly measured (FISIM) 96

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as part of value production, including estimated fees for which no explicit charges are made. Financial intermediators legitimated this claim by arguing that savers would receive a lower interest rate and borrowers would pay a higher rate if all financial services had explicit charges. Thus, in addition to the direct charge based on the interest gap, national accounts now included financial intermediators’ estimated indirect charges for services as value production. This new definition automatically increased the contributions of the financial sector to GDP, thereby increasing nations’ total GDP with no real change in productivity. Although financial services are necessary to keep capital moving through the economy, “it does not follow that interests and other charges on the users of financial services are a productive output” (Mazzucato 2018, 108). As a result of the decision to include FISIM as producing value, although the value of real (versus fictitious) commodities does not increase, when economies shift toward financialization, GDP automatically increases. Furthermore, when borrowing increases, as it did in the 1990s, GDP increases even though higher debt diverts capital away from the production of goods and services to interest payments by individuals, corporations, and governments. Although the 2008 SNA specified financial charges permitted on corporate balance sheets in more detail, over time financial intermediaries placed more FISIM charges on their balance sheets. Furthermore, although financialization dramatically increased risk, the SNA measurements did not adequately account for risk. The new measure narrowly focused on risk to the enterprise and did not include an adjustment for the higher risk to society. For example, there was no adjustment to FISIM for selling high-risk products to consumers that already carried a high debt load even though financial intermediaries understood that many of these consumers were unable to make their mortgage payments (Bitner 2008), thereby erasing any positive contribution to GDP when they defaulted. Incorporating FISIM into national accounts distorted GDP and created incentives for financial intermediaries to engage in more speculative activity such as securitization. The higher short-term profits in financial intermediaries in turn, created incentives for investors to place more capital in these fictitious commodities, which stimulated the production 97

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of even more derivatives and other financial instruments. Rather than increasing the efficiency of the economy as a whole, as high GDP implies, this shift undermined efficiency in the economy because capital was tied up in finance versus actual value-producing investments such as plants and equipment, infrastructure, and green technologies. The flawed logic of including FISIM as value production is exposed by examining the SNA, which shows that the financial sector’s contribution to value increased over time. If the financial sector contributed to the overall efficiency of the economy, this measure should go down over time, not up. As an analogy, if the real price of automobiles rises over time, it would raise questions about the monopoly power or inefficiency of owners. In contrast, the rising cost of financial intermediation is considered a sign of a strong financial sector and economy. T h e P ol i t ic s of E x pa n di ng Cor por at e Prope rt y R igh ts a n d R educi ng Consum e r R igh ts To take advantage of the declining economic and political power of the manufacturing sector, national banks exercised their structural and instrumental power to engage in political capitalism to advance their capital accumulation agenda. However, this strategy generated conflicts with current market participants: state banks, investment banks, credit unions, S&Ls, and insurance companies, for example. Because capitalists themselves were unable to resolve these conflicts, they were addressed by the state, where politicians mediated conflict among these capitalist class fractions by enacting new policies, rules, and regulation (Prechel 1990). The emerging policies, laws, and state structures extended corporate property rights in ways that permitted a wide range of corporations to participate in financial markets. To advance their interests, prospective market participants used existing state structures to legitimate extending their property rights to engage in securitization activities that were previously restricted to government agencies and government-sponsored enterprises. After banks gained a foothold in this market, they used existing laws and state structures to legitimate future policy initiatives to advance their 98

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capital accumulation agendas. For example, after the laws were changed to permit national banks to create nonbank subsidiaries, banks argued that organizing these entities as subsidiaries undermined efficiency, and they exercised their instrumental power to pressure the executive branch and Congress to pass laws permitting them to transform subsidiaries into branch banks, which are not capitalized. By the end of the twentieth century, neoliberal financialization permitted entrepreneurial financial managers to create financial products that were sold, divided into parts, and resold in financial markets. Because each transaction generated revenues, corporations rewarded financial managers with high salaries and bonuses, using incentives to create, sell, transform, and resell more financial products. Although private-label, asset-backed securities were largely nonexistent in the 1980s, they increased to $400 billion in 1998. After the Gamm-Leach-Biley Act of 1999 allowed national banks to participate in investment banking, ABSs rapidly increased, reaching $1.7 trillion in 2006 just before the financial crisis (Cetorelli and Peristiani 2012). Corporations also succeeded in weakening consumer protection laws, including truth-in-lending laws, by eliminating the requirement for real estate brokers to provide credit disclosure information to mortgage holders and exempting financial managers from securities laws designed to provide accurate information to investors. Incentives to engage in financial malfeasance were further increased when corporate elites used the massive resources under their control to pressure Congress to enact laws that limited the capacity of investors to hold financial managers and professionals liable for giving advice that aided and abetted financial malfeasance. It is not surprising that neoliberal financialization coincided with the shift in the courts. Since the 1970s, Republican presidents had made a concerted effort to appoint conservative judges who extended corporate property rights and redefined the concept of free speech to empower corporations and the upper class to exercise instrumental power to their own benefit. The realignment of these organizational and political-legal arrangements made home mortgages available to more consumers with a low probability of making their payments over the long term. Working- and 99

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middle-class consumers were enticed to enter this market with low-interest teaser loans and the rapid increase in housing values. This focus on shortterm profits by home builders and financial intermediaries created the conditions for a crisis of overproduction and underconsumption. The potential for the crisis was exacerbated by information asymmetry due to decision making deep inside the corporations and the failure to distribute crucial information to consumers. Contrary to its idealized claims, neoliberal financialization increased risks at multiple levels of the social structure, from consumers to parent companies. Neoliberal financialization entailed a fundamental realignment of corporate-state relations. Although each part of the restructuring entailed formally rational means to increase profits, formally rational means can have irrational outcomes. In this case, the organizational and politicallegal arrangements that emerged in the middle and late twentieth century created irrationalities in the form of incentives for management to engage in high-risk behavior that subverted the goal of ensuring long-term economic growth and stability.

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chapter 4

Converging Economic and Political Interests

By the late twentieth century, neoliberalism in the United States took its more extreme form of market fundamentalism that entails belief in the moral superiority of organizing social life according to market principles (Soros 1998; Stiglitz 2002; Somers and Block 2005). Extreme neoliberals charged those who opposed their policies as obstructing economic growth that would benefit the working and middle classes. However, believers in market fundamentalism are detached from its empirical limitations. This idealized solution to complex problems disguises a basic reality of the relationship of governments, corporations, and markets: decisions are made deep inside the corporation where managers are far removed from markets (Galbraith 1967, 91–92). As a result, much information never reaches markets. Furthermore, much information that reaches markets is not distributed to consumers. The analysis of the fourth policy period demonstrates how market fundamentalism served as a guide to restructure organizational and political-legal arrangements in ways that permitted the spread of unregulated derivatives trading. In contrast to the first three policy periods, where banks assumed a lead role, energy sector managers were the first to mobilize politically to create an unregulated derivatives market that was at the heart of the 2008 financial crisis. Initially, the managerial class in the energy sector engaged in political capitalism to pursue this agenda independently. However, when their interests coincided with their counterparts in the finance, insurance, and real estate (FIRE) sectors, they pooled their instrumental power to advance their mutual political and economic interest. Whereas the first three policy periods permitted banks and other corporations to participate in regulated financial markets, the fourth period transformed corporate political embeddedness in ways that permitted financial managers to create and participate in unregulated derivatives markets, a leading cause of the 2001 and 2008 financial crises. 101

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The analysis that follows addresses a central question in historical and political sociology: Under what conditions do class fractions with different economic interests unify politically to advance their economic agendas? Cor por at e Consol idat ion a n d R isk s i n t h e E n e rgy Sec tor Like the banking sector, New Deal policies permitted utilities to use the holding company structure because they were considered natural monopolies and essential to capitalist growth and development. In both industries, the holding company was tightly regulated. To avoid abusive practices, the Utilities Holding Company Act of 1935 limited pyramiding (Galbraith 1967, 130) and established price-setting mechanisms in energy markets based on fuel type, age of the facility, and other cost-based variables. To further stabilize the production of natural gas, prices were set by take-orpay contracts, where pipeline companies made long-term commitments to purchase natural gas from producers and sell it to consumers. Although these political-legal arrangements stabilized prices, natural gas firms argued that prices and profits were so low that there was little incentive to invest in exploration for new natural gas reserves. As a result, the natural gas market grew at a modest pace during the middle decades of the twentieth century. Re-regulation of the Natural Gas Market during the Decay-Exploration Phase One of the early advocates of market reform in the energy sector was Ken Lay, who had received his PhD in economics. In 1972, he accepted a position in the government and became an undersecretary of energy in the Department of Interior to assist in developing a national energy policy, where he advocated for deregulating natural gas. Lay left the government in 1974 to work for a small pipeline company that purchased natural gas from producers and transported it to consumers. However, he maintained his relationship with officials whom he had met during his short career in the government. In that same year, the Organization of Petroleum Exporting Countries (OPEC) raised oil prices. With large, commercial consumers switching from oil to natural gas, natural gas shortages became so extreme that in 1976 and 1977, schools and factories in the Midwest were forced to close. 102

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The natural gas industry viewed the energy crisis as an opportunity to pressure the federal government to revise corporate-state relations governing this market. To advance their agenda, pipeline and natural gas producers aligned their capital accumulation agenda with the state’s agenda to increase energy production. They argued that at current prices, it was too risky to invest in new exploration projects. Their argument rested in part on periodic and unpredictable warmer temperatures that resulted in lower prices. The failure to invest in new exploration projects was manifested as conflict between the energy industry and the government because it undermined the state’s agenda to ensure stable capitalist growth and development. To resolve this conflict, in 1978 Congress acquiesced and enacted legislation to increase the price paid to producers. To limit the potential for future shortages, it also passed legislation to restrict demand by limiting the construction of heating facilities that used natural gas (Eichenwald 2005:9). Higher prices stimulated exploration, which increased the supply of natural gas, boosted the profits of natural gas producers, and advanced the state’s agenda to increase energy supplies. OPEC’s ongoing oil embargo and high oil prices also created incentives for many large, wholesale consumers to switch to natural gas. When the energy crisis subsided and natural gas prices dropped, pipeline companies were locked into the long-term take-or-pay contracts that were negotiated during the crisis, and several pipeline companies went bankrupt. In response, the pipeline industry mobilized politically to further redefine the political-legal arrangements governing this market. As in the past, a central component of their strategy was to align their capital accumulation agenda with the state’s agenda to increase the domestic energy supply. Ken Lay, now president of the small pipeline company Transco, led a political coalition whose primary agenda was to replace take-or-pay contracts with a market where prices were negotiated on the spot. In 1984, he became president of the larger Houston Natural Gas pipeline company and continued to pursue his political strategy to create a “spot market.” The first major policy to create the spot market was enacted in 1984, during the Reagan administration, when Federal Energy Regulatory 103

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Commission (FERC) order 380 was implemented to allow local natural gas distribution companies to purchase gas on the open market. Because much of the natural gas supply had to be transported through pipelines, producers and distributors had to negotiate with the pipeline companies. To overcome this obstacle and make transactions easier, the FERC passed order 436 in 1985 to encourage pipeline companies to make their pipelines accessible to utility companies and other wholesale consumers (Fusaro and Miller 2002; Fox 2003). Although these political-legal changes created mechanisms to more easily buy, transport, and sell natural gas, pipeline companies pressured the federal government to release them from the long-term obligations they committed to under the take-or-pay contracts. In 1987, the FERC acquiesced and permitted pipeline companies to renegotiate these contracts, creating the conditions to establish a spot market. By 1984, anticipating this change, Houston Natural Gas had formed a consortium with five other pipeline companies, a law firm, and the investment bank Morgan Stanley to create the energy brokerage firm Natural Gas Clearinghouse.1 The company was so successful that in the following year, Morgan Stanley acquired controlling interest in the consortium through stock purchases from the other owners. Eventually more than 75 percent of natural gas sales were conducted on the spot market (Fusaro and Miller 2002). However, the spot market could not overcome the problem of supply-and-demand fluctuations associated with changing weather patterns and other difficult-to-predict conditions. As a result, producers refused to make large capital investments to explore and develop natural gas reserves. Corporate Consolidation and Creation of Enron Corp. In 1985, to take advantage of the capital accumulation opportunities in this emerging market, Houston Natural Gas merged with its much larger competitor, InterNorth, to create Enron Corp. InterNorth was receptive to a merger in part because the corporate raider, Irwin Jacobs, was acquiring a large share of its stock. A merger would dilute Jacobs’s shares and prevent the takeover. Furthermore, both companies anticipated re-regulation of the energy market and were acquiring companies to gain a larger market share. 104

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Instead of competing over the acquisitions, the merger represented the first step in a two-step process to consolidate this market. This merger created one of the largest pipeline companies in the United States with the capacity to purchase, transport, and sell natural gas to customers dispersed over a large geographic region. The new Enron Corp. then merged with or acquired more competitors, consolidating an even larger share of the energy market. Despite InterNorth’s substantially larger size, Lay negotiated to relocate corporate headquarters to Houston and replace the former InterNorth CEO after a few years. Merging with this larger firm required a large payout to InterNorth’s shareholders and resulted in substantial debt for Enron. The merger and Enron’s subsequent expansion was facilitated by the MLSF, which facilitates corporate consolidation by permitting parent companies to gain ownership control over other companies by purchasing just over 50 percent of their stock and selling up to 50 percent of their own stock and the stock in existing subsidiaries without relinquishing ownership control. This organizationally and financially flexible structure also permits a parent to liquidate stock to address unanticipated capital needs. Moreover, the sale of stock is less likely to attract the attention of stock analysts who might interpret the sale of physical assets as a response to a weakened financial condition. Exercising Structural and Instrumental Power to Create a Derivatives Natural Gas Market After the merger, Enron continued to employ InterNorth’s consulting firm, McKinsey & Company, to help it develop the natural gas market. McKinsey assigned a consultant with a background in finance to assist the firm in developing this market, Jeffrey Skilling. During this transition period, Enron and other pipeline companies struggled with how to succeed in this market. For decades, wholesale customers had purchased natural gas at a fixed rate and were hesitant to participate in a spot market. The profit-making opportunities in the natural gas industry were further hampered when, in response to the uncertainty of the spot market, many large consumers shifted to coal and oil. After numerous failed proposals to stabilize this market, Skilling came up with the idea of using the pipeline business to connect producers and 105

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consumers, a fundamental transformation of Enron’s business model. Instead of selling its pipeline services to transport natural gas, Enron would broker contracts between producers and buyers—that is, it would operate like a bank for natural gas. Using the “Gas Bank” as a metaphor, Skilling proposed that producers make deposits of natural gas in the Gas Bank at a guaranteed below-market price and customers would withdraw natural gas from the Gas Bank at a guaranteed above-market price. This business model assumed that producers would be willing to sell at belowmarket prices and customers would be willing to buy at above-market prices to reduce their respective risks. In short, Skilling proposed to create a natural gas derivatives market where contracts are based on the value of an underlying commodity that specify an obligation by producers to deliver a product at a set price at a future date and an obligation for buyers to purchase the commodity at the agreed-on price. Skilling presented the idea to Rich Kinder, a rising executive expected to become Enron’s next president and CEO. With Kinder’s support, Skilling presented his proposal to a group of trading executives. The executives, however, were unconvinced that producers would sell at below-market prices and consumers would buy at above-market prices. Although Kinder was cautious, he was also concerned that if another pipeline company developed this market, Enron had to be prepared to move into it or it would miss out on tremendous capital accumulation opportunities. To advance this agenda, Kinder and Skilling presented this idea to potential customers. After two weeks, they had more than $1 billion of multiyear natural gas contracts (Eichenwald 2005, 43). In the meantime, however, traders outside Enron began to take seriously the potential for the natural gas derivatives market, and the New York Mercantile began to trade natural gas derivatives in 1990 (McLean and Elkind 2003). Concerned that the regulated exchanges would control the market, Lay told Kinder to hire Skilling as a full-time employee to expand the natural gas derivatives market. After he did so, Enron transformed the Gas Bank from a metaphor to a subsidiary corporation, Enron Finance, with Skilling as the chairman and chief executive officer. Enron’s strategy coincided with bank policy to tighten credit to exploration and drilling 106

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companies in this uncertain natural gas market. Skilling soon renamed Enron Finance as Enron Gas Services Group and expanded its activities, filling the void left by bank policy and making loans to natural gas producers for exploration and production in return for a guaranteed supply of natural gas at a fixed price in the future (Bryce 2002). Producers accepted these terms because they guaranteed a profit. Enron Finance’s strategy to make natural gas available at a fixed price at a future date also appealed to commercial natural gas consumers. These organizational arrangements shifted risk from producers and consumers to Enron and, without their knowledge, to its stockholders. Despite Kinder and Skilling’s success in obtaining futures contracts, key Enron executives remained skeptical, and the strategy was only partially implemented. Yet Kinder and Skilling persisted and maintained that if Enron did not implement this strategy, another company would and Enron would lose out on this profit-making opportunity. Early Warnings of Bounded Rationality in the Multilayer-Subsidiary Form While the parent company was attempting to develop a natural gas market, its internal audit department received a tip from a bank that led to uncovering large losses in a small trading subsidiary. Approximately a year and a half before Enron merged, InterNorth had created a subsidiary in Valhalla, New York. After the merger, this subsidiary was renamed Enron Oil and employed forty traders who speculated on crude oil and refined products (Bryce 2002, 37). Unknown to parent company management, these subsidiary managers were also engaging in high-risk oil trading. The same year Enron was created, Enron Oil reported $10 million in earnings, which resulted in a bonus of $3.1 million for these traders. In the following year when the parent company lost money, Enron Oil reported a $28 million profit, which resulted in bonuses of $9.4 million, with a large share of it retained by the top manager and trader, Louis Borget (McLean and Elkind 2003, 17). In a communication to Enron’s board of directors, Borget claimed that oil traders who used complex financial tools could generate substantial earnings with low fixed investment and risk (McLean and Elkind 2003, 17). The parent company’s top management 107

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accepted this argument and quickly become dependent on revenues from this subsidiary. What the parent company didn’t know was that Borget and Enron Oil’s treasurer, Thomas Mastroeni, had transferred substantial amounts of capital to an offshore bank in Panama in 1985. In the absence of adequate oversight, they had bridged structural holes between Enron Oil and these offshore entities to manipulate earnings that translated into benefits in the form of higher bonuses. Subsidiary management also began to take greater risks and kept two sets of accounting books to hide transactions and cover up capital transfers (McLean and Elkind 2003, 19). In early 1987, the parent company’s internal audit department received a phone call from Apple Bank in New York reporting a wire transaction from an offshore bank of approximately $5 million, with $2 million put in an Enron Oil manager’s personal account. The parent company’s internal investigation revealed that subsidiary managers had suffered some trading losses. Although these losses were manageable, the investigation also discovered that subsidiary traders had set up deals with other corporate entities that covered up trading losses by cancelling losses on one contract with a second contract that generated the same gain (McLean and Elkind 2003, 180). Using internal financial transactions deep inside the corporation, subsidiary managers also moved profits from 1986 to 1987 to cover up losses. At this time, shifting profits from one time period to another to smooth earnings was illegal (Bryce 2002, 38; McLean and Elkind 2003, 18). In short, traders in the subsidiary were engaging in illegal financial transactions. In their defense, traders claimed that they engaged in this behavior to cover unexpected future shortfalls. The investigation also revealed that Borget and Mastroeni falsified bank statements to hide unauthorized payments. Despite these conclusions, Enron executive Rich Kinder maintained that these were “legitimate common transactions in the oil trading business” (in McLean and Elkind 2003, 21). The financial chicanery and malfeasance was not revealed to Enron’s stockholders, and Borget and Mastroeni were not fired or even punished. Instead, dependent on revenues from this trading subsidiary to make debt payments on its merger with InterNorth Corp. and subsequent acquisitions, parent company management permitted these subsidiary 108

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managers to continue trading (Bryce 2002, 39). In short, top management’s decision to overlook financial malfeasance was motivated by its need to raise revenues to pay down debt. Failure to do so would lower securities ratings, which would put downward pressure on stock values that might trigger additional debt payments. Absent adequate parent company oversight, traders at Enron Oil engaged in riskier activities that resulted in a worse crisis in mid-1987. Mike Muckleroy, an internal auditor who help resolve the 1985–1986 crisis, was told by members of his business network that Enron Oil traders were short several million barrels of oil on their trades (Bryce 2002, 39). The company’s external auditors, Arthur Andersen, also uncovered evidence of unrecorded commitments on trades. Muckleroy informed Ken Lay, but despite the evidence, top management still took no action other than informing subsidiary traders to limit their trading to 12 million barrels of oil to contain future potential losses. However, it soon became apparent that subsidiary managers continued to bet on crude oil prices. At this time, Enron Oil’s total assets were approximately $400 million. If the traders made incorrect assumptions and prices rose, the subsidiary would owe hundreds of millions of dollars to traders on the other end of the deal. When crude oil prices unexpectedly dropped, this is precisely what occurred. Borget, who may have been under pressure to produce revenues for the parent company, believed that he could trade his way out of these obligations with more bets—an extremely risky strategy in this highly volatile market where large price shifts were frequent due in part to the war between Iran and Iraq and the subsequent unpredictability of oil shipments through the Strait of Hormuz. In the end, Borget was on the losing side of these trades, and the subsidiary suffered massive losses that it could not cover up. Enron’s preliminary investigation revealed that Enron Oil was responsible for the delivery of more than 80 million barrels of crude oil that it did not have; estimates suggest that this is similar to the amount pumped from the gigantic North Sea oil field in three months (McLean and Elkind 2003, 22). Enron’s internal audit also discovered a separate set of books hiding losses by falsifying transactions (Eichenwald 2005, 35). The gravity of the situation prompted Enron’s president, John Seidl, 109

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to track down CEO Ken Lay, then in Europe. The two arranged an emergency meeting in Newfoundland where Seidl told Lay, in reference to the parent company, “We’re broke” (Bryce 2002, 37). Lay and Seidl flew to Valhalla, where Lay fired Borget for violating company policy and replaced Enron Oil’s chief financial officer (Eichenwald 2005, 37–38). At that time, the parent company’s debt reached approximately $3.5 billion and continued to rise as a consequence of its aggressive merger and acquisition strategy. At the time, Enron’s stock valuation was about $4.7 billion. When the estimated $1.5 billion loss from the oil trades was added to its debt, Enron in fact had a negative net worth of about $300 million (Bryce 2002, 41). Because Enron was at the limit of its debt capacity, it could not borrow capital to cover the losses. Moreover, the unanticipated stock market crash of 1987 weakened financial markets, making it virtually impossible to raise capital through issuing stock. The parent company was on the verge of bankruptcy. If Enron could not solve the problem at Enron Oil before it was exposed to the public, its stock value would decline and the company would be forced into bankruptcy. In a desperate attempt to avoid bankruptcy, Enron again concealed its financial condition from the investing public, stock analysts, and government oversight agencies and sent a team of its most experienced traders to Enron Oil to renegotiate as many of these trades as possible. Aided by an unexpected drop in the price of crude oil and working eighteen to twenty hours a day for three weeks, these traders, who included Muckleroy, turned a potential loss of $1.5 billion loss into a $140 million loss. By combining revenues from its other operations, Enron was able to reduce its consolidated quarterly loss to $85 million and avoid bankruptcy (McLean and Elkin 2002, 22–23). In short, an unexpected shift in the market saved Enron. Unlike the previous financial malfeasance at Enron Oil, this crisis was too large to continue to conceal from the public. The president and treasurer of Enron Oil received short sentences for their financial crimes. It is noteworthy that these subsidiary executives denied any malfeasance and argued that they were instructed by top management to engage in these high-risk trades to generate revenues for the parent company (McLean and Elkin 2002, 18). 110

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It is unclear which version of the narrative is correct: whether the traders in the Enron Oil subsidiary acted independently or whether they were instructed by parent company management to take risks to generate much-needed revenues. However, what is clear is that parent company management provided massive incentives to subsidiary managers in the form of bonuses of $3.1 and $9.4 million in 1986 and 1987, respectively, for generating revenues. It is also clear that financial malfeasance occurred deep inside this large, complex MLSF where traders had a high degree of autonomy that created sufficient ambiguity for parent company management to deny knowledge of subsidiary managers’ behavior. Although this excuse became common in subsequent years, computerized information processing and monitoring systems in fact have the capacity to monitor managerial decisions in large, complex corporations (Prechel 1994). It is also difficult to verify whether Enron Oil’s managers were instructed by top management to smooth earnings. However, soon after Enron was created, top management had begun to lobby oversight agencies for permission to use special accounting techniques to shift profits and losses from one time to another. This political strategy succeeded in 1987 when Enron obtained permission from the SEC and the US Attorney’s Office to shift profits from quarter to quarter (McLean and Elkind 2003, 18, 24). In 1995, for example, Enron smoothed earnings by taking $70 million in revenues off its books because it earned more money in that year than it needed to make its earnings target, and it placed these revenues back on the books during the next quarter (Swartz and Watkins 2003, 88). Enron was one of many corporations that engaged in earnings manipulation, which became increasing widespread in response to the emphasis on increasing shareholder value. Smoothing earnings offers several advantages. One is that revenue volatility raises a red flag among stock analysts and credit rating agencies because it implies high risk (Krier 2005). In contrast, analysts consider consistent revenues representative of stability and low risk, which they reward with positive securities ratings, which are typically followed by higher stock values. The MLSF itself is a means to smooth earnings because low earnings in one product line can be offset by high earnings in another subsidiary, as Enron did with Enron Oil. 111

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Enron’s near bankruptcy had little effect on top management’s faith in market fundamentalism. One exception was Kinder, who suggested that the firm limit its risk in the trading market. However, he was also aware that if Enron did not enter the natural gas trading market, its competitors would capture a larger share when this market expanded. In the end, Kinder argued for a business model where profits from trading would be limited to 30 percent, and the remaining 70 percent would come from physical assets such as natural gas pipelines and processing plants. Mor e Pol i t ic a l C a pi ta l ism Redefining Revenue Reporting Despite knowledge of the high-risk behaviors at Enron Oil, oversight agencies did not enact regulations to limit high-risk behavior. In fact the opposite occurred. In 1992, with the support of its external auditor, Arthur Andersen, Enron convinced the SEC to permit the parent company to use mark-to-market accounting. Whereas historical accounting enters revenues when they are received, mark-to-market accounting enters revenues when the deal is made. Enron was among the first nonbank to use this form of accounting, with other energy corporations including Dynegy and Williams Companies soon to follow (Bryce 2002, 61, 67; Fox 2003:40; McLean and Elkind 2003, 42; Swartz and Watkins 2003, 76). The SEC also created parameters for nonbanks’ use of this accounting technique. To illustrate, when mark-to-market is based on the price of securities, corporations are required to adjust their valuations in relationship to changes in the market price. If a corporation purchased 100 shares of GE stock at $50 per share and two months later it was traded at $60 per share, the corporation would report a $1,000 paper profit. Conversely, if the stock value declined in that period, it would report a paper loss. Banks were the exception to this rule: they were still tightly regulated. However, derivatives were exempt from these restriction, which exempted management from adjusting the value of their derivatives contract when markets changed, which permitted them to operate like banks but without being regulated like banks. To justify exempting derivatives contracts from this rule, corporations maintained that these contracts may not be settled for several years beyond a particular price 112

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shift, price shifts may occur many times, and it was cumbersome to change their accounting valuations each time a price shift occurred. Exempting derivatives from this rule permits management to report all of the revenues from a futures derivative on the day the deal closes, creating substantial disparities between reported and actual revenues. Specifically, it might be twenty years before the corporation receives all of the revenues from a derivative. Thus, mark-to-market accounting of derivatives dramatically overstates earnings. Because these decisions are made deep inside the corporation, investors and oversight agencies had little knowledge of the portion of reported revenues from actual assets like energy plants versus fictitious commodities like derivatives. As derivatives became a larger portion of a business, the gap between reported and actual revenues increased. Most important, mark-to-market accounting of derivatives ignores potential market failures and assumed that derivatives contracts close in accordance with the originally stipulated conditions. This false assumption had a large material effect on Enron’s financial statement. It is estimated that if Enron had used historical accounting to report its trading revenues for the entire year, its 2000 revenue would have been $6.3 billion. Instead, using mark-to-market accounting, Enron reported almost $100 billion in revenues in 2000 (Cruver 2002, 140, 163). Political Action Committee and Lobby Expenditures Despite the internal financial obstacles (i.e., high debt) to developing a natural gas derivatives market, Enron and other energy companies continued to exercise instrumental power using their organizational resources to pursue their political strategy. Led by Enron, the energy industry accelerated its political action committee expenditures throughout the 1990s. During the 1992 election cycle, Enron alone contributed almost $300,000 to members of Congress (Swartz and Watkins 2003, 68) and between 1989 and 2001, it contributed more than $5.9 million to 71 of the 100 US senators and 188 of the 431 members of the House. Among the largest recipients of Enron’s PAC contributions during this period were Senators Phil Gramm (TX-R) and Kay Bailey Hutchinson (TX-R), who received $101,500 and $101,350, respectively. Like Lay, Gramm was an economist and long-term 113

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proponent of market fundamentalism. Lay also chaired Phil Gramm’s 1992 Senate reelection committee. Political contributions to other members of Congress included US House Majority Leader Tom DeLay (TX-R) who received larger PAC contributions from Enron than any other corporate donor (Fox 2003, 112). In late 1996, DeLay sponsored a bill to deregulate the electrical industry within two years. If this bill had passed, it would have provided Enron with tremendous advantages over energy companies that were less prepared for the transition to unregulated markets (Fox 2003, 112). In November 2001, Enron donated $25,000 to DeLay and an additional $50,000 to his national PAC that was established to redefine the state’s congressional districts (Mitchell 2002). Enron also made substantial donations to the Bush family, which had acquired a large share of their wealth in Texas’s energy industry. In 1994, Ken Lay personally contributed approximately $38,000 to George W. Bush’s campaign to defeat the Texas Democrat governor, Ann Richards. (Much of Lay’s personal wealth and the wealth of other members of the managerial class at Enron and other energy companies were from their generous stock options programs.) Enron also contributed $114,000 to George W. Bush’s campaign for president of the United States during the 1999–2000 election cycle (Bryce 2002). Later, Enron contributed $50,000 to Bush’s 1994 presidential inauguration (Fox 2003, 113), and Ken Lay donated an additional $300,000. Other exercises of Enron’s instrumental power included $57,000 to John Ashcroft’s Senate election campaign before he was appointed attorney general in the George W. Bush administration (Fusaro and Miller 2002, 124). Between January 1991 and June 1999, Enron contributed more than $1.4 million in soft money to the Republican Party, which supports general political activities and is not subject to regulations or limits that govern campaign contributions. These large financial contributions often resulted in invitations to top management to participate in political-social networks where corporate elites could express their policy perspectives to political elites in an informal setting. Ken Lay, for example, was an invited guest in the family quarters of the White House by President George H. W. Bush (Eichenwald 2005, 46) and to a White House brunch the day after George W. Bush 114

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was inaugurated as president (Eichenwald 2005, 416). In 2001, he met with Vice President Dick Cheney to discuss the nation’s energy policy. Although the energy industry’s political expenditures were heavily weighted to the Republican Party, which endorsed deregulating energy and financial markets, the energy industry did not limit their political contributions to one political party. During the 1998–1999 election cycle, which coincided with the industry’s political strategy to pass legislation necessary to create the over-the-counter derivatives market, corporations in the energy industry contributed almost $6.4 billion in PAC contributions, including approximately $5 billion to Republican candidates and $1.4 billion to Democratic candidates. The industry’s lobby expenditures were among the highest of all industries. Enron alone spent $1.9 and $2.1 million in 1999 and 2000, respectively, lobbying President Clinton and Congress (Fox 2003, 224). The Revolving Door between the Energy Industry and the Federal Government As in many other industries, a revolving door between corporate and political elites in the energy industry provided opportunities for corporate leaders to have direct input to government policies that affect the corporations that employed them and that many returned to after government employment. To illustrate, President G. W. Bush considered Ken Lay for treasury secretary, but decided against the appointment because he had already filled two key positions with energy executives from Texas: Dick Cheney and Don Evans (Eichenwald 2005, 417). However, Larry Lindsey was on Enron’s payroll before accepting the position of chief economic adviser in Bush’s administration (Bryce 2002, 272). Bush also appointed as secretary of the army Thomas White Jr., who previously held the position of vice chairman of Enron’s subsidiary Enron Energy Services, and as deputy White House chief of staff, Karl Rove, a major Enron stockholder. The revolving door also includes placing former government officials on the payroll of large corporations, where they could use their networks in the government to advance corporate agendas. James A. Baker III, who advised President George H. W. Bush and served as the secretary of treasury in the Reagan administration, was hired by Enron to consult 115

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on foreign investments. After the first war with Iraq, Baker lobbied Kuwait on behalf of Enron to develop a $600 million power plant (Fox 2003, 113). Enron also hired Henry Kissinger to consult on setting up businesses in China (Bryce 2002, 76, 79). Robert Mosbacher, a Texas oilman and former secretary of commerce, was also added to Enron’s payroll (Eichenwald 2005, 48). State-Level Political Capitalism Given the US federalist structure, states have partial regulatory authority over utilities. Thus, Enron’s capacity to create and succeed in this market depended on its ability to buy and sell energy across state lines, which required dismantling state utility monopolies. Although Enron created its own network of lobbyists to focus on states, Enron did not have the expertise to address every issue that would emerge given the fifty different state enforcement structures and consumer and other interest groups. This obstacle prompted Enron to join forces with the conservative policy planning organization American Legislative Exchange Council (ALEC), which advances the neoliberal principles of limited government and unregulated markets. ALEC raises money through high membership fees and from conservative donors in exchange for writing model legislation for states to advance conservative and corporate interests. Enron also teamed up with Koch Industries and others in ALEC’s energy and environmental policy task force to re-regulate energy markets. Led by Enron, ALEC drafted legislation, created materials supporting re-regulation, and distributed them to the several thousand elected lawmakers in all states. Enron also became a major contributor to ALEC, and in 1997 the corporation underwrote part of its annual conference where Ken Lay delivered the keynote welcoming presentation that focused on the benefits of re-regulating electrical utilities and the interstate sale of electricity. Although Edison Electric Institute, the trade association for investor-owned state utilities, opposed these changes, Enron and Koch Industries prevailed in this conflict in part because they were willing to make large monetary contributions to ALEC (Hertel-Fernandez 2019, 45). Although ALEC maintains that its high fee rates ensures its neutrality, these fees creates a bias toward big businesses that can afford member fees. 116

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Enron’s investment in state-level politics paid off. By 2000, twentyfour states enacted legislation to re-regulate electrical power markets. Although this constitutes slightly fewer than half of state legislatures, it gave Enron more than ample opportunity to enter these markets formerly closed to nonutility corporations. P o l i c y P e r i o d I V, 2 0 0 0 – 2 0 0 7 Political Capitalism and the Expansion of Derivatives Markets and Adventure Capitalism Although the energy industry succeeded in pressuring federal and state governments to make incremental regulatory changes, their primary goal was to transform political-legal arrangements governing energy trades. Led by Enron, the energy lobby maintained that the natural gas market would operate more efficiently if derivatives contracts were sold on unregulated exchanges. However, with a few exceptions (e.g., currency exchange rates), the Commodities Futures Trading Commission (CFTC) limited derivatives trading to regulated exchanges such as the Chicago Mercantile. Whereas the SEC monitors the stock market, the CFTC oversees US commodities trading from food to currency and precious metals, making it one of the largest financial markets in the world. The energy sector, which had the support of President George H. W. Bush, a former oilman, received a setback when Bill Clinton defeated President Bush in November 1992. To ensure that their political strategy was not derailed by a Democratic president and Congress, the energy industry intensified its lobbying efforts and pressured the CFTC to remove energy trading from its jurisdiction. As in the past, to legitimate its strategy, this political coalition aligned its capital accumulation agenda with the state’s agenda to increase domestic energy supplies. Lobbyists argued that unregulated derivatives trading would increase predictability in the market and reduce the risk to producers, who in turn would make greater investments in natural gas exploration. Wendy Gramm, the head of the commission, held political appointments in both the Reagan and George H. W. Bush administrations, and, like her spouse, Senator Phil Gramm (R-TX), she was a neoliberal economist and supported the proposal to remove energy trades from CFTC 117

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jurisdiction. The commission voted along party lines, and the Republican majority passed the provision by a two-to-one vote. This crucial decision exempted energy companies from oversight by the CFTC and paved the way for them to enter the derivatives trading markets. The committee’s dissenting vote was cast by Sheila Blair, who viewed the exemption as a “dangerous precedent” (Bryce 2002, 84). 2 The CFTC decision represents a critical event in the transition to adventure capitalism as it created opportunities for energy companies to develop speculative over-the-counter energy derivatives businesses with no government oversight agencies. After this decision, several large energy companies, including Dynegy, El Paso, and Williams joined Enron and expanded their internal trading floors (McLean and Elkind 2003, 105). The commission’s decision had important implications because it permitted these firms to operate more like investment banks and hedge funds than traditional energy companies. However, unlike FIRE-sector firms, energy companies were not monitored by financial oversight agencies (Fox 2003, 48, 188). Although oversight of the FIRE sector deteriorated during this same historical period (chapter 3), they were required to have a securities license or register with the SEC and conduct their trades on regulated exchanges, such as the New York Mercantile Exchange and the Chicago Board of Trade, that, unlike unregulated exchanges, require firms to have collateral requirements overseen by the CFTC (Bryce 2002, 83; Bakan 2004, 100). The Dot-Com Bubble and Economic Decline The 1990s was a period of rapid growth in the stock market, fueled by the combination of rapid technological change associated with the expansion of the Internet. This stock market growth was fueled in part by the rapid increase in initial public offerings (IPOs), by start-up companies and existing corporations, from 90 in 1990 to 256 in 1991 to 438 in 1993 and 572 in 1996 and remained high until 2000 (Gao, Ritter, and Zhu 2013). Beginning in 1995, stock market and IPO growth were driven further by low-interest loans that fueled start-up companies such as Intel, Cisco, and Oracle. These conditions contributed to speculation in the software and Internet industries. Adventure capitalists poured money into the technology 118

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sector hoping that their investments were in upstarts with cutting-edge technology. In some cases, their speculative behavior paid off when the IPO of stock doubled or even tripled when offered to the public. However, speculative growth in this economic sector came to a halt after the NASDAQ stock index peak on March 10, 2000, at 5,143.32. In the following days, companies such as Dell and Cisco began to unload their own stock, which initiated a giant sell-off in this industry with a market value loss of 10 percent in a few weeks. Within a few months, some publicly traded dot-coms, which once reached hundreds of millions of dollars in market capitalization, lost all their value. As a result, investment in this sector almost stopped, and unemployment increased. While the dot-com bubble was limited to US stocks, it affected large segments of the global economy. In response, central banks began to look for ways to stimulate the global economy, and investors who had become accustomed to high rates of return looked for new capital accumulation opportunities. Risk in This New Social Frontier At the same time the dot-com bubble burst, critics inside and outside the state raised concerns about the risk of OTC derivatives trading. In 1999, President Clinton’s Working Group on Financial Markets—consisting of the secretary of the treasury, Lawrence Summers; the chair of the Federal Reserve, Alan Greenspan; the Securities and Exchange commissioner, Arthur Levitt; and chair of the Commodity Futures Trade Commission, Brooksley Born—reviewed the viability of this new market. The FIRE sector joined the energy sector and lobbied the working group to permit OTC derivatives trading. Aided by the historical conditions of economic decline and the government’s goal of stimulating the economy, the energy and FIRE sectors succeeded when the working group issued a report that advised not monitoring derivatives trading among banks, corporations, and trading companies. However, the report recommended against permitting trading energy commodities on electronic exchanges arguing it would result in price and supply manipulation of energy markets (Fox 2003, 216). The working group also raised concerns about using over-the-counter derivatives to trade natural gas because calculating the risk was complex, and a failure 119

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in this market could have widespread effects on economic growth and stability. Several interrelated characteristics make natural gas derivatives speculative and high risk: • It is difficult to predict the risk level in new derivatives markets because information on price shifts does not exist. With an absence of historical data on a market, there is little information to evaluate whether cost and price curves predicted future prices (Bryce 2002, 66). In contrast, traders in established futures markets (e.g., corn, pork bellies, soybeans, wheat) have access to decades of data on the variables that are used to project costs and prices, among them, fuel, weather patterns, and number of acres planted. • Natural gas prices must include the cost to move the commodity across many transmission points in a complex network of pipelines. Because each transmission point is a cost point and there are many ways to move natural gas from the point of origin to the point of delivery, it is difficult to calculate the cost of each transmission pathway. • Natural gas has many kinds of consumers, including utility companies that want more energy in the winter, manufacturing companies that want less energy during economic downturns, companies that want the commodity delivered to a specific site, and companies that want to hire someone else to transport the commodity (McLean and Elkind 2003, 38). • In contrast to futures in the agricultural sector, where projections are made over several months, natural gas futures may entail projections for up to ten to twenty years.

Although market fundamentalists asserted that natural gas derivatives increase predictability for producers and consumers, this rationale does not have face validity because predicting price is dependent on the availability of data about future events, which does not exist. Speculation and risk in the natural gas market are increased even more because derivatives bundle many of the same or similar products into a single contract. Whereas bundling can mitigate the effects of the failure of a single product, it also concentrates risk because the potential of a market failure always exists. The potential of market failures is 120

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particularly high in new derivatives markets because many risks are unknown or unforeseen, and unanticipated events can affect the value of the underlying commodity and, thus, the value of derivatives. Some political and economic elites were aware of these risks. However, the risk associated with natural gas derivatives was not sufficient to deter market fundamentalists. Enron alone bought and sold a wide range of derivatives worth tens of billions of dollars. The trading subsidiaries at Enron and other energy companies quickly began to resemble FIRE-sector firms. However, unlike these firms, energy derivatives trading was exempt from oversight, and these firms were also not required to report how much collateral they held to back their derivatives contracts (Bryce 2002, 83). In short, energy trades fell through the cracks of the complex patchwork of financial oversight. Expanding the Power Bloc: A Political Alliance between the FIRE and Energy Sectors An opportunity to make the OTC derivatives trading permanent emerged in the late 1990s when Congress was due to reauthorize the Commodity Exchange Act of 1936. At this time, the global derivatives market had grown to $88.2 trillion. Advocates in the FIRE sector argued that the current regulatory structure limited US firms from participating in this rapidly expanding and profitable market. Undeterred by political opposition, the managerial class in the energy and FIRE sectors lobbied for legislation that would be harder for incoming administrations to overturn. Although class fractions among capitalists within the FIRE sector competed over market share, they had a mutual interest in expanding the derivatives market and created a well-financed political strategy to advance their mutual economic interests. To increase their instrumental power, banks and financial firms merged the Association of Reserve City Bankers and the Association of Registered Bank Holding Companies in 1993 to create the Bankers Roundtable. In 2000, the instrumental power of the Bankers Roundtable increased even more when the insurance sector joined it, which signifies a crucial step in creating the FIRE-sector power bloc. After the insurance sector joined this political coalition, the organization, whose primary goal was to advance policy benefiting 121

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the entire FIRE sector, was renamed the Financial Services Roundtable. During this same period, the American Securitization Forum (ASF) was created to advocate for expanding the securitization market. Officially founded in 2002, ASF is a broad-based organization that advocates the common interests of all aspects of the securitization market, thereby providing political unity between the FIRE and the energy sectors to reregulate securitization markets. To overcome opposition from oversight agencies and the President’s Working Group on Financial Markets, this political coalition lobbied Congress and other parts of the executive branch by launching a wellfinanced lobby to pressure Congress to enact legislation allowing over-thecounter (i.e., unregulated) derivatives trading. Between 1998 and 2001, the oil and natural gas industry exercised instrumental power by spending more than $62, $60, $50, and $51 million annually on lobbying. In 1997, Enron’s government affairs budget was $37 million to finance one of the largest lobbying efforts in corporate America. However, the FIRE sector dwarfed energy sector expenditures, which spent more than $207, $214, $230, and $236 million on lobbying during these same years (Center for Responsive Politics 2017). In 2000, Phil Gramm and other members of Congress proposed legislation that allowed OTC derivatives trading (Bryce 2002, 81–84). This legislation was also supported by key members of the executive branch, including Robert Rubin, Alan Greenspan, and Lawrence Summers. To lay the groundwork for subsequent legislation, Gramm met with the chairmen of the SEC and CFTC and the leaders of the regulated derivatives exchanges. When the Commodities Futures Modernization Act of 2000 was introduced on May 25, 2000, in the House of Representatives (H.R. 4541), widespread opposition to the bill quickly emerged. Three House committees held hearings on the proposed legislation and created different amended versions of the bill. Another version of the bill was introduced in the Senate on June 8 (S. 2697). Given that derivatives were widely used in agricultural markets, the Senate Agriculture Committee entered the conflict and met with the Banking Committee to evaluate the bill. On

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August 25, the Agriculture Committee provided an amended version of S. 2697. Passage of this bill was further complicated when the SEC and CFTC disagreed on how to regulate these markets. On September 14, these oversight agencies presented a joint regulation strategy for securities futures. However, Senator Gramm maintained that the bill needed to be expanded to remove prohibitions of the swaps market from SEC regulation. Swaps allow investors to buy protection to hedge the risk of default on a bond or other debt instrument. One type of swap, credit default swaps (CDSs), was invented by financial managers at JPMorgan in 1994, and this market increased in subsequent years. In some ways, CDSs are similar to insurance: they create a contract where the buyer pays a premium and is reimbursed for the insured asset in the event of a loss. However, there is an important difference: in contrast to insurance, CDSs allow speculative investors to purchase protection to hedge the risk of default on bonds and other high-risk financial debt instruments. The policy formation process became even more contentious when Democratic members of Congress claimed that they were excluded from negotiating the differences among the three committee versions of H.R. 4541. They were especially concerned with the House Republican leadership and Senator Gramm’s involvement with the House bill. Despite the controversies surrounding the OTC derivatives provision, the administration announced its support of the House bill and on October 19, 2000, it passed by a 377–4 vote. The policy formation process became increasingly contentious in the following weeks, with Senator Gramm at the center of several controversial issues. Contrary to the President’s Working Group, Gramm argued that energy companies should be permitted to trade OTC futures, SEC should not regulate swaps, and the CFTC should not regulate commodities futures because they were bank products. After Gramm and other member of Congress introduced revised versions of the House and Senate bills, noting the short legislative schedule, Treasury Secretary Summers pressured Congress to act on this historic and wide-reaching legislation.

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On December 14, 2000, just two days before Congress recessed for the holiday break, the revised House bill was introduced; the Senate bill was introduced on the following day. The House bill passed with a vote of 292–60. After several previous political defeats, the Senate version of the bill received little support and was never brought up for a vote. Hearings were not held in either the House or the Senate. Instead, the bills were passed by the respective committees in the House and Senate, which precluded the opportunity to debate or vote. Then Senator Gramm and the Republican House leadership attached the Commodity Futures Modernization Act of 2000 (H.R. 5660) to the Consolidated Appropriations Act for FY2001 (H.R. 4577). Given that most legislators were unaware of the transformative attached commodities legislation to the 11,000-page appropriations bill, it passed with a 290–60 vote in the House and by unanimous consent in the Senate, with virtually no discussion of the attached landmark derivatives trading legislation. On December 21, 2000, less than a week after H.R. 4577 and S. 2697 were introduced to Congress, President Clinton signed this historic legislation into law. A little-known provision in the law, which later became known as the Enron loophole, exempted a wide range of derivatives trades from regulation and virtually guaranteed that corporations could create their own OTC derivatives exchanges that were removed from public scrutiny and government oversight (Swartz and Watkins 2003, 227). Gramm left the Senate in 2002 when he entered the revolving door by accepting a position with the bank UBS AG. Although banks were permitted to trade certain foreign exchange rates as OTC derivatives and enter the mortgage-backed securities (MBSs) market in 1984 (chapter 3), this legislation greatly expanded the FIRE sector’s capacity to create new financial instruments, including MBSs. By removing these derivatives from public scrutiny and government oversight, this legislation created more structural holes that increased information asymmetry and financial managers’ autonomy to engage in irrational speculation outside widely accepted market conventions with unpredictable outcomes. The OTC derivative market quickly expanded into a multitrilliondollar business. The legislation created opportunities for widespread 124

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speculation, but had no provisions to ensure that market participants had adequate capital to back their OTC derivatives trading business. C r e at i ng t h e Housi ng Bu bbl e Several interrelated components of the social structure created incentives for adventure capitalists in the FIRE sector to engage in behaviors that contributed to the housing market bubble. Although banks had sold mortgages to Fannie Mae since the 1930s, the 2000 legislation resulted in rapid growth in private-label MBS and CDS markets as bank conglomerates, investment banks, and financial services firms became participants in this largely unregulated market. After FIRE-sector firms entered this market, the percentage of home loan originations by Fannie and Freddie declined from approximately 50 percent of the market in 2002 to 30 percent in 2005. FIRE-sector firms packaged home mortgages into MBSs and sold securities in them. A parallel process occurred in commercial real estate: whereas the steady increase in real estate valuations created incentives for banks to sell commercial mortgages, the expanding commercial MBS market provided a means to unload these “large, risky loans” (Johnson and Kwak 2010, 129). Another source of risk in the unregulated private-label securities market was the expansion of subprime mortgages. As housing prices increased and median family income remained relatively stable, many consumers who qualified under traditional lending standards had purchased homes by 2003–2004. However, the demand for MBSs remained strong, meaning that there was money to be made at all stages in the financialization commodities chain, including fees to brokers selling mortgage loans, small banks buying loans and selling them, and investment banks underwriting loans. In the absence of oversight, mortgage underwriting standards rapidly deteriorated. Risk was increased even more by firms that implemented automated loan approvals to speed up the underwriting process. Additional risks emerged as adjustable rate mortgages became more widely used. In many cases, lenders engaged in “willful disregard” for borrowers’ ability to repay the loan; in 2005, 68 percent of adjustable rate mortgage loans originated with two of the largest lenders, Countrywide Financial and Washington Mutual, which required little or no documentation to 125

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support borrowers’ capacity to repay the loan (Financial Crisis Inquiry Commission 2011). Although the financial crisis is often characterized as a subprime mortgage crisis, this narrative is inaccurate. Clearly the subprime market expanded as disclosure requirements declined under the revised Truth in Lending Act and financial incentives prompted brokers to sell mortgages to applicants they knew were unlikely to be able to make their payments (Bitner 2008). However, many middle- and upper-middle-class buyers knowingly made decisions to purchase homes that they could not afford. These buyers assumed that housing values would continue to increase in value. In fact, many middle- and upper-middle-class homeowners bought a home and sold it at a profit before interest rates increased on their adjustable-rate mortgages and then repeated this process (Financial Crisis Inquiry Commission 2011). Although the increase in foreclosures occurred first in the subprime market, foreclosures in the prime market quickly exceeded the number of subprime foreclosures (Ferreira and Gyourko 2011). The underlying problem was not the consumers. The problem was how the home mortgage market was restructured and the incentives for corporations and financial managers and brokers operating in this market. Specifically, prior to re-regulation, financial organizations such as banks and S&Ls had an interest in the creditworthiness of borrowers because defaults weakened banks’ balance sheets. However, with the expansion of the securitization market, where mortgages are sold to other firms, investors’ capacity to repay the loan was no longer a problem for the mortgage broker or loan originator. With risks passed on to other organizations, and ultimately investors, high profits for the bank and bonuses for financial managers created incentives to expand the market. The FIRE sector captured a large share of the MBS market because it had the human capital to carve MBSs into tranches with different risk levels that appealed to investors with different risk tolerances (Johnson and Kwak 2010, 124). The FIRE sector also had the social capital with their access to a large network of investors to sell these securities. Although the risk of securities in different tranches varied, rating agencies tended 126

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to overrate most tranches because they continued to assume that the value of the underlying commodities, the home mortgages, would continue to increase as they had for the past seventy years. FIRE-sector firms were able to sell tranches to large and small investors throughout the global economy as investors assumed that the AAA rating was accurate. These investors included other banks, corporations, mutual funds, pension funds, foreign governments, municipalities, school districts, and individuals. The housing bubble overlapped with consolidation within the FIRE sector where parent companies pursued mergers and acquisitions to gain access to more markets and advance their capital accumulation opportunities. However, this strategy concentrated risk into fewer giant parent companies. To illustrate, firms that invested in commercial real estate acquired real estate investment trusts (REITs), which compounded the risk carried by the parent company. Risk increased even more in 2004 when a coalition of corporations succeeded in convincing the SEC to permit them to value some balance sheet assets themselves. This regulatory change no longer required corporations to mark assets to the market, which created an opportunity for management, hoping that the market would change in their favor, to falsify balance sheets and financial statements (Lenzner 2012). This decision represented the continued faith in neoliberal ideology and market fundamentalism, which assumed that market signals would generate behavior to protect firms’ equity and shareholder value. Prior to the emergence of neoliberal political-legal arrangements, banks’ balance sheets were not particularly transparent. However, because interest rates on mortgages did not vary substantially over time and defaults were relatively predictable, loan balances were considered an adequate representation of banks’ financial strength. In contrast, derivatives can “dramatically gain or lose value in seconds,” which reduced the reliability of balance sheets as measures of corporations’ financial stability (Steinherr 2000, 203). Moreover, since MBSs create steady income streams, many FIRE-sector firms kept some MBSs and placed them offbalance-sheet, which created an even higher risk. With the possible exception of the Federal Reserve Bank, which continued to be unconcerned with the risk of off-balance-sheet financing and repeatedly reported that 127

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risk levels were manageable, few people knew the amount of MBSs that banks held in off-balance-sheet entities. Despite these risks, virtually no countervailing political-legal arrangements were enacted to monitor these markets. Although FIREand energy-sector corporations developed complex financial models to structure derivatives contracts, the core problem remained: it was difficult to predict the future value of the underlying commodity. Despite these flaws, neoliberal advocates continued to have faith in OTC derivatives. This unjustified optimism accelerated after 1993 when financial intermediation services (FISIM) were counted as value production. Because this modification of how to calculate value production increased GDP, it contributed to the incorrect belief in a healthy FIRE sector. The Basel Accords: International Regulations on Financial Risk As financial markets became increasingly globalized, representatives of ten central banks formed the Basel Committee on Banking Supervision in 1974 to establish recommendations to limit risk in global financial markets. The first Basel Accord, dubbed Basel I, occurred in 1988 to set minimum capital requirements for banks to ensure that they had sufficient capital to avert a crisis. Basel I focused on credit risk and risk-rated assets. The risk formula had five tiers of capital and recommended a percentage of assets in each category based on their risk. To illustrate, Basel I recommended that banks hold a limited percentage of securitized assets such as MBSs. It also recommended that banks with an international presence hold capital equivalent to 8 percent of their risk-rated assets, report off-balance-sheet items including derivatives, and factor derivatives into their risk-weighted assets. Banks were required to submit reports listing the assets in each tier to their respective central bank. In the United States, that was the Federal Reserve Bank for banking holding companies and the Office of the Comptroller for other types of banks. Rapid expansion of global financial markets prompted the Basel Committee to revisit Basel I, and in 2004, it announced Basel II, which amended the amount of capital necessary for banks to hold in relationship to the risk associated with their assets. A core characteristic of Basel II 128

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is how banks established minimum capital requirements. Whereas Basel I established a formula for banks, Basel II provided banks with greater flexibility by permitting them to develop their own risk measurement. Although Basel II included a more refined measure of risk categories (e.g., systemic risk, pension risk, liquidity risk, legal risk), allowing banks to establish their own risk measurement, permitted bank managers to lower their minimum capital requirements. Basel regulators were influenced by neoliberal ideology as they assumed that banks would not underestimate their risk because market participants (e.g., customers) would select banks that better managed their risk and punish those that had lax risk management controls. This component of Basel II incorrectly assumed the neoliberal markets supplied adequate information to ensure that customers could make informed decision when selecting a bank. Implementing Basel II was hampered by cross-national cultural differences, banking structures, and domestic bank policies and regulations. Regulators from ninety-five countries stated that they planned to implement Basel II by 2015. In June 2007, concerned over the slow pace of implementation, Shelia Blair, US FDIC chair, warned: There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent. The fact is that banks do benefit from implicit and explicit government safety nets. . . . Without proper capital regulations, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real . . . as we saw with the US banking and S&L crisis in the late 1980s and 1990s. (Blair 2007)

Despite Blair’s warning, inadequate pressure was placed on banks to adhere to Basel II’s capital requirements. Blair’s prediction became reality in 2007 when the first signs of the financial crisis emerged and in 2008 when the US government bailed out banks with taxpayer dollars. The first major signs of the pending crisis occurred in June 2007 when Bear Stearns transferred $1.6 billion to bolster the financial position of its hedge funds that invested in the subprime housing market. In the 129

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following month, Bear Stearns’s asset management group reported that it’s High-Grade Structured Credit Fund lost more than 90 percent of its value and another hedge fund, its High-Grade Structured Credit Enhanced Leveraged Fund, lost virtually all of its investors’ capital. The collapse of these hedge funds occurred approximately a month after Blair’s warning. The Spread of Structured Financing, Securitization, and Special-Purpose Entities in Nonbanks Despite warnings from multiple sources, the FIRE power bloc did nothing to stabilize the high-risk markets they created. Financialization increased incrementally in the 1970s when additional property rights were allocated to Freddie Mac and in the 1980s when manufacturing firms were permitted to securitize physical assets and place them in off-balance-sheet entities. It then rapidly accelerated in the 1990s after virtually all banks and nonbanks were given the right to participate in a wide range of financial markets. Growth in this market continued as nonbank parent companies used the multilayer-subsidiary form to reconfigure their structures by creating subsidiaries to participate in the market. In addition to rapid expansion of GE Capital into this market, by 2005, General Motors Acceptance Corporation (GMAC), which was created to provide financing for GM customers, generated 80 percent of the parent company’s revenues (Blackburn 2006). The percentage of corporate profits from financialization rapidly increased from 12 percent to 39 percent between 1981 and 2001 (Brenner 2004, 76; Phillips 2002). Although derivatives, which are based on the value of an underlying commodity, were the centerpiece of this market, they were also the primary mechanism for expanding structured financing and securitization. Structured finance creates financial instruments to transfer risk to another corporate entity, and securitization entails bundling income-producing instruments that can be turned into tradable securities. By the late 1990s, financialization had become so lucrative that the investment bank Donaldson, Lufkin & Jenrette raided Citibank to hire financial managers with human capital in structured financing so it could obtain a larger share of this lucrative market. Later, Donaldson was acquired by Credit Suisse to expand its business in structured finance (McGeehan 2002). 130

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By 2001, after acquiring the necessary human capital, investment banks provided more than half of the financing to US nonfinancial firms (US Government Accountability Office 2003, 7). Rather than increasing transparency as neoliberals claimed, neoliberal financialization did the opposite: secrecy became the norm. As the FASB (see chapter 2) warned in 1959, special-purpose entities (SPEs) and special-purpose vehicles (SPV) are mechanisms to hide corporate finances from oversight agencies and the public (Powers et al. 2002, 38). These organizational entities can take the legal form of subsidiaries, partnerships, or trusts that are often located offshore, where they are virtually impossible for the oversight agencies and the public to access, even if they are held by a public corporation. They are also extremely flexible and can be co-owned by the parent company and other corporations or individuals (Levitt 2002; Johnston 2003; Gladwell 2007). To maximize profits from derivative markets, adventure capitalists and their financial managers securitized more and more speculative and high-risk assets within increasingly complex financial instruments including swaps: derivative contracts in which two parties exchange financial instruments. Swaps became widespread in the 1990s for hedging or speculating on a wide range of assets that entail cash flow between the parties to the swap. Typically the principal asset is fixed and not transferred, while the other is variable. One type of swap, for example, is a fixed amount of capital hedged against floating currency exchange rates. The first party in the swap issues a ten-year loan or bond at a set interest rate, but this entails a risk because the lender must borrow capital based on floating currency exchange rates. To limit this risk, the first party finds a second party willing to bet or hedge the risk. The first party pays the second party a fixed rate of interest on the bond balance to assume the risk, and the second party agrees to pay a set interest rate plus 1 percent on the principal. If floating currency exchange rates increase, the first party benefits; if rates drop, the second party benefits. In short, swaps are fictitious commodities that bet on future price shifts. Given that they are OTC contracts that are not traded on exchanges, they are removed from government oversight even though they may have a large effect on corporate balance sheets. 131

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E x e rcisi ng Pol i t ic a l Pow e r to E rode Ov e rsigh t of Fi na nci a l M a r k ets As corporate structures became increasingly complex and financial markets expanded, the US political economy spread risk to more spheres of society. By the late 1990s, the working and middle classes placed more of their wealth in retirement and other mutual funds, fund managers invested this wealth in corporate securities, and corporations made greater use of off-balance-sheet financing. The increased systemic risk did not go unnoticed. Attempts to Limit Risk To make corporate finances more transparent, FASB made several attempts to regulate financial markets. Although this effort was met with opposition from the FIRE-sector power bloc and their supporters in Congress (Levitt 2002, 140), regulators succeeded in implementing a rule that required corporations to obtain 3 percent of the capital that is at risk in an SPE from a source independent from the parent company and its subsidiary corporations (Levitt 2002; Partnoy 2004,174). The 3 percent rule assumed that this level of investment was sufficient to ensure that the third-party partner made decisions that represented the business interest of the partnership. It also meant that 97 percent of the capital in an SPE could be debt not reported on corporate balance sheets (Levitt 2002). The 3 percent rule was an arbitrary standard with no evidence to support that it would result in adequate financial oversight. Thus, there is no way to know whether the changing value of assets held in the partnership would be reflected in the corporation’s balance sheets. As off-balance-sheet financing spread, FASB created rule FAS 125 in 1996 to make corporations more transparent. This rule specified the distinction between “transfers of financial assets that are sales from transfers that are secured borrowings” (Financial Accounting Standards Board, 1996, 2003). Entities that did not follow these rules were not eligible for offbalance-sheet treatment and were required to be reported on the parent company’s consolidated financial statement.

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A Lost Opportunity to Regulate Offshore Banks and Tax Havens During the 1990s, SPEs became more common as parent companies made greater use of international banking laws permitting corporations to hold complex financial instruments in offshore subsidiaries, partnerships, and trusts. The primary purpose of placing these entities offshore is to circumvent tax laws. Although the Cayman Islands are well known for permitting capital transfers to offshore corporate entities, many countries set up banks with few disclosure requirements in order to enter the lucrative international banking business. The lack of regulation over capital transfers to offshore banks is important because together with the increased use of structured financing, it became easier for corporations to conceal the contractual agreements defining financial responsibility in these financial instruments. These organizational and political-legal arrangements created more information asymmetry among affected parties. Whereas the financial managers who created them knew the details of these complex contracts, investors and oversight agencies had little or no information on them. For decades, the IRS had had little success in pursuing individuals and corporations that evaded taxes by using offshore tax and bank havens. However, an opportunity to revise international banking arrangements governing offshore entities emerged when a national security issue arose following the 1997 Asian financial crisis and the 1998 attacks by Osama bin Laden on US embassies in Kenya and Tanzania. With the support of several multilateral organizations, including the International Monetary Fund, the Organization for Economic Cooperation and Development, and the Financial Action Task Force, President Clinton presented a plan at the July 2000 G-7 summit to bring nations permitting tax and bank havens into compliance with G-7 countries’ banking transparency standards. This initiative ended with the election of George W. Bush as president, whose administration argued that the Clinton proposal was, according to Treasury Secretary Paul O’Neill, “too broad and . . . not in line with [the new administration’s] tax and economic priorities” (Wechsler 2001, 56). Although the Bush administration developed an alternative plan, it had little effect on international capital transfers; wealthy individuals 133

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and corporations continued to place corporate entities in offshore banks, concealing their finances from government oversight agencies, investors, and creditors. Fund Cuts to Government Oversight Organizations In addition to shifting corporations to the disembedded end of the politically embedded-disembedded continuum that permitted them to increase their size and gain structural and financial flexibility and greater control over markets, corporations continued to engage in political capitalism and successfully pressured the executive branch and Congress to reduce government oversight. Although this process began during the Carter administration, the Reagan administration imposed deep cuts in the budgets of the SEC and other regulatory agencies precisely when it required more resources to oversee larger and more complex corporate structures, further decoupling corporations from government oversight. The increased size and complexity occurred in both nonfinancial and financial corporations. To illustrate, Enron owned at least 20 percent of the stock in fifty other companies that were required to file separately with the SEC. In addition, Enron’s 2000 Form 10-K lists more than fifty pages of affiliate corporations, many of them not consolidated into its balance sheet (US Congress 2002b, 35). Like most other large corporations organized as an MLSF, Enron also acquired or created foreign corporate entities to enact its globalization strategy. FIRE-sector firms also increased their size and complexity. By 2006, Citigroup held 1,513 domestic and international corporate entities that were diversified in most parts of the FIRE sector globally and domestically. Citigroup consisted of at least one commercial bank, cooperative bank, credit union, financial holding company, holding company, industrial bank, insurance company, underwriter, nondepository trust company, savings bank, savings and loan association, securities broker/dealer/ underwriter, farm credit organization, savings and loan holding company, and edge corporation (a subsidiary engaged in foreign banking). Many of these entities were structured as subsidiaries, but others were structured as limited partnerships, limited liability partnerships, or trusts (Tavakoli 2003). The various components of this complex corporate structure 134

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continued to be regulated by the patchwork of oversight agencies, with no single agency overseeing the entire corporation. Although Enron and Citigroup were among the largest and most complex parent companies in their respective economic sectors, they were not exceptions. By 2004, 84.7 percent of the 2002 Fortune 500 parent companies were structured as an MLSF. Although the mean number of subsidiaries was thirty-nine, thirty-seven of these parent companies had more than one hundred subsidiaries that were hierarchically structured in up to eight levels. Another ten of the largest parent companies had more than two hundred subsidiaries, and two had more than three hundred subsidiaries (Prechel and Morris 2010, 335). Subsequent administrations continued to underfund oversight agencies. To illustrate, although corporate filings to the SEC increased by approximately 60 percent and complaints increased by 100 percent between 1991 and 2000, the SEC’s staff increased by only 29 percent and its budget increased by a mere 16 percent (US Government Accountability Office, 2002). Furthermore, more than three hundred companies went public during the 1990s stock market boom (Creswell 2006). Because many of them were Internet companies, which are considered high risk, the SEC placed a high priority on monitoring their IPOs. As a result, it delayed its routine three-year review of more established large companies (those with more than $250 million in assets) and did not conduct routine annual reviews of giant corporations such as Enron. The IRS’s monitoring and enforcement capability declined even more than the SEC’s. The IRS is responsible for monitoring more than 5 million corporations that file tax returns annually. Congressional cuts to its budget resulted in a drop in full-time IRS employees from 113,028 in 1992 to 82,495 in 2003. During this same period, the FIRE sector expanded to become the second largest economic sector behind manufacturing. Although malfeasance is highest in growth segments of the economy, the audit rate for the financial services sector was only 16 percent. This sector had at least 1,210 corporations with $2.5 billion or more in assets. If all of the IRS’s auditors had been assigned to just these large corporations, there would be too few employees to audit them (Transactional Records Access Clearinghouse 2005). Audits of businesses that held more than 135

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$250 million in assets, which received 87 percent of the income and controlled 90 percent of the assets in the economy, dropped from 54.63 percent in 1992 to 28.98 percent in 2003 (Transactional Records Access Clearinghouse 2005). Also, despite the increased use of pass-through entities such as partnerships that hold capital and do not pay corporate taxes, the IRS’s audit rate of these business entities declined from 5.1 percent in 1992 to 3.2 percent in 2003. By 2002, the increased size and complexity of the corporation required IRS employees to spend more than a thousand hours on average auditing a single corporation (Transactional Records Access Clearinghouse 2006). Even when IRS auditors find violations, they can be overturned. For example, an IRS auditor discovered that in 1993 and 1994 Enron had made false financial reports to the SEC that inflated its profits. When Enron appealed the case, the IRS appeals officer supported the auditor. However, a higher-level official in the IRS overturned the decision of the appeals officer. Moreover, the privacy clauses in tax law prohibit IRS employees from reporting their finding to other government oversight agencies. As a result, the investing public and the SEC were not made aware of this investigation (Johnston 2003, 174). To decouple corporations even more from oversight, the 1998 IRS Restructuring and Reform Act contained a provision that mandated firing IRS employees who were found guilty of making false allegations against taxpayers. Predictably, audits initiated by IRS employees declined after this legislation was passed (Johnston 2003, 175). Conflicts of Interest and Structural Holes: Accounting Firms, Investment Banks, and Rating Agencies Because opportunism exists in markets, nongovernmental intermediaries between corporations and markets (e.g., auditors, lawyers, stock analysts) exist to filter, verify, and evaluate complex financial information (Coffee 2004, 127). The relationship between corporations and these intermediary organizations changed in the 1990s in ways that created incentives to engage in or condone financial malfeasance. The incentives to overlook malfeasance were particularly high for the large public accounting firms. Historically, accounting firms function 136

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as external auditors responsible to ensure that corporations follow generally accepted accounting principles (GAAP) and provide accurate and transparent financial statements to the investing public. This changed with neoliberal financialization when accounting firms increased their corporate consulting services in order to benefit from the lucrative business associated with the rapid increase in corporate restructuring as MLSFs, mergers and acquisitions, and a wide range of financial transactions, including underwriting stock and bond offerings and off-balance-sheet financing. Between 1993 and 1999, when re-regulation was in full swing, revenues for management consulting services by external auditors grew 26 percent annually, in part because there were no restrictions on providing auditing and consulting services to the same firm. By 2000, management consulting revenues reached $6 billion, doubling the $3 billion for auditing services (Bogle 2005, 34). As audit firms became more resource dependent on consulting fees, incentives emerged to overlook accounting practices that did not conform to GAAP as a critical external audit of a firm could jeopardize access to their lucrative consulting business. To eliminate this conflict of interest and ensure auditor independence, Arthur Levitt, chairman of the SEC, proposed in 1998 that Congress pass a rule prohibiting accounting firms from doing auditing and consulting business for the same firm. Levitt held meetings with the largest accounting firms to convince them of the importance of separating these two business, but they rejected the proposal, arguing that organizing these product lines as separate corporate entities provided effective internal firewalls between their auditing and consulting businesses. For example, in 1988, Arthur Andersen restructured as an auditing and tax business, Arthur Andersen, and Andersen Consulting organized as subsidiaries under the parent company, Andersen Worldwide, a private limited liability partnership. Levitt, however, was not convinced and continued to press for this regulatory change. The Big Five accounting firms responded by exercising their instrumental power: they launched a well-financed lobby effort and contributed $14.5 million during the 2000 election cycle to political parties and members of the House and Senate. Opposition quickly emerged in both the House and the Senate to the SEC’s proposal. Some members of 137

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Congress began to prepare an appropriations rider that prohibited the SEC from using its funding “to implement and enforce the rule” (Levitt 2002, 132). Others threatened to cut the SEC’s budget and deny Levitt’s request to increase salaries to keep qualified attorneys at the SEC. Threatened with the possibility of a reduction in the SEC’s enforcement capability, Levitt acquiesced. The final ruling was adopted in November 2000. The failure to close this structural hole perpetuated a social structure with conflicts of interest that benefited accounting firms for overlooking corporate financial malfeasance. Although the SEC failed to prohibit accounting firms from providing auditing and consulting services to the same corporate client, it limited the big accounting firms “to perform[ing] up to 40% of a company’s internal audit work” (Levitt 2002, 138). The SEC also succeeded in requiring client firms to reveal non-audit revenues on their annual proxy statement, information that allows investors to judge for themselves whether conflicts of interest exist. Conflicts of interests also existed between investment banks and corporations. Historically, investment banks provided loans and underwriting services on securities issuances (i.e., stocks, bonds), corporate restructuring, and advice on mergers and acquisitions. With neoliberal financialization, investment banks began to advise corporations on a wide range of financial products, including how to develop financial instruments to cope with firms’ capital needs such as off-balance-sheet financing (US Government Accountability Office 2003, 8–9). Whereas corporations were dependent on investment banks for these financial products and services, investment banks became dependent on the lucrative fees and commissions for providing them. As described in the following chapter in more detail, this resource-dependent relationship created conflicts of interest where investment bankers were incentivized to overlook the rules permitting off-balance-sheet financing. Neoliberal organizational and political-legal arrangements also created conflicts of interest between corporations and securities rating agencies. As described in chapter 2, from the time the securities rating system was established in 1900 until the 1970s, investors paid securities rating agencies. However, in the 1970s, issuers of securities began to 138

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pay securities rating agencies (Lavelle 2013, 181). This arrangement created conflicts of interest and incentives for corporations to terminate contracts with the rating agency that gave them low securities ratings and replace them with an agency that might give them higher ratings. The shift to neoliberal financialization exacerbated this conflict of interest as corporations began to use more high-risk financial instruments. Dependent on resources for revenues, rating agencies shifted from protectors of financial markets to sanctioning MBSs derived from high-risk assets, thereby creating misinformation for investors. Conflicts of interest on this neoliberal social frontier became more extreme over time as corporations became more dependent on resources held in other organizations (e.g., financing, human capital) and decoupled from regulatory oversight. Transformative Changes in the Social Structure The long-term engagement in political capitalism by big business resulted in five interrelated transformative changes during the decay-exploration period of the financial social structure of accumulation that empowered the managerial class to engage in speculative behavior. The first occurred between the mid-1970s and the mid-1980s when the still-dominant manufacturing power bloc pressured the federal government to provide it with massive tax cuts. Among the most important was the 1986 tax policy eliminating the capital transfer tax. This legislation was followed by a rapid transformation to the MLSF that permitted capital transfers among corporate entities under parent company control with no mechanisms for regulations to monitor the flow of capital among them. This period also entailed the acceleration of the revolving door between big business and government, providing former business executives with more opportunities to influence government policy. The second transformative change accelerated socializing capital. Although many observers maintained that there was a shortage of investment capital in the 1970s and early 1980s, this assumption is incorrect. There was adequate capital in the US economy due to legislation in the 1970s, 1980s, and 1990s that had created incentives for the working and middle classes to invest in retirement and other mutual funds. The 139

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problem confronting corporate America was that the prevailing MDF did not provide a means to access this capital because divisions are not legally independent entities and therefore cannot issue securities. Their solution was to pressure the federal government to enact legislation that permitted use of the MLSF.3 Beginning in the 1990s, the Federal Reserve’s low-interest-rate policies created additional incentives for the working and middle classes to shift their saving to mutual funds, where institutional investors invested it in corporations and high-risk financial instruments. However, the risk level in these instruments was unknown given the neoliberal political-legal arrangements, The third transformative change redefined the rules governing securitization and the use of off-balance-sheet entities. The initial expansion of off-balance-sheet financing occurred in the 1980s in the manufacturing sector, where tax breaks were so massive that corporations could not use them all. Once regulators approved this form of securitization, it quickly spread to other economic sectors, and by the 1990s, securitization was widespread in corporate America. Placing securitized assets off-balance-sheet created additional opportunities for managers to mislead the investing public because this mechanism created opportunities to give the impression that a corporation’s balance sheet was strong when it was not. Further, as I show in the following chapter, many assets that were placed off-balance-sheet were not passive. The fourth transformation change included dismantling the GlassSteagall Act, the Holding Company Act of 1956, and related changes permitting commercial and investment banks, insurance companies, and real estate firms to merge and create the FIRE sector. The fifth transformative change entails the struggle between corporate and political elites over whether energy and FIRE-sector firms should be permitted to engage in OTC derivatives trading. This political coalition employed neoliberal ideology to argue that the regulatory structure undermined market efficiency and restricted innovation. The first major victory occurred in 1992 when the energy sector convinced the CFTC to remove energy derivatives trading from its jurisdiction. As in other policy arenas, the managerial class used this policy to legitimate future policy initiatives to further extend corporate property rights. In the late 140

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1990s, when Congress was due to reauthorize the Commodity Exchange Act of 1936, the energy sector viewed this as an opportunity to make their property right to trade derivatives permanent. The FIRE sector joined energy and argued that cumbersome regulations undermined their capacity to compete with foreign banks in the expanding global derivatives market. The convergence of the economic interests of these class fractions created a powerful and well-financed political coalition with the shared objective to make OTC derivatives trading difficult for a new administration to reverse. Their efforts succeeded in 2000 when Congress enacted the Commodity Futures Modernization Act, further legitimating high-risk financialization. This political victory signified that the FIRE sector was the new dominant power bloc. Political capitalism extended beyond the energy and FIRE sectors. When other class fractions (e.g., manufacturing, retail) recognized the capital accumulation opportunities in neoliberal financialization, they created financial subsidiaries to advance their capital accumulation agendas. This new social structure of accumulation blurred the lines between finance and other economic sectors as most sectors supported changes to policies and laws that permitted nonbanks to participate in speculative financial markets. The sixth transformative change created the managerial class, where top managers owned a large share of securities in the corporations they managed. This transformation of management into substantial owners was an outcome of a shift in executive compensation to stocks and stock options. The primary drivers of this change were large individual and institutional investors who proposed making greater use of stock options as executive compensation to incentivize management to increase shareholder value. After initially resisting this change, management soon realized that they could benefit and increased the use of stock options. As re-regulation created more opportunities for the managerial class to engage in high-risk behaviors, stock options created perverse incentives for managers to pursue high-risk strategies to increase their own income and wealth while placing the public’s capital at risk. Neoliberal politicallegal arrangements contributed to risk by permitting the FIRE and energy sectors to establish their own risk-level standards on complex financial 141

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instruments and operate derivative exchanges inside the corporation that were largely free of government regulation and removed from public scrutiny. As in other economic sectors (Prechel 1991, 2000), these changes in corporate-state relations created a more prominent and less autonomous state where government policies and laws are congealed in a larger and more complex organizational state. While the expanded organizational state makes it more prominent, the state becomes less autonomous as the larger and more complex structure creates more access points and opportunities for capitalist class fractions to contact government bureaucrats and lobby them to redefine corporate-state relations in ways that advance their capital accumulation agendas. The transformation of corporate-state relations has important consequences. The power of the managerial class increased to unprecedented levels in the late twentieth century and has continued into this century (chapter 8). While the managerial class advances the neoliberal agenda that champions the efficiency of markets and the inefficiency of government oversight, the emergent social structure has created information asymmetry by burying decision making deep inside complex corporate structures and concealing risk from the investing public. By juxtaposing ideology (the ideal) with the concrete organizational and political-legal structures (the real), the analysis shows that the managerial class misled the investing public. As the case studies in the following chapter show, neoliberal financial markets do not distribute the kind of information or create the level of transparency that its advocates claim they do. Instead, neoliberal social structures bury crucial information deep inside the corporation, thereby permitting the managerial class to exploit information asymmetry to advance their interests, including shifting risk from corporations to investors, especially the class of assets held by the working and middle classes.

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chapter 5

Creating Risk, Engaging in Financial Malfeasance, and Crisis In response to questions by the US Senate’s investigation into Enron’s financial malfeasance in 2002, Jeffrey Skilling’s response is remarkably similar to Samuel Insull’s response to comparable allegations after the 1934 failure of Middle West Utilities (see chapter 2): I believe the financial statements were an accurate representation of my understanding of the financial condition of the company. . . . This chart shows exactly, exactly what the total amount of the outstanding liabilities were that were non-consolidated liabilities—it’s not—it was in the 10-K. Anyone reading the 10-K would have a hard time missing this page. (US Senate, Commerce Committee, 2002)

Both managers denied breaking the law in their capacity as top executives of large, complex corporations with multiple subsidiaries, subsidiary layers, and other corporate entities. In both cases, the public entrusted their money with managers who used it to engage in high-risk behavior to their own benefit and maintained that the system permitted them to engage in these behaviors. Despite these similarities, one important distinction exists. In the aftermath of the collapse of Insull’s Middle West Utilities and many other corporations and banks, in response to public distrust of business leaders, regulatory structures were established to limit and monitor their risktaking behavior. However, by the end of the 1990s, business leaders had succeeded in dismantling many financial regulatory safeguards. This chapter represents a shift in focus from corporate political behavior to an examination of how the emerging organizational and political-legal arrangements permitted corporate managers to make decisions deep inside the corporation to engage in risky and deceitful behaviors. It also examines how investment banks and corporations colluded, to their mutual benefit. 143

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These case studies of energy and financial corporations illustrate the organizational and interorganizational mechanisms that perpetuated financial malfeasance. They expose how corporations and investment banks cooperated with each other to exploit structural holes in their organizational and political-legal arrangements. Corporate managers bridged these structural holes to benefit their corporations and themselves at the expense of the public. The analysis shows that the complex and interconnected system of capitalism cannot be understood by examining only part of the system. Shifting the focus to the internal life of corporations and their resource-dependent relations with other organizations illuminates how the MLSF enables managers to hide risk and financial malfeasance. Explicit within this framework is the embeddedness of social actors in social structures. Thus, social action and social structure must be examined together. The core proposition maintains that the prevailing organizational and political-legal arrangements created a constellation of motives, incentives, and opportunities for managers to advance their interests by engaging in financial malfeasance. Social actors benefit by directly extracting resources for themselves and indirectly through promotions or salary increases they receive for advancing corporations’ capital accumulation agendas. Bou n ded R at iona l i t y a n d G at ek e epe rs This chapter demonstrates how structural holes are created when oversight agencies are replaced with a purported efficient market that fails to transmit crucial information to all participants affected by a transaction. Structural holes create opportunities for managers to engage in illegitimate behaviors that include capital transfers among corporate entities that conceal losses or place high-risk financial instruments in corporate entities intended to hold low-risk assets. Absent information on capital transfers, neither investors nor oversight agencies accurately understand corporations’ financial condition. The analysis exposes a crucial flaw in neoliberal ideology: when structural holes exist, adherence to laws and rules (or their intent) is dependent on trust, with no guarantee that trust ensures compliance. FIRE-sector chief financial officers and other financial managers are positioned to bridge structural holes and act as gatekeepers: social actors 144

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who control access to resources and benefits they do not own (Corra and Willer 2002, 182). As gatekeepers, chief financial officers have opportunities to skim capital from the corporation to enrich themselves and hide debt from oversight agencies and the investing public for three reasons: (1) they know how to create complex financial instruments; (2) their position in the social structure provides them with opportunities to expand their social capital and establish relationships with unconnected social actors (e.g., managers in investment banks) who control valued resources (i.e., capital); and (3) they know how to use financial instruments that the investing public doesn’t understand or even know about. These conditions create opportunities for managers to exploit structural holes. The case studies of Enron and the energy industry and FIRE-sector corporations show how managers cooperated to exploit structural holes in the organizational and political-legal arrangements to benefit themselves and corporations at the expense of the public. T h e E n ron C a se Researchers often ask the extent to which a case is typical and generalizable. However, although resemblance and generalizability are important, the emphasis on these issues ignores a crucial aspect of the case study method. The primary value of a case study is not in its generalizability but its capacity to determine whether a phenomenon resembles or differs from prevailing conceptions of the empirical world and why those resemblances or differences are theoretically important. Atypical cases show that a social change occurred or that existing theory failed to direct researchers’ attention toward the phenomenon (Prechel 1994, 728). After researchers identify key variables for atypical cases, they can employ quantitative analysis to test whether those characteristics and relationships exist in a large number of other cases. After political and economic elites dismissed the Enron and other corporate failures in the early 2000s as caused by a “few bad apples,” these financial breakdowns quickly became a fading memory. This is unfortunate because FIRE-sector managers aided Enron managers’ financial malfeasance and used many of the same high-risk financial instruments developed at Enron to create the much larger 2008 financial crisis. 145

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Enron is worthy of a case study in its own right for a number of reasons. As one of the first large nonbank corporations to make extensive use of high-risk financial instruments and morph into a nonbank financial corporation, it is atypical. Like the steel company described in chapter 2, soon after the multilayer-subsidiary form (MLSF) became viable in 1986, Enron changed to this structure. Although most US corporations adopted the MLSF form, little is known about how this corporate form structured corporate entities to conceal risk and malfeasance from oversight agencies and the investing public. Enron’s top management fully embraced neoliberal ideology and used it to guide their corporation strategy. Ken Lay, Enron’s CEO, began to develop a strategy to create a lightly regulated market for natural gas in the early 1970s (chapter 4). Jeffrey Skilling, who became Enron’s president, was a long-term believer in neoliberal free markets and viewed financialization as a breakthrough capital accumulation strategy. Skilling ridiculed rules designed to control corporate behavior and characterized corporations that produced physical commodities as dinosaurs. At Enron, he used his human and social capital to transform the parent company into an asset-light flexible entity capable of creating markets. The endorsement of Enron’s market-creating strategies and structures by organizations in their environment legitimated these behaviors. For example, for six consecutive years (1995–2000), Enron was named the most innovative company in America by Fortune Magazine. In addition, Andrew Fastow, the primary architect of financialization at Enron, was awarded the Professional Excellence Award from CFO Magazine for his innovative management. These legitimating organizations contributed to Enron’s capacity to establish an imprint (Stinchcombe 1965) that other energy companies copied. Enron also created incentives for other companies to enter this market and set up similar trading strategies and financial structures. Because Enron was the first company to enter the energy derivatives market on a large scale, it had a significant influence on creating the rules for trading energy derivatives. Its success at increasing its stock value also motivated corporations outside its immediate organizational field to mimic its strategy and structure, contributing to isomorphism in corporate America. 146

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The rapid rate of change at Enron makes it easier to observe transformations in its strategy and structure. Changes that occur over a long period are more difficult to observe, and the time needed to complete such research often makes it infeasible. By contrast, Enron’s strategy to create retail energy markets occurred over a short time that was accelerated after Skilling was hired in 1990. By 2000, Enron traded more derivatives than tangible assets (e.g., natural gas) and functioned more like a financial trading company than an energy company. Multiple congressional investigations of Enron, court cases, and other legal proceedings provide a rich archive of historical documents to reconstruct Enron’s strategy and structure. These documents have a high degree of validity and reliability; the internal corporate documents describe the decisions and capital transfers that occurred deep inside the corporation. Of particular interest are the detailed descriptions of Enron’s off-balance-sheet special-purpose entities (SPEs). I selected the SPEs examined in this chapter from Enron’s approximately four thousand SPEs because many were so complex that it is virtually impossible to follow the trail of capital and risk transfers (Powers, Troubh, and Winokur 2002). The capital transfers among the selected SPEs are well documented because they were a central part of the US Justice Department’s prosecution of Enron’s managers and three British investment bankers. The financial and legal documents that the federal government used to build its case against Enron’s managers were also thoroughly scrutinized by the defense team. Furthermore, the depositions of defendants and witnesses were taken under oath, which, by law, are considered to be truth. These documents make it possible to examine how Enron transformed itself from a regional pipeline company into the seventh largest US corporation and the darling of Wall Street with steadily rising stock values even as it was rapidly moving toward bankruptcy. The decline of Enron’s stock from its peak to bankruptcy represents a $40 billion to 45 billion loss of investors’ capital, which included many low-salary office workers who lost most of their retirement savings.

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C r e at i ng a Fl e x ibl e , L a rge , a n d Com pl e x Cor por at e St ruc t u r e Shortly after the political-legal arrangements were reconfigured to permit corporations to use the MLSF, Houston Natural Gas merged with its much larger competitor InterNorth and acquired smaller companies, which it incorporated as subsidiaries (chapter 4). Enron also diversified into broadband, electricity energy production (e.g., it acquired a utility holding company), retail energy trading, and other economic sectors in domestic and international markets (figure 5.1). Enron soon created the largest natural gas pipeline company in the United States with the capacity to purchase, transport, and sell natural gas to customers dispersed over a large geographic region. The MLSF structure permitted top management to increase financial and organizational flexibility in the following ways: • Acquiring or spinning off subsidiary corporations through stock transactions • Lowering the cost of consolidation by permitting the parent company to establish ownership control by owning just over 50 percent of the acquired or merged firm’s stock and incorporating them as legally independent subsidiaries • Retaining managers (i.e., human capital) in the acquired companies who continue to operate the firm as they did prior to consolidation • Establishing more precise financial controls by separating out subsidiaries’ costs and revenues and holding subsidiary management accountable to achieve financial goals set by the parent company • Creating motives and incentives for managers to focus on short-term profits to maximize shareholder value • Creating off-balance-sheet entities to move assets and debt off balance sheet

While Enron’s domestic pipeline operations continued to realize profits, many of its poorly managed foreign subsidiaries became a drain on the parent company’s capital flow. Enron obtained a large share of the capital to invest in developing countries from government agencies such as the Export-Import Bank and the Overseas Private Investment Corporation and big banks by convincing them of future rapid growth in these markets. 148

1 Fourth-Level Subsidiary

1 Third-Level Subsidiary

3 Second-Level Subsidiaries

Enron International Asset Management

1 Second-Level Subsidiary

Enron Broadband Services

Figure 5.1. Enron’s MLSF and Selected Corporate Entities.

1 Third-Level Subsidiary

29 Second-Level Subsidiaries

7 Second-Level Subsidiaries

3 Third-Level Subsidiaries

Enron North America

Enron North America

Off-Balance-Sheet Entities (eg. Partnerships, Subsidiaries, Trusts)*

2 Second-Level Subsidiaries

Enron Energy Services

1 Fifth-Level Subsidiary

7 Fourth-Level Subsidiaries

10 Third-Level Subsidiaries

1 Second-Level Subsidiary

Enron Renewable Energy

Enron’s MLSF and Selected Corporate Entities

Off-Balance-Sheet Partnerships, Subsidiaries, Trusts

Enron Finance

2 Third-Level Subsidiaries

3 Second-Level Subsidiaries

Portland General Electric

7 Second-Level Subsidiaries

Houston Natural Gas

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Foreign investments included energy plants in the Philippines and Dabhol, India, a barge-mounted energy plant in the Dominican Republic, a steel mill in Thailand, a British water company, a private water and sewer utility in Argentina, various projects in China, and a massive 1,875-mile natural gas pipeline from production sites near Santa Cruz, Bolivia, through an endangered rainforest to Porto Alegre, Brazil. As Enron focused on creating markets, it failed to adequately scrutinize some projects and neglected others, resulting in massive cost overruns. To illustrate, the offer to acquire the Argentina utility was three times as high as the next offer. Also, the Dabhol project was halted two years after it started when Enron had already invested $900 million in it. These international operations were organized under Enron’s first-level subsidiary Azurix, which went public in 1999, raising $700 million in its IPO. This IPO was successful because management had concealed the high operating cost of Enron’s foreign operations. Cr e at ing R isks Expanding the natural gas derivatives market entailed several organizational changes at Enron. After Ken Lay hired Skilling in 1990 to develop this market, the entity known as the Gas Bank was renamed Enron Finance. By 1991, this entity was renamed again as Enron Gas Services Group and transformed into a subsidiary with Skilling appointed as its CEO. Enron then created another entity, known as Enron Gas Market, to negotiate trades with customers. Later, to facilitate rapid decision making, Enron Gas Marketing and Enron Finance activities were merged to create Enron Capital and Trade Resources, giving Skilling control over both activities. This subsidiary was located on a separate floor in the Enron building and operated largely independently from the rest of the company, developing its own personnel policies and compensation systems. Skilling’s personnel policies at Enron Capital and Trade Resources included an incentive system that lavishly rewarded traders who closed a large number of deals in a short time period. The policies also included a mechanism to annually dismiss 20 percent of its least productive traders, which created additional incentives for traders—many of them 150

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inexperienced recent MBAs—to close deals. Bonuses were also based on the size of the deals, creating incentives for traders to inflate the deal value. Enron traders negotiated contracts with customers and sent them to risk managers as separate entities. However, these entities did not have an adequate firewall to separate traders from risk assessors, permitting traders to routinely pressure risk-assessment managers to quickly approve contracts. In short, incentives created motives for traders to bridge structural holes between Enron’s trading unit and it risk-assessment unit to benefit themselves. As a result, many derivative contracts lacked financial integrity (Cruver 2002). After management created a structure to finance its trades, Enron had a tremendous advantage in this new market over companies whose customers obtained external financing from banks. Because suppliers were reluctant to make large investments in the volatile natural gas market, Enron also financed many of its suppliers’ operations. Although this structure facilitated rapid decision making, it created additional risks because Enron was on both sides of these deals. That is, it negotiated contracts and financed deals with both suppliers and consumers of natural gas. On the one hand, if a producer failed to deliver natural gas at the agreed-on date, Enron had to purchase gas on the market, which was often more expensive, to keep its agreement with customers. On the other hand, if a consumer failed to purchase natural gas at the agreed-on price, Enron would be stuck with natural gas that it often had to sell below market price. Because these decisions were made deep inside the MLSF with little or no information on them reaching the market where it could be assessed by the public, Enron was considered an overwhelming success. Fifteen years after it was created, it was one of the largest and most complex energy companies in the world with twenty thousand employees and more than $100 billion in reported revenues. The year before management filed for bankruptcy, Enron consisted of 189 domestic subsidiaries, more than 100 foreign subsidiaries, and approximately 4,000 partnerships holding SPEs (Partnoy 2004, 171). It is estimated that Enron had set up almost 700 off-balance-sheet partnerships in offshore bank and tax havens in the Cayman Islands where they avoided taxes and eluded oversight (Gonzalez 151

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2002). Enron’s two top executives, Lay and Skilling, held many of the top managerial positions in its seventy-seven first-level subsidiaries (Dun & Bradstreet 2003). Creating this large and complex corporation required massive amounts of capital. As a result, Enron’s debt level remained high, which kept its stock at the low end of investment grade. During this same time period, institutional investors became increasingly aggressive in pressuring management to maximize shareholder value (MSV). T h e E x pa n sion of S h a d ow B a n k i ng : F i n a n c i n g E n r o n ’s G a s B a n k Skilling realized that the corporation was at the limit of its debt-carrying capacity, and the additional debt required to expand the natural gas derivatives market threatened to downgrade Enron’s stock to junk status, triggering debt repayments. In short, although the natural gas derivatives market was growing, Enron did not have the capital to fully implement this strategy. High-Risk Accounting and Financing: Mark-to-Market Accounting and Securitization Although Enron Capital and Trade Resources captured a large share of the natural gas derivatives market, it required a great deal of financing. However, the parent company already carried a high debt load from its 1985 merger and its rapid expansion into global energy and water markets. Thus, Enron was near the ceiling of this debt-carrying capacity, and additional borrowing could result in a stock devaluation that would trigger a debt payment that it could not pay. To maximize shareholder value, which meant keeping debt off Enron’s balance sheet, Skilling pursued two financialization mechanisms. First, Skilling began to use mark-to-market accounting, which reports sales when a contract is agreed to before any actual payment is made—and it may take years for full payment in the natural gas derivatives market. To compete with Enron on earnings, other large energy companies, including Duke Energy, Reliant Energy, and Enron’s closest rival Dynegy, mimicked this mechanism. This rapid growth in reported earnings made Enron a top 50 Fortune 500 company. 152

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Skilling’s second strategy was to employ structured financing, which was no longer considered an exotic means to raise capital. As described in chapter 2, manufacturing corporations securitized their unused tax breaks and sold them to other firms in the 1980s. Also by 1987, Skilling’s former employer, McKinsey & Company, began to view structured financing as a mechanism to remove debt from corporate balance sheets. Structured financing can take many forms, but securitization is a common one that pools assets or debt and sells securities in the pool and pays investors from the returns on the assets. By the late 1980s, financial services and consulting firms were advising businesses on how to use financial instruments to strengthen their balance sheets, and by the late 1990s, securitization was widely used. Corporations securitized debt, banks securitized credit card loans, states securitized proceeds from tobacco litigation, and composers securitized song royalties (McLean and Elkind 2003, 157). Securitization represents a historical transition from the mid-twentieth century when the primary mechanism to finance firms’ operations was drawing from cash reserves or issuing debt. Although Skilling was not an expert in securitization, his consulting experience at McKinsey had provided him with enough knowledge to realize that this financial tool provides a viable form of off-balance-sheet financing. To fill this human capital deficit, like the capital-dependent steel company described in chapter 2, Skilling sought an investment banker who specialized in structured financing. In 1990, he hired Andrew Fastow, an investment banker at Continental Bank Corp. who advised corporations on how to use structured financing to reduce debt, improve their balance sheets, and solve their capital flow problems. Fastow was one of many managers with expertise in investment banking and other forms of finance whom Enron hired. Skilling’s hiring policies were motivated by his own educational experience of being hired as a graduate of an elite MBA program. Skilling also hired managers previously employed by the major accounting firms and investment banks: the investment bankers provided knowledge on structured finance (e.g., creating off-balance-sheet partnerships), and accountants provided knowledge on how to maneuver through accounting rules and financial reporting requirements. In addition to providing Enron 153

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with the human capital to use financing and accounting instruments, former investment bankers and external auditors now provided the social capital to connect Enron with investment banks and audit firms. Special-Purpose Entity Partnerships and Subsidiaries Enron was one of the first nonbank parent companies to make widespread use of off-balance sheet financing by creating SPE subsidiaries and partnerships to securitize assets and debt. SPE subsidiaries, partnerships, and trusts separate liability from the parent company and have their own assets, liability structure, and legal status intended to make them secure investments even if the parent company goes bankrupt. In some cases, these complex corporate entities required more than a hundred pages of documentation. Although SPEs are lightly regulated, a few accounting rules do apply to them: ownership has to be transferred to the SPE, parent companies cannot compensate investors because that would not transfer the risk, an independent third party must make strategic decisions in the SPE subsidiary, and the third-party partner must invest 3 percent of the total value of the SPE. The 3 percent rule assumes that this level of ownership ensures the third party exercises proper oversight. It is reported that Fastow thought the 3 percent rule was silly because it would be easy to find someone to invest that amount. In 1991, Enron created its first securitization entity, Cactus. By mid1993, it had raised $900 million with Cactus to securitize natural gas futures contracts. Enron sold securities in these funds to investors such as General Electric that were paid from profits when these partnerships began to generate revenues. Although legal, these off-balance-sheet entities were high risk because the value of futures contracts in new markets depended on a wide range of unforeseen events. That is, unlike securitization of physical assets such as the depreciation allowance on physical assets and tax credits guaranteed by the government in the manufacturing sector, the value of the underlying energy commodity was subject to unknown future events that affect the market.

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E n r o n ’s I n s i d e T r a d i n g F l o o r By the late 1990s, Enron was the largest natural gas trading company in North America, managed the largest portfolio of natural gas derivative contracts in the world, and traded more derivatives than tangible assets (US Congress 2002b, 60). Enron used many types of derivatives, including swaps, to reduce risk by swapping floating prices for fixed prices. Managers also bundled derivative contracts to create credit default swaps (CDSs), which hedge risk by offsetting financial positions where one party pays another party to hold their risk. As the risk of the underlying asset increase, the cost of the CDS increases; if the risk is very high, either the price of the derivative is prohibitively high or it is impossible to find investors. As financial managers developed more types of structured finance, FASB made another attempt to tighten accounting rules governing their use. In 1998, it proposed an accounting rule requiring corporations to report all entities on their financial statements in which they held less than 50 percent ownership. If this rule passed, companies like Enron would be required to shift billions of dollars of debt to their balance sheets. Enron, joined by its external auditor, Arthur Andersen, scores of other companies, and the Bond Market Association, quickly sent a letter to FASB objecting to the rule. This political coalition also lobbied Congress, which pressured FASB to withdraw it. The defeat of the FASB rule was important to companies like Enron because it made them exempt from reporting their total debt. At this time, Enron’s total debt was estimated at $10 billion. If it reported its offbalance-sheet debt, it would raise its debt-to-equity ratio to 70 percent (Fox 2003, 217), which would likely set off a drop in its stock valuation and force it into bankruptcy. FASB obtained a mild victory in 2000 when it succeeded in replacing FAS 125 with FAS 140 (see chapter 2), which specified the distinction between transfers of sales and transfers of debt in SPEs (Financial Accounting Standards Board 2003). Despite Enron’s political victory, it did nothing to solve its underlying financial problems because many of its energy derivatives lacked financial integrity and lost money. Even if a derivative made money, it had to be 155

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financed for years before it realized a return. Together with the capital flows in its foreign subsidiaries, derivatives trading increased the parent company’s capital dependence on external financing. Mor e Secu r i t i z at ion: E ng agi ng i n Col lusion to M a nage E a r n i ngs When the Commodities Futures Modernization Act was passed in 2000, permitting nonbanks to trade on unregulated exchanges, Enron had already set up an electronic trading platform inside the firm that functioned like a commodities exchange. Management also expanded its trading business beyond oil and natural gas to include other energy products such as electricity. Soon other energy companies, including Dynegy, El Paso, Reliant Energy, and the Williams Companies, mimicked Enron and set up their own internal trading platforms. Now, corporations could trade derivatives with virtually no public scrutiny or government oversight. As Enron created more derivatives trading markets, Fastow was assigned the task of raising capital to finance these operations. Together with a small group of employees, he created hundreds of SPEs to raise offbalance-sheet capital. He was rewarded in 1998 when he was promoted to chief financial officer, which combined the work of raising capital through off-balance-sheet financing with the position of ensuring the fiscal integrity of the firm. The problem with combining these activities is that no one in the firm had the expertise and authority to overrule the use of these potentially high-risk financial instruments. Like many other large corporations, Enron diversified into other markets to meet its ongoing capital needs, which included gambling on high-tech Internet stock. In March 1998, through its first-level subsidiary Enron Broadband, Enron purchased 5.4 million shares in Rhythms NetConnection (hereafter RhythmsNet), a high-speed Internet company, at the pre-IPO price of $1.85 per share. A year later, in May 1999, RhythmsNet went public, and its stock sold for $21 per share. The following day, its stock increased to $69 per share, and Enron’s $10 million investment skyrocketed to $300 million (Powers et al. 2002, 77). At this same time, Enron desperately needed revenue to ensure that its stock value continued climbing. Management contemplated selling the 156

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RhythmsNet stock, transferring the capital to the parent company, and reporting the gain as revenue. However, a provision in the IPO preventing Enron from selling the stock for four years (Powers et al. 2002). Top management also considered reporting the gain of this highly volatile Internet stock. However, if the stock value declined at some future date, management would have to report the loss, which would damage Enron’s prospects for future stock growth. The dilemma confronting management was a subsidiary that held $290 million in potential profits that Enron could not use when it desperately needed revenue to strengthen its balance sheet. After debating how to transform this capital into a form that it could use while protecting itself from a decline in RhythmsNet’s stock price, management decided to hedge the stock: a financial device such as a futures option that is designed to mitigate the risk of a decline in the value of an asset (Oxford 2006, 256). However, a traditional hedge was not viable because it would be virtually impossible to find investors who would guarantee the future value of highly volatile Internet stock. Bridging Structural Holes to Engage in Illegitimate Behavior Fastow was given the responsibility of solving the RhythmsNet problem. After meeting with Lay and Skilling, he assembled a small group of accountants, attorneys, and financial managers with expert knowledge in structured finance to set up an off-balance-sheet SPE to hedge the RhythmsNet stock. The first step of the hedge entailed creating an offshore partnership named LJM Cayman L.P. (LJM1), which Enron incorporated in the Cayman Islands, for the sole purpose of doing business with the parent company (Fowler 2006).1 When setting up LJM1, Fastow invested $1 million to establish himself as the general managing partner. He also obtained $7.5 million each from two limited partners affiliated with Credit Suisse First Boston and National Westminster Bank (NatWest) (Powers et al. 2002, 81; Fastow 2004, 3). Credit Suisse made its investment in LJM1 through another Cayman Island partnership, Enron’s Rhythms Net Bet (ERNB). NatWest made its investment through a third Cayman Island subsidiary, Campsie Limited. Together with Fastow’s $1 million investment, these investments 157

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capitalized LJM1 at $16 million. LJM1 was further capitalized by parent company stock, valued at $276 million at the time, at the lower price of $168 million in exchange for a $64 million bank note as a down payment for the RhythmsNet stock. LJM1 then created an off-balance-sheet SPE subsidiary, LJM Swap Sub, LP (Swap Sub) to purchase a hedge option from Enron for its shares of RhythmsNet (Powers et al. 2002; Fastow 2004, 3). LJM1 capitalized Swap Sub by transferring $3.75 million in cash and approximately $129.9 million of the Enron stock held by LJM1. After these capital transfers were complete, Enron received a put option valued at approximately $104 million from Swap Sub on 5.4 million shares of RhythmsNet stock (Powers et al. 2002, 80) that gave Enron the right to require Swap Sub to buy its RhythmsNet stock for $56 per share in June 2004, completing the hedge (Powers et al. 2002, 81). A put option is a financial instrument that provides the owner the right, but not the obligation, to “put” the asset up for sale at a predetermined price and date. Put options are commonly used to protect against the decline of stock price. Thus, the sale of a put option suggests that the future value of the asset is in question. The contract that created Swap Sub establishing LJM1 as the general partner was a violation of rules governing off-balance-sheet partnerships. Fastow later stated in this plea bargaining agreement, “As the General Partner, I controlled LJM1 and LJM2, while at the same time I was Enron’s CFO” (Fastow 2006, 4). This blatant violation of the GAAP rule occurred despite multiple individuals and organizations inside and outside Enron responsible for oversight, including Enron’s top management and board of directors; its external auditor, Arthur Andersen; and the external auditor of LJM1 and Swap Sub, PricewaterhouseCoopers (Powers et al. 2002, 82). Although a few Enron experts in structured finance who were not part of Fastow’s group raised questions about the legitimacy of these financial instruments (Swartz and Watkins 2003), they were ignored, and Swap Sub remained off Enron’s balance sheet. In addition to this flagrant conflict of interest, these financial instruments did not transfer risk from the parent company. Specifically, if the value of the RhythmsNet stock dropped when the hedge matured, the 158

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Enron stock that was transferred to Swap Sub would cover all or most of the hedge. As a result, most of the risk remained with the parent company, which meant that Enron should have reported these financial instruments as a loan. Worse, if both RhythmsNet and Enron stock declined, which eventually occurred, the hedge would fail, resulting in financial disaster for Enron. More Off-Balance-Sheet Entities and Collusion with Investment Banks Enron’s aggressive growth strategy, poor performance in several global subsidiaries, and losses in its natural gas trading subsidiary increased the parent company’s capital dependence. To alleviate its capital needs, Fastow suggested that Enron use the equity market to raise capital. Although Skilling was concerned that a public offering might saturate the market and push the stock price down, he convinced Lay and Skilling that a parent company stock offering would succeed. Fastow was correct: Enron raised $800 million from the parent company’s stock offering and several $100 million by issuing stock in its subsidiaries (table 5.1). However, these stock offerings were insufficient to meet Enron’s capital needs. The problem confronting management was that they had reached the limits of conventional financing. The only option was more off-balancesheet financing. As Enron’s capital dependence increased in the late 1990s, so did the importance of Fastow’s Global Finance Group, which was restructured as a subsidiary under this new name. The capacity of Global Finance to generate capital from off-balance-sheet financing transformed it from providing financial services for the parent company to a profit center in its own right. This change in organizational structure gave even more autonomy to the small network of expert managers negotiating offbalance-sheet financing. In December 1999, Global Finance created a much larger partnership, LJM2 Co-Investment, L.P. (hereafter LJM2). The rationale for this partnership was an extension of the LJM1 strategy to manage risk and increase financial flexibility through corporate entities with nonaffiliate status (Powers et al. 2002). Fastow was also the managing partner of LJM2. 159

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Table 5.1. Capital Raised at Enron and Selected Subsidiaries from Stock Issuances Parent Company and Subsidiaries

Year

Capital Raised

Underwriter Fees (assuming 6 percent)

Enron Global Power & Pipelines

1994

$225 million

$13.5 million

Enron Oil & Gas

1995

$667 million

$40 million

Rhythms NetConnection

1999

$290 million

$17.4 million (sale to a SPE)

Azurix

1999

$695 million

$42 million (Merrill Lynch, $25 million)

Enron Oil & Gas spin-off

1999

$600 million

$36 million

Enron Corp.

1999

$800 million

$48 million

New Power Co.

2000

$250 million

$15 million

Note: Enron raised additional capital from other subsidiaries including the sale of 7 percent of Enron Energy Services in 1998 for $130 million and part of Enron Broadband Services for $30 million in cash and a $70 million note (Swartz and Watkins 2003, 138, 166, 203, 230). Enron also completed a private equity offering of $42 million in New Power Company, a subsidiary.

The LJM2 partnership documents the close ties between Enron and the FIRE sector: LJM2 included approximately fifty limited partners with FIRE-sector corporations including the insurance corporation American International Group (AIG) and many of the world’s largest financial firms, including Citigroup and Lehman Brothers. On top of this, more than one hundred Merrill Lynch executives, one of the largest securities firms in the United States, invested $22 million in LJM2 (Gasparino and Smith 2002). Merrill Lynch also used its brokerage network to market LJM2 stock to investors, securing institutional investors such as the Arkansas Teacher Retirement System (Fowler 2006). Like LJM1, LJM2 helped manage cash flow, debt, and earnings by transferring millions of dollars to the parent company. Although the goal was to raise $200 million, Enron’s financial condition was so deceptive that with little effort, LJM2 raised almost twice that amount, $394 million (Powers et al. 2002, 73). FIRE-sector firms were incentivized to find investors for Enron securities by its lucrative stock underwriting, merger and acquisition, and 160

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off-balance-sheet business, which made Enron one of the most soughtafter corporate clients. Initially investment banks easily marketed Enron’s partnerships to big investors such as mutual funds, insurance companies, and wealthy individuals. But as its financial statements became less transparent, investment banks became suspicious of Enron’s financial status. However, rather than risk losing Enron’s business by requiring more transparency, investment banks asked for guarantees on their investments in Enron’s partnerships. As Fastow stated: “I understand that Ben Glisan [Enron’s treasurer] was told that the bank would participate only if it were to receive assurances from Enron that it would not lose its 3% equity and that certain structural features, intended to minimize risk [to the banks], were made part of the structure” (Fastow 2006, 8, 12). To satisfy the banks, Global Finance guaranteed many of the LJM2 SPEs with Enron stock. Thus, risk was not transferred to the partnership, as required, but instead remained with the parent company. Also, some SPEs that LJM2 created lacked a third-party general partner so the 3 percent independent ownership criterion was not met. Given that investment banks were essential to setting up these partnerships, they were aware of these rule violations. Many of Enron’s SPEs did not meet GAAP requirements and therefore should not have been treated as off-balance-sheet financing; instead, they should have been included in Enron’s consolidated financial statement (Powers et al. 2002, 83–84; US Congress 2002b). As Ben Glisan stated in reference to one of Enron’s SPE during court proceedings, “This alleged third party funding served as the supposed 3% outside equity that I knew was required. As I knew, this transaction violated existing accounting principles in that its form was misleading and was accounted in a manner inconsistent with its economic substance” (US District Court 2003). Before Enron’s bankruptcy in 2001, this network used LJM2 to set up more than twenty deals (Fastow 2004, 2006) that included holding underperforming assets that Enron could not sell.

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E x ploi t i ng Asy m m et r ic I n for m at ion to M a nage E a r n i ngs Financial malfeasance was not simply the outcome of self-interested individuals or a shift in norms. Instead, corporations mobilized politically to transform the organizational and political-legal arrangements in ways that created opportunities for management to engage in these behaviors. After this social structure was created, off-balance-sheet entities were a key component of Enron’s rationally calculated means to achieve its substantively rational goal to maximize shareholder value. As Fastow stated: The structured-finance transactions were typically sized to compensate for the difference between Enron’s actual financial performance and its goals, which included a 15% after-tax earnings-per-share growth rate, an approximate 40% debt to capitalization level, and an approximately 4.0 times funds flow from operations to interest expense rates. Enron management discussed that they believed that the market would require these financial metrics, among others, in order to justify Enron’s stock price or to continue to transact business on exiting terms. (Fastow 2006, 3, 18)

Lack of Enforcement Capacity Management was able to accomplish these objectives because banks cooperated with Enron by providing the human capital to devise financial structures, and it is difficult for enforcement agencies such as the SEC to identify financial malfeasance when decisions are located deep inside large, complex corporations. This social structure created asymmetric information and opportunities to treat off-balance-sheet entities as independent of the parent company when they do not qualify for such treatment, thereby concealing illegitimate behaviors from oversight agencies and the investing public. The lack of oversight existed as many agencies were stripped of the resources to enforce the securities rules and laws. Fastow stated: I believe that based on conversations with certain bankers, they knew that the prepays and some of the share-trust transactions created the false appearance of funds flow from operations and that some of the FAS 125 and 140 transactions and LJM partnerships’ transactions created the false appearance of earnings

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and funds flow from operations and reduced reported debt. (US District Court 2006, 2)

Management’s ability to disguise loans as sales was facilitated by using offshore tax havens where few financial disclosure requirements exist. Although the examples presented thus far are among the largest fictitious capital transfers, many more partnerships were created to give the false impression that Enron’s balance sheets represented actual revenues. Asymmetric information allowed Enron managers to move approximately $27 billion, or almost 50 percent of its unprofitable assets, off the balance sheet. If Enron had not negotiated hundreds of off-balancesheet agreements with investment banks, its debt in 2000 would have been 40 percent higher (Johnson 2002). It is almost certain that disclosure of this massive debt would have been followed by a downgrade of Enron’s stock to reflect its risk level. Instead, managing its earnings with offbalance-sheet entities had the opposite affect: Enron’s stock values increased steadily between January 2000 and February 2001 (table 5.2), giving the false impression that the parent company was financially sound, resulting in further investment of the public’s money into the corporation. The Gatekeeper Two interrelated characteristics in this network allowed the chief financial officer to establish himself as a gatekeeper who controlled resources and benefits that he did not own, bridge structural holes, and benefit financially. Fastow’s positions as Enron CFO and managing partner of LJM1 and LJM2 provided closeness centrality, where central actors can quickly interact with others to transmit information or exchange resources. Fastow’s positions in the social structure also provided him with betweenness centrality, where two groups of social actors are dependent on a single actor to connect their respective networks or organizations (Knoke and Guilarte 1994, 88–89; Knoke 2001, 67, 223). In this case, Fastow connected Enron and investment banks. Fastow’s position as gatekeeper was sustainable because these networks consisted of sparse connections, limiting the number of those who have access to critical information. The sparse connections on Enron’s side of 163

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Table 5.2. Change in Enron’s Stock Values, 1997–2002 Date

Enron Stock Closing Price

July 15, 1997

39.00

December 31, 1999

44.38

January 20, 2000

67.25

February 28, 2000

64.81

May 31, 2000

72.88

January 25, 2001

85.00

February 21, 2001

73.09

May 29, 2001

53.05

July 13, 2001

48.78

August 15, 2001

40.25

September 4, 2001

35.00

September 28, 2001

27.23

October 19, 2001

26.05

October 23, 2001

19.79

November 28, 2001

0.61

November 30, 2001

0.37

December 2, 2001: Enron filed for bankruptcy. December 3, 2001

0.40

June 27, 2002

0.11

Sources: Bryce (2002); Fox (2003); Cruver (2002).

the network consisted of a small number of experts in accounting, law, and structured finance who operated deep within the corporation. Their location in the corporate structure gave them autonomy to negotiate deals. Similarly, a small number of investment bankers (three from NatWest) had the autonomy to negotiate deals for their firm. This network created asymmetric information that allowed the CFO to negotiate formal contracts and set up informal agreements with others in the network. As a result, few outside the network were aware of or understood the contracts that created the off-balance-sheet entities. These conditions increased the probability of creating a clique where social actors share strong mutual relations, which generate “convergent expectations and 164

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normative understandings” that “reduce differences among social actors” (Knoke and Guilarte 1994, 90). Why Enron Managers in the Network Maintained Secrecy Information asymmetry permitted managers inside the network to illegitimately use off-balance-sheet financing to manage earnings and conceal losses while creating opportunities to manipulate these contracts to benefit themselves. For example, the small number of managers in Fastow’s group were given opportunities to invest in the SPEs (Kranhold, Wartzman, and Wilke 2002), which created incentives and motives for them to cooperate on these transactions. In late 1999, the value of RhythmsNet stock declined so much that it was verging on bankruptcy. This situation prompted Global Finance to dismantle Swap Sub and create opportunities for managers in the Swap Sub clique to benefit from the transaction. Fastow and another former investment banker in the group, Michael Kopper, convinced outof-network financial managers that Enron would pay Swap Sub $30 million to unwind the deal (Fox 2003, 159). To these out-of-network social actors, this transaction appeared reasonable because $30 million was approximately the same amount as the increase in the value of Enron’s stock during the time the stock was held by Swab Sub. Enron transferred this capital to Swap Sub in exchange for the Enron stock in Swab Sub. On the other side of the deal, given that RhythmsNet was near bankruptcy, the three investment bankers from NatWest convinced their superiors that $1 million was a fair value for their original investment of $7.5 million in Swap Sub. Because information was asymmetric, top management at NatWest was not aware that this SPE contained several million dollars in profit from the increase in the value of the Enron stock. Thus, NatWest’s top management accepted the offer and wrote the remaining $6.5 million as a loss. To illegitimately reward themselves, network members took several steps. First, they created another SPE, Southampton Place, that Michael Kopper managed. This partnership was set up to buy LJM1’s interest in Swab Sub, which would effectively dismantle it. In March 2000, Kopper offered a small number of network members who worked on various LJM 165

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deals the opportunity to invest in Southampton Place. After Southampton Place paid Credit Suisse First Boston $10 million, which included its original $7.5 million investment and a $2.5 million return on it, and Natwest $1 million, the SPE held approximately $19 million (Fastow 2004, 3). Fastow and Kopper then created another entity, Southampton K, and transferred approximately $7.3 million from Southampton Place to it (Fastow 2004, 4). Then one of the NatWest investment bankers wired approximately $250,000 to Michael Kopper, the managing partner of Southampton Place, from an account in the Cayman Islands to purchase Southampton K. Another wire transfer moved the $7.3 million in Southampton K to a Cayman Islands account held by one of the NatWest investment bankers (US District Court 2002a, 11; US Congress 2002b, 81). Finally, the approximately $11.7 million remaining in Southampton Place was divided among various investors in the partnership from the Enron side of the network (Powers et al. 2002, 70). Together, these offbalance-sheet transactions shifted $19 million to network members. In his plea agreement with the US Justice Department’s Enron Task Force, Fastow (2004) stated: The Southampton “investors” were (1) a foundation in the name of my family, which contributed $25,000 and received approximately $4.5 million; (2) Enron employee Michael Kopper, who contributed $25,000 and caused another entity under our control to loan an additional $750,000, and received approximately $4.5 million; and (3) five Enron and LJM employees agreed upon by Kopper and me, who contributed a total of less than $20,000 and received a total of approximately $3.3 million.

The government inquiry concluded, “Two of the five LJM employees invested $5,800 in Southampton Place in March 2000 and received $1 million in return a few months later” (Powers et al. 2002, 16). As Enron’s finances became less transparent, investors and regulators became suspicious, and it appeared that the SEC was going to investigate its partnerships. In response, Enron’s board of directors questioned Fastow about his return from the partnerships. In a written response, he stated 166

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that his compensation was $23 million from his $1 million investment in LJM1 (US Congress 2002b, 36). In addition, as general manager of LJM1, he received an annual salary of $800,000 (Barrionuevo 2006). Fastow also acknowledged a return of $22 million in two years from an investment of $5 million in the LJM2 partnership. In total, Fastow received approximately $30 million from LJM1 and LJM2 (Powers et al. 2002, 3). To summarize, the internal network became a clique where its members shared strong mutual relations that generated “convergent expectations and normative understandings,” reducing “differences among social actors” (Knoke and Guilarte 1994, 90). Financial malfeasance remained undetected because the gatekeeper recruited network members with the skills to illegitimately bridge structural holes and create financial incentives for them to engage in these behaviors. Network members understood that the benefits they received depended on maintaining secrecy. Incentives for Banks in the Network to Maintain Secrecy To encourage investment banks to participate, Fastow created a ranking system and distributed resources and benefits to financial firms “friendly” to Enron, which meant they were willing to provide financing for Enron projects on short notice. Firms at the top of the list (Tier 1 banks) were rewarded with preferential access to Enron’s lucrative investment banking business. These network members included many of the largest FIREsector firms in the global economy: Citibank, JP Morgan Chase, Canadian Imperial Bank of Commerce, Credit Suisse First Boston, Barclays, Merrill Lynch, Royal Bank of Canada, and Deutsche Bank. Fastow testified: “I had frequent contact with some of their executives in connection with the transactions Enron did with them” (Fastow 2006:1). Placement at the top of the ranking system meant cooperating with Enron Global Finance. For example, although the Royal Bank of Canada was “viewed as a Tier-2 Bank,” Enron’s CFO “treated it as a Tier-1 Bank after the group of bankers from NatWest” that negotiated the Rhythms deal moved to the Royal Bank of Canada (Fastow 2006, 23; US Congress 2002a ). Rewards to FIRE-sector firms established motives and incentives to cooperate with Enron. To illustrate, between 1989 and 2000, investment 167

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banks received more than $206 million from Enron in underwriting fees on stock offering (table 5.1). Furthermore, financial firms that were limited partners in Enron’s SPEs received more than $214 million in underwriting fees (McGeehan 2002). Enron also paid investment banks for advice on mergers and acquisitions, derivatives trading, debt restructuring, and setting up off-balance-sheet partnerships. Citigroup alone received $167 million between 1997 and 2001 from Enron for financial services (Johnson 2002). Merrill Lynch received a return of $525,000 on one deal plus the initial $250,000 fee (22 percent) on its six month no-risk investment of $7 million. Dependent on resources controlled by Enron, FIRE-sector firms bridged structural holes with Enron and controlled interactions within their internal networks. Both parties understood that the LJM partnerships were illegitimate, so secrecy was essential: Enron paid significant fees to CSFB [Credit Suisse First Boston] related to these transactions. Based on my conversations with CSFB executives, both Enron and CSFB understood that: (a) these vehicles were a way to finance assets and were not true operating companies; (b) Enron effectively controlled the vehicles; and (c) the book value of the assets in the vehicle was, in some instances, in excess of the market value of the assets. (Fastow 2006, 17)

Both weak and strong ties were used to bridge structural holes in ways that allowed management to manipulate earnings and inflate stock values. On the one hand, strong ties among managers within Enron Global Finance were essential to create these financial instruments and capital transfers. On the other hand, weak ties, which entail connections with acquaintances and distant friends (Granovetter 1973), connected FIREsector and Enron Global Finance managers. The capital transfers among the partnership continued because all parties in the network benefited from these secret arrangements. FIRE-sector managers did not simply respond to Enron’s requests. According to Fastow (2006), investment bankers proposed SPEs as a means to increase shareholder value: Nighthawk, presented to me by Citi’s . . . , enabled Enron to report a healthier

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balance sheet than it otherwise would have. Mr. . . . explained to me that the purpose of Nighthawk was to convert debt into minority interest. Nahanni, also designed by Citi, was done primarily to generate funds flow from operations. I can recall no real business purpose associated with Nahanni or Nighthawk. (4)

To ensure these transactions occurred, investment banks created motives and incentives for employees to cooperate with Global Finance by providing large bonuses for closing these deals. In 2006, for example, the top five banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman, and Bear Stearns) gave bonuses totaling approximately $36 billion, which is equivalent to the gross national product of Ecuador (Lashinsky 2007, 141). While corporations like Enron were morphing into financial corporations, they were not the only firms participating in the high-risk derivatives market. By June 1998, the global OTC derivatives market reached $70 trillion. US firms accounted for 40 percent of this market with banks’ share at 25 percent and investment banks’ share at 15 percent. The rapid expansion of this market occurred in part because the primary financial regulator, Alan Greenspan, chairman of the Federal Reserve Bank, legitimated it by asserting in March 1999 that financial markets were moving toward “inevitable” equilibrium: “We live in what is mostly a stable economic system in which market imbalances give rise to continuous and inevitable moves toward equilibrium resolutions” (Greenspan 1999). Enron imploded less than two years later. Why Enron Managers Outside the Gatekeeper’s Networks Maintained Secrecy Although only a few Enron managers directly participated in financial malfeasance, many benefited from its rising stock values that created incentives for institutional investors to invest more of the public’s capital in the corporation. In addition to the large bonuses paid to traders and other Enron employees, the firms distributed massive amount of capital in stock options. Stock options had been used as a form of compensation in some of the largest corporations since the 1970s (Lewellen 1971; Zeitlin 1989, 169

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78; Herman 1981, 91–94). However, the trend toward management ownership increased in the 1980s and then accelerated in the 1990s when stock options became viewed as an incentive for management to behave more like owners and maximize shareholder value (Useem 1984, 30–32). Despite initial resistance by management (Boyer 2010, 219–220), stock options increased from 27 percent (1992) to 51 percent (2000) of CEO pay among the Standard and Poor’s industrial firms. Between January 1999 and May 2002 alone, 1,035 corporations granted approximately $66 billion in stock options, of which $23 billion went to 466 members of the managerial class in 25 corporations (Fortune 2002a). This massive increase in stock options as a form of executive compensation created incentives for managers to engage in high-risk financial strategies to MSV, which included increasing the value of their own stock and the probability of obtaining future stock options. Like most other parent companies, Enron made extensive use of stock options to motivate managers to MSV. During the three years preceding its collapse, twenty-eight of Enron’s board members and top managers received almost $1.2 billion—an average of more than $42.5 million each—from exercising stock options. Jeffrey Skilling and Richard Causey received at least $103 million and $23 million, respectively, much of it from stock options (US District Court 2004). It was reported than Ken Lay received millions from the secret sale of stock options and other Enron stock shortly before it collapsed. Enron’s widespread use of stock options as executive compensation created incentives for management and board members to maintain secrecy while engaging in adventure capitalism as the exposure of this behavior would result in a decline in stock value and the value of their stock options. Two recipients of the largest stock option payouts managed subsidiaries that are partially responsible for Enron’s catastrophic failure. Lou Pai, CEO of Enron Energy Services trading subsidiary, exercised stock options worth more than $270 million before his departure. Rebecca Mark, CEO of Enron International, which held many of the Enron’s unsuccessful international subsidiaries until she departed to manage Enron’s water business, Azurix, received more than $82.5 million in stock options (Bryce 2002). Although Pai was named in a lawsuit initiated by 170

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the University of California Board of Regents for investment losses in employee retirement funds, he was dismissed from the lawsuit in January 2007. Enron’s bankruptcy filing stated that it also paid $309.8 million to 144 executives in 2001 who “cashed in stock options worth $311.7 million” (Bryce 2002, 360). Bonuses and stock options were so widespread that a former employee characterized Enron as a millionaire factory (Cruver 2002, 67). Enron may have been the first, but it definitely was not the last millionaire factory. 2 A Catastrophic Failure on the New Social Frontier By the late 1990s, Enron was losing capital at an unsustainable rate from two sources. Enron International, a first-level subsidiary that held many of Enron’s foreign operations, had overpaid for many assets and miscalculated the cost to operate others. Also, Enron’s OTC energy trading subsidiary— where inexperienced traders from elite MBA programs were incentivized to close lots of deals, especially high-value deals—lost vast amounts of capital. To meet Enron’s capital needs, Global Finance raised approximately $20 billion annually in off-balance-sheet subsidiaries, partnerships, and trusts. Although many of these entities violated one or more of the rules governing off-balance-sheet financing, information asymmetry regarding the source of this capital allowed management to maintain a strong balance sheet. As a result, Enron more than doubled its stock value from $39 a share on July 15, 1997, to $85 on January 25, 2001 (table 5.2). Asymmetric information ensured that most investors and oversight agencies had no idea of the risk. However, if the off-balance-sheet entities failed, Enron shareholders were responsible, which is precisely what occurred. In October 2001, Enron had to report a $618 million loss in an off-balance-sheet partnership. Following a downgrade in its debt rating, Enron was required to repay $690 million in partnership debt (Levitt 2002), triggering an SEC investigation of its partnerships (Fusaro and Miller 2002). Three weeks later, management restated net income by $586 million, and by late October, the value of Enron’s stock had dropped to $11 per share. On December 2, 2001, Enron’s management filed for a $63.4 billon bankruptcy, the largest in the United States until it was surpassed by WorldCom in the following year. 171

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If Enron had not negotiated off-balance-sheet agreements with financial firms, its reported debt would have been 40 percent higher in 2000 (US Senate, Government Affairs Committee 2002). A more accurate assessment of Enron’s risk level would have resulted in downgrading its stock to junk status long before 2000. It is noteworthy that several other energy companies lost massive amounts of investors’ capital during this same time period. The stock value of Dynegy dropped from $46.94 on November 13, 2001, to $6.08 on June 27, 2002 (Bryce 2002, 321, 342). Little is known about what transpired at firms like Dynegy, but it is likely that after the Enron implosion, management eliminated many of their SPEs and placed active assets onto their balance sheets. In the absence of funding to support adequate oversight, during the fifteen years that Enron morphed from a regional pipeline company to the seventh largest US corporation and one of the largest energy and financial conglomerates in the world, it set off only a single regulatory alarm. This alarm, an allegation to the IRS, was overruled during Enron’s appeal, and, in accordance with the patchwork of political-legal arrangements monitoring public corporations, it was not disclosed to the public or other oversight agencies. The facade of wealth that Enron developed occurred with the corroboration of managers inside and outside the corporation with the human capital (expertise) and social capital (network ties) to set up complex financial instruments that increased risk. The decisions that perpetuated financial malfeasance remained unknown to the public and oversight agencies because they occurred deep inside the corporate structure. In the aftermath of the Enron meltdown, Andrew Fastow (2006) revealed that he developed off-balance-sheet partnerships that did not hold passive assets and therefore were illegitimate. Andrew Fastow (2006) stated, “I was hired by Mr. Skilling in 1990 primarily to execute offbalance sheet financing. In 1997, when I assumed responsibility for finance at Enron, I engaged in transactions . . . with certain . . . banks that had a material impact on Enron’s financial statements.” After the bankruptcy, lawsuits were brought against thirty-two Enron employees for violating securities and related laws. In return for providing testimony that implicated Ken Lay and Jeffrey Skilling, Andrew Fastow 172

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was given a reduced six-year prison sentence for pleading guilty to two conspiracy counts. In return for this testimony, Fastow also negotiated a plea agreement for his wife, a partner in some of the off-balancesheet entities. Skilling was sentenced to a twenty-four-year prison term for conspiracy, securities fraud, false statements, and insider trading. Throughout his prison term, Skilling claimed that he was innocent and unsuccessfully appealed his case several times. Other Enron executives were charged with a range of financial crimes, including securities fraud, wire fraud, insider trading, falsifying records, and conspiracy. Several of these executives successfully fought the charges brought against them. Others were given probation or received prison terms that ranged from less than a year to five and a half years. Shortly after Enron collapsed, a vice chairman committed suicide, and Ken Lay died before facing charges. Michael Kopper pleaded guilty to “one count of conspiracy to commit wire fraud” and “one count of conspiracy to engage in monetary transactions in property derived from specified unlawful activity” and received a short prison sentence (US District Court 2002a). Without admitting guilt to alleged malfeasance, Enron’s outside directors settled for $168 million. The Demise of Enron’s External Auditor By the late 1990s, Arthur Andersen was both Enron’s auditor and primary consultant. In 1999 and 2000, Enron paid Arthur Andersen $46.8 million and $52 million, respectively, for auditing, consulting, and tax work. Of the $52 million that Arthur Andersen received from Enron in 2000, only $25 million was directly from auditing. Of the remaining $27 million, $13 million was for consulting and $14 million for audit-related activities (Fusaro and Miller 2002, 128). Knowingly or unknowingly, Arthur Andersen created incentives and motives for employees to overlook clients’ GAAP violations by promoting employees for obtaining business from large clients like Enron and paying high salaries for managing these accounts. One midcareer partner for Arthur assigned to Enron was paid more than $1 million a year. In its defense, Arthur Andersen maintained that it was unaware of many of Enron’s off-balance-sheet entities and if its executives had knowledge of these entities, they would have required Enron to place them on its balance sheet. However, the behavior of an Andersen employee raises 173

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questions about this claim. The day after Enron announced that a SEC investigation was initiated, an Andersen partner assigned to Enron ordered the destruction of thousands of email messages and documents. The shredding began on October 23 and continued until November 9. The resource-dependent relationship between Enron and Arthur Andersen was not an exception. Providing auditing and consulting services to the same corporation creates conflicts of interests throughout corporate America. To illustrate, in 2000, General Electric paid its outside auditor $103.6 million, which included only $23.9 million for audit fees. The majority of the payment ($79.7 million) was for consulting services (Bogle 2005, 35). Similar conflicts of interest existed between corporations and the law firms; in 2001, the law firm Vinson & Elkins, which provided legal advice to Enron on setting partnerships, received approximately 7 percent ($30 million) of its revenue from Enron. In 2002, Arthur Andersen was found guilty of criminal charges related to its affiliation with Enron. Although this conviction was overturned by the Supreme Court in 2005 because of flawed jury instructions, Andersen’s legitimacy declined and many corporations terminated their relationships with the firm, leading to the demise of its auditing business. Andersen restructured itself using a different business model, changed its name to Andersen Global, and this artificial person lives on. The Enron bankruptcy raised many questions about the role of external auditors. As described in chapter 4, the SEC attempted to eliminate conflicts of interest and ensure auditor independence. However, corporate power triumphed over state power when the largest auditing firms mobilized politically and obtained the support of members of Congress, forcing the SEC to compromise on its original plan. Settlements by FIRE-Sector Firms That Corroborated with Enron Although the SEC alleged that FIRE-sector firms corroborated with Enron, SEC violations are tried in civil, not criminal, court. Many of these cases alleged that FIRE-sector firms assisted Enron with setting up “complex structured-financial transactions” to manage earnings (US Securities and Exchange Commission 2003b). Most of these cases were settled without 174

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admission of guilt, including a settlement of a $40 billion class-action lawsuit brought by the University of California Board of Regents on behalf of fifty thousand shareholders against several large FIRE-sector firms. The lawsuit alleged that these firms participated in setting up illegitimate offbalance-sheet partnerships and subsidiaries for Enron to dupe investors by disguising loans and selling fictitious paper assets (Cook and Taub 2007). Three FIRE-sector subsidiaries settled for $6.6 billion: $2.4 billion from Canadian Imperial Bank of Commerce, $2 billion from Citigroup, and $2.2 billion from JPMorgan Chase subsidiaries. By late 2006, an additional $222.5 million was obtained from Lehman Brothers, $69 million from Bank of America, and lesser amounts from other financial firms (Fowler 2006). At that time, Barclay PLC, Credit Suisse Group, Merrill Lynch, Toronto Dominion Bank, Royal Bank of Canada, Royal Bank of Scotland, and Deutsche Bank AG had not settled. Other FIRE-sector firms exploited the political-legal arrangements and decided to fight allegations filed against them. Merrill Lynch, Barclay PLC, and Credit Suisse Group argued that because they did not prepare or approve of Enron’s financial statements, they only aided and abetted the fraud, but class-action lawsuits can only pursue primary violators. In March 2007, the corporate-friendly US Circuit Court of Appeals dismissed “the lawsuit’s class-action status and ruled that the plaintiffs could not allege that the banks were primary players in fraud that helped fuel Enron’s failure” (Hays 2007). A panel of three appeals court judges stated, “Presuming [the] plaintiffs’ allegations to be true, Enron committed fraud by misstating its accounts, but the banks only aided and abetted that fraud by engaging in transactions to make it more plausible; they owed no duty to Enron’s shareholders” (Cook and Taub 2007). In another case, a conservative Supreme Court upheld the 1994 securities and racketeering law that managers and professionals cannot be held liable for providing advice that aids and abets white-collar crime. Thus, this law continues to protect accountants, consultants, lawyers, managers, and financial advisers who made speculative statements about corporate finances, decoupling corporations from government oversight agencies and weakening shareholder and consumer protections.

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Politically Embedded Markets The crucial flaw in neoliberal re-regulation is that it falsely assumes that third-party oversight undermines efficiency, and markets are efficient mechanism to transfer information to investors. Neoliberals fail to acknowledge that when decisions are made deep inside large and complex organizations, opportunistic adventure capitalists can act as gatekeepers and influence both sides of deals they negotiate with other firms to their benefit. The financial malfeasance that resulted in the crisis at Enron was not the outcome of a few rogue managers. Instead, it was viable because neoliberal re-regulation shifted corporations toward the disembedded end of the embedded-disembedded continuum that permitted a network of managers at Enron and FIRE-sector firms to act autonomously from third-party oversight. The Enron case demonstrates a core theoretical insight: Enron was not atypical. The shift of corporations to the politically disembedded end of the embedded-disembedded continuum decoupled corporations from oversight agencies and increased the probability of similar behaviors in other corporations. Shortly after the collapse of Enron, the SEC filed allegations of financial malfeasance related to exaggerating earnings against Adelphia Communications, InClone Systems, Sunbeam, Tyco International, Waste Management, WorldCom, Xerox, and dozens of other large corporations (Levitt 2003, 139, 123). Neoliberal ideology legitimated the organizational and political-legal arrangements permitting Enron managers to engage in financial malfeasance and lawbreaking. Despite the role of investment banks that perpetuated the crimes at Enron (US Congress 2002a), neoliberal ideology continued to prevail in the post-Enron era. Many of the same FIRE-sector firms that took advantage of profit-making opportunities by aiding and abetting Enron in setting up its murky subsidiaries participated in other forms of financial malfeasance including the home mortgage market.

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chapter 6

A “Great Crisis” in the FIRE Sector

In the mid-1980s, as banks began to exploit loopholes in the banking laws, central bankers became concerned that an increasingly decentralized banking system would result in crisis: “I can well visualize the day, if we don’t act and all the states go their own way and all the loopholes are exploited, that in a few years, we’ll be back here and we will have a great crisis” (Paul Volcker, in CQ Almanac 1984b). As chapters 3 and 4 showed, given the structural and instrumental power of banks and other financial organizations, it was relatively easy to convince receptive political elites such as President Reagan and Volcker’s replacement as chair of the Fed, Alan Greenspan, to employ neoliberal ideology to guide redefining corporate-state relations in banking and related sectors. Despite the collapse of Enron and other giant corporations due to risk taking and financial malfeasance, political and economic elites continued to assert that markets provided adequate information to ensure efficient financial transactions. The new organizational and politicallegal arrangements created the conditions for a “great crisis.” However, it was not the “great crisis” that Volcker anticipated. The crisis occurred for the opposite reason that Volcker expected. Neoliberal political-legal arrangements created a highly centralized banking system that concentrate risks in a few giant FIRE-sector firms that put the entire financial system at risk. After the market failures, many energy firms retreated from the trading market for derivatives. Ironically, this vacuum was filled by many of the same FIRE-sector firms that enabled Enron to set up its derivatives trading operation and its illegitimate off-balance-sheet partnerships to finance it. Within a few years, the managerial class at Bear Stearns, Credit Suisse, Citigroup, Deutsche Bank, Lehman Brothers, and Merrill Lynch used the resources under their control to establish or expand trading operations in Houston. 177

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After energy corporations shifted their focus back to traditional markets, the political coalition between the energy and FIRE sectors fell into decline. However, by 2000, the FIRE sector had established itself as a dominant power bloc as re-regulation permitted financialization as a capital accumulation strategy and means of corporate consolidation. These conditions enhanced the FIRE sector’s structural power, which increased its instrumental power to maintain political influence. By the early 2000s, FIRE-sector lobbying expenditures and PAC contributions were among the largest of all economic sectors. Their political spending continued to focus on increasing their property rights, thereby enabling them to create and participate in more financial markets. This chapter demonstrates how the prevailing organizational and political-legal arrangements permitted FIRE-sector corporations to engage in many of the same behaviors and use many of the same financial instruments as Enron did. In fact, it could be argued that the FIRE sector mimicked the speculative behavior of the energy sector. However, the sector focused on credit markets, which have more widespread, direct, and extreme adverse effects on the working and middle classes. P o l i t i c a l C a p i t a l i s m , A n t i t r u s t L aw s , a n d t h e Cr e at ion of Gi a n t FIR E-Sec tor Fir ms As US financial markets became increasingly intertwined with global markets, banking and financial firms argued that consolidation was necessary to compete in these markets. By 2001, the largest banks expanded their structural power by consolidating hundreds of banks and financial service firms into a few giant FIRE-sector corporations. After consolidation, Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns dominated the investment banking component of the market. Citi and JP Morgan Chase dominated the bank conglomerate sector. American International Group (AIG), MBIA, and Ambac Financial Group (AMBAC) dominated the securities insurance market. Moody’s Investors Services, Fitch, and Standard and Poor’s dominated securities ratings (Johnson and Kwak 2010). These giant corporations used the resources under their control to extend securitization to most major credit markets (e.g., automobile loans, 178

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credit cards, and secondary mortgages), increasing risk in the economy as a whole. Furthermore, corporate consolidation linked the fate of the largest FIRE-sector firms to these credit markets. Because each company controlled a large portion of the securitization market, if one corporation failed, the entire securitization market and the other corporations in this market would be adversely affected. If the market weakened and corporations were unable to provide the necessary financial services for daily business transactions, the entire economy would come to a standstill, as it did in the 1930s, which is why New Dealers regulated this economic sector in the first place. Banks’ primary targets were government-sponsored organizations (GSEs) such as Fannie Mae and Freddie Mac, which controlled the secondary mortgage market. Whereas Fannie and Freddie controlled 100 percent of the secondary mortgage market from the 1930s to the 1980s, their market share after neoliberal reregulation dropped to 30 percent, with the remaining 70 percent controlled by FIRE-sector firms and their subsidiaries. FIRE-sector firms controlled an even larger share of the total derivatives market; although a private (i.e., unregulated) derivatives market did not exist in 1980, by 2000, it had garnered approximately 90 percent of the derivatives market valued at approximately $95.2 trillion (Partnoy 2004, 170). This market was much riskier than the energy derivatives market. Whereas energy companies like Enron held much of the risk in the energy derivatives market they created, FIRE-sector firms used their networks to distribute risk throughout the global economy to wealthy investors, other banks and corporations, mutual funds, pension funds, municipalities, school districts, and foreign governments. The FIRE sector was able to expand this market and distribute risk because they had the human capital to create financial instruments and the social capital—via their access to large networks of investors—to sell securities in them. Additional risk to the system was created when FIRE-sector firms were permitted to engage in proprietary trading: using their own capital to invest directly in speculative high-risk financial instruments. Proprietary trading contrasts with the traditional practice of investing on behalf of clients and receiving commissions and fees from the trade (Investopedia 2020). It also creates conflicts of interest because 179

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firms may prioritize their own trades over those of their customers. Hedge funds were among the first to engage in proprietary trading and made tremendous amounts of money by making high-risk bets on derivatives, currencies, and virtually anything else that might realize a profit. Their success enticed banks to set up proprietary trading desks that became viable after dismantling the Banking Act of 1933 and related legislation. Proprietary trading in MBSs and other high-risk derivatives was one of the primary reasons for the FIRE-sector failures and the 2008 financial crisis. As the derivatives market expanded, so did FIRE-sector firms’ resource dependence on high-risk forms of securitization. Between the mid-1980s and the early twenty-first century, when the underlying commodity (houses) remained stable, the principal and interest payments on MBSs and related derivatives created steady income streams for FIRE-sector firms. Like all derivatives markets, the secondary mortgage market was based on several assumptions: the value of the underlying assets are stable, defaults are unrelated events (one default does not cause another), variation in geographic location of the underlying commodity (e.g., houses) constitutes diversified investments, and failed mortgages are offset by the sale of new mortgages. As the analysis that follows shows, this neoliberal business model ignores the contagion effects of markets. Expanding the Subprime Mortgage Market While the median household income stagnated between 2000 and 2007 and housing prices nearly doubled in some markets, capital continued to flow into financial markets from institutional and foreign investors. With ample capital and the demand for traditional mortgages rapidly declining, banks devised a strategy to create a new class of consumers by expanding the subprime mortgage market. By 2004, there was a noticeable uptick in the subprime market from the sale of mortgages to consumers with low credit ratings and little or no credit history. Capital was so abundant that so-called liar loans became increasingly common as lenders failed to conduct credit checks on applicants. In addition, the elimination of the legal requirement for brokers to disclose the terms of the loan (e.g., payment schedules on variable interest rate mortgages) created opportunities for 180

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brokers to convince consumers to purchase mortgages that they could not repay (Bitner 2008). In some cases, banks targeted poor communities. For example, through church and community organizations, Wells Fargo mortgage officers targeted black communities in Baltimore to identify potential homeowners and convince them to purchase variable-rate subprime mortgages. The higher fees from these mortgages also incentivized brokers to sell subprime mortgages to consumers who qualified for prime mortgages with lower interest rates. Assuming that the housing market would continue to increase, many middle- and upper-middle-class consumers knowingly speculated by purchasing homes with variable-rate mortgages that they could not afford in the long term. Their strategy was to sell the house when interest rates on their loans increased. In the two decades prior to the 2008 crisis, some of these consumers sold houses and purchased larger houses several times. Housing values increased so rapidly in some markets that middle- and upper-middle-class speculators purchased a second house or condominium while it was under construction and sold it for a profit when it went on the market. In states with the largest increase in housing values, including Arizona, California, Florida, and Nevada, investor mortgage originations increased from 25 percent to 45 percent between 2000 and 2006. Other homeowners used the equity in their home to obtain home improvement loans or develop consumptive habits that emulated the upper class. Given the ratio between the equity in their homes and housing values after the financial crisis, many mortgages were under water, and delinquencies increased to 35 percent in 2007 and 2008 (Haughwout, Donghoon, Tracy, and van der Klaauw 2011). Basel II As banks increased their structural power and financial markets became more globalized, the Basel Committee on Banking Supervision proposed standards to more closely regulate risks. The core component of the 2004 Basel II Accord was to ensure that banks held adequate capital in reserve in relationship to their risk level (chapter 4). Given that these standards reduced the amount of capital available to loan or invest, many banks resisted by arguing that Basel II standards were unreasonable. 181

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Unable to convince the Basel Committee to lower their risk standards, the FIRE-sector managerial class used the resources under their control to assign teams of accountants, financial managers, and lawyers to identify loopholes in the regulation. Their solution was structured investment vehicles (SIVs): nonbank entities similar to ABSs and CDOs that spread risk except they are capitalized and actively managed. However, debt with terms of less than a year do not require SIVs to hold capital to offset risk (McLean and Nocera 2010, 240). SIVs were invented by Citigroup in 1998 but were not widely used initially. However, after Basel II was passed in 2004, assets held by SIVs tripled, and by 2007 they were managing more than $400 billion. To exploit this loophole, FIRE-sector firms created SIV subsidiaries, transferred debt and other forms of risk to them, and placed these subsidiaries off-balance-sheet, sometimes in offshore accounts. Banks financed SIV subsidiaries by issuing short-term securities such as commercial paper, notes, public bonds, and low-interest credit. Instead of holding 8 percent of their risk-assessed value in reserve as required by the Basel Accord, this financial instrument allowed banks to hold capital equivalent to only 1.8 percent of their assets. The 6.2 percent difference amounted to billions of dollars to loan or invest, dramatically increasing profits and risk to the banking system.1 Collateralized Debt Obligations: Market Participants Add More Risk To create additional capital accumulation opportunities in the secondary mortgage market FIRE-sector managers began to make greater use of collateralized debt obligations (CDOs). Like MBSs, CDOs are asset-backed securities that pool cash to create more fictitious commodities. However, unlike MBSs that are constructed directly from mortgages, CDOs are constructed from MBSs or securities backed by other assets. That is, “debt was being used to buy debt” (Johnson and Kwak 2010, 123). In 1987 Michael Milken at Drexel Burnham Lambert had created the first CDOs by acquiring high-risk junk bonds issued from different firms, packaging them together, and spreading the risk throughout financial markets by selling securities in them. As long as the underlying asset remain stable, CDOs produced predictable income streams and quickly 182

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spread throughout securities markets. The first CDOs in the mortgage market were created in 2003 when the housing market began to accelerate. CDOs became a popular component of financialization. Instead of spreading risk evenly among investors in MBSs, managers used CDOs to create different classifications of securities with different risk levels, known as tranches, that facilitated the distribution of these securities to investors with different risk tolerance. Some tranches consisted of lowrisk assets with lower interest rates and lower returns. Others were high risk with high interest rates and higher returns. Over time, CDOs were constructed from increasingly risky assets such as subprime mortgages. Whereas MBSs investors received cash flows directly from the principal and interest as homeowners paid off their mortgages, returns on CDOs were dependent on capital flow at two levels of the financialization commodities chain. That is, given that CDOs are constructed from a bundle of MBSs, cash flow to the CDO is dependent on the payment of both the mortgages and the MBSs. Incentivized by cash flows from CDOs, many banks kept CDOs in their own investment portfolios, increasing their own risk. Mortgage-related CDOs reached $225 billion in 2006, a ten-fold increase in three years, and continued to increase at a record pace until the housing market began to melt down in 2007. The rapid growth in CDOs was stimulated by the expanding subprime mortgage market. Mortgage brokers were encouraged to sell as many subprime mortgages as possible so firms could package them into MBSs, repackage them as CDOs, and sell tranches in them. Selling securities in CDOs required high scores from the credit rating agencies. Although there are only three large credit-rating agencies, they competed for business in the mortgage bond market. These agencies soon became dependent on what they assumed to be reliable streams of income. However, conflicts of interest existed between credit rating agencies and banks: the rating agencies knew that if they provided a low credit rating, the bond issuers might move their business to another firm. As a result, most mortgage-backed bonds received the highest possible credit rating, AAA, even when they contained high-risk mortgages. This conflict of interest emerged with the decision in the 1970s to shift payment to credit ratings agencies from securities buyers to the banks issuing securities. 183

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As in other arenas of corporate-state relations, risks in financial markets emerged from change in one dimension of the social structure (creating riskier financial instruments) without a concomitant change in another dimension of the social structure (regulatory oversight), decoupling corporations from regulatory oversight. By 2007, when more than $1.5 trillion in subprime loans existed and thousands of families faced foreclosure, researchers began to expose these high-risk financial instruments. Research shows that in one deal, Goldman Sachs lumped 8,274 subprime second mortgages valued at $494 million into a CDO and placed it in a corporate entity, Goldman Sachs Alternative Mortgage Products, then created tranches in the CDO with an AAA rating and sold them to investors. Although this CDO received a high credit rating, it should have been rated as junk because the “average equity that the second-mortgage borrowers had in their homes was 0.71%” (Sloan 2007, 120). In short, 80 percent of the homes were mortgaged with the first loan, and the second mortgage covered almost all of the remaining 20 percent. As a result, homeowners had almost no risk. If housing prices rose, the home could sell for a profit. If housing prices dropped, the mortgage holder could walk away from the home with very little loss. Despite warnings that the housing market was becoming unstable in 2007, participants in the securitization chain did not curtail their behavior. Instead, FIRE-sector managers figured out a way to make money on the pending crisis by betting against the very same CDOs they were selling to investors. When the secondary mortgage market began to destabilize, FIRE-sector firms such as Goldman Sachs, which benefited from information asymmetry, continued to sell these financial instruments to unsuspecting investors while removing them from their own portfolio. This strategy succeeded because brokers were motivated to continue selling subprime mortgages by the high fees associated with them, and information asymmetry permitted them to do so long after bank insiders knew the risks. Goldman protected its assets by transferring risk to CDO investors

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Credit Default Swaps: Market Participants Add More Risk Credit default swaps (CDSs) also became widespread in secondary mortgage markets. Swaps, I have noted, are financial derivatives used to hedge (offset) risk where one party pays another party to hold their risk. The buyer hedges risk by making payments to the seller who, in the event that the debt issuer defaults, agrees to buy the security’s premium and interest. The CDSs market was extremely attractive because bond issuers rarely go bankrupt. Furthermore, banks and hedge funds can reduce their risk from selling CDSs by buying protection on them from another firm. If the bond defaults, the bank or hedge fund would have to pay the buyer of the CDS it sold but would receive payments on the CDSs it purchased. Banks and hedge funds assumed they could make a great deal of money by selling CDSs and collecting premiums while rarely paying out capital. In this way, CDSs are like insurance: if a bond fails, someone pays. However, bonds, especially mortgage bonds, are not like most insurance events such as a broken arm where events are unrelated. In contrast, after one bond defaults, the probability of other bond defaults increases. Despite this risk, the global CDS market had grown to approximately $60 trillion by the end of 2007 (Davidson 2008). Like Enron, banks and other firms can sell these financial instruments over the counter versus trading them on regulated exchanges. As a result, there is no reliable third party to provide information on the extent to which banks and other firms were exposed to the bond market. Moreover, if CDSs are not backed by other CDSs, like a life insurance policy, if the underlying asset (bond) fails, the issuer has to pay on the CDS. Despite the increased size of FIRE-sector firms, if multiple bonds failed, the insurer might not be able to pay or borrow the necessary capital to fulfill its end of the contact. If one of the larger FIRE-sector firms failed, this event would shrink the global pool of capital, thereby tightening credit markets. Prior to banks’ entrance into the MBS market, their balance sheets were not particularly transparent. However, financialization transformed the meaning of balance sheets by creating devices that “dramatically gain or lose value in seconds” (Steinherr 2000, 203). Although appointees to the top regulatory positions, many of whom were former bank executives, 185

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were aware of the risks created by the securitization commodities chain years before the crisis (Rajan 2005), market fundamentalism prevailed, and they failed to establish a regulatory structure to mitigate market risk. Furthermore, market fundamentalists overstate the efficiency of the financial commodities chain, since each link in the chain constitutes an additional cost: constructing derivatives requires human capital, and those costs are incorporated into the price of the respective derivative. As derivatives became a core income source for FIRE-sector firms, social actors at all levels were incentivized by high compensation to carry out the deception from real estate brokers at the bottom of the financialization commodities chain to the managerial class at the top. The Organizational Network of Market Participants Several resource-dependent organizations were crucial to the expansion of the secondary mortgage market. First, asset-managing organizations created, issued, and maintained financial instruments by trading and ensuring the recovery of mortgages in default. Ideally, the asset manager had a substantial investment in the instrument, which created an incentive to manage the CDO in a way that increased its value. Asset managers were incentivized to ensure that CDOs were successfully marketed because part of their compensation came from their own investment in the CDO, which typically occurred before they marketed it to investors. Second, investment banks were pivotal in the securitization chain and worked with asset managers to structure the CDO in a way that provided returns to investors, underwrote it, and created the CDO equity tranches. Other responsibilities included ensuring that adequate collateral existed and working with credit rating agencies to obtain ratings for the various tranches. Investment firms also worked with attorneys to create offshore entities that purchased assets and issued the CDO tranches and with accounting firms that verified the value of each form of collateral backing the CDO. Underwriters directed a tremendous amount of business to accounting firms, which created an incentive for the accounting firm to satisfy the underwriter versus the investor. A large share of the CDO deals between 2002 and 2007 were underwritten by just five investment banks or their subsidiaries: Merrill Lynch with 107, Citigroup with 80, 186

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Credit Suisse with 64, Goldman Sachs with 62, and Bear Stearns with 52 (Kedrosky 2010). Third, investment banks sent a tremendous amount of business to the third organization in this network: rating agencies. To ensure the investment banks continued to send business to them, rating agencies had incentives to give these banks high credit ratings on their CDOs. Fourth, to control risk, other organizations in the network sold CDSs to reimburse investors for potential losses. The buyers of a CDS in turn limited their risk by shifting it to an organization, typically a hedge fund that guaranteed the creditworthiness of the debt security (Investopedia, retrieved 2017). After the transfer, hedge funds sold tranches in them to distribute risk throughout the global economy. A number of types of organizations invested in CDOs: commercial banks, insurance companies, investment banks, mutual funds, pension funds, private banks, school districts, municipalities, and trusts. Investors also included other CDOs, wealthy individuals, and smaller investors. The primary motive to participate in this market was the potential for a higher return than other securities. FIRE-sector firms and nonbank financial subsidiaries held many MBSs and CDSs in SIV subsidiaries. SIV subsidiaries permitted parent companies to legally transfer debt and other forms of risk to the entity and place it off-balance-sheet, frequently in offshore tax accounts. SIV subsidiaries were financed by issuing short-term securities such as commercial paper, notes, public bonds, and low-interest credit. They accumulated capital from the difference between the return they paid to investors and the rate of return on their investments. SIV subsidiaries in turn used capital to invest in other securities that paid a higher rate. SIVs appeared stable because the ultimate parent company was responsible for repaying the lines of credit in them (Palley 2012, 64). Because SIV subsidiaries were perceived to be an easy way to earn money, many corporations used these structures to participate in the secondary mortgage market. As this market expanded, organizations in the network depended on resource from it, which perpetuated the financialization commodities chain and adventure capitalism. Banks funneled so much capital into the secondary mortgage market that they contributed to destabilizing the housing market and 187

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fueled the crisis of overproduction and underconsumption in the home and commercial building markets. The oversupply of the underlying commodity in this complex financialization commodities chain resulted in declining prices, setting off the financial crisis. The Beginning of the 2008 Financial Crisis: The Bear Stearns Rescue When the value of houses declined, so did the value of the MBSs, CDSs, and CDOs. When the mortgage market collapsed, hundreds of bank and nonbank parent companies were required to bail out their SIVs. However, given that many parent companies used loopholes to circumvent the capital requirements of Basel II, they lacked sufficient capital reserves to meet their financial obligations. Bear Stearns, the first major casualty, illustrates how derivatives can transform balance sheets quickly. In July 2007, Bear Stearns’s asset management entity reported that two of its funds had lost all or most of their investor capital. Losses continued to mount in other Bear Stearns funds as the firm was deeply vested in securitization. These losses were exposed to the public when the firm could not make its debt payments. Its stock dropped to less than 7 percent of its value two days earlier and dramatically less than its value of $172 per share six months earlier (Taibbi 2014, 151–156). In March 2008, with support from the Federal Reserve Bank, JPMorgan Chase acquired Bear Stearns in a stock swap for $2 a share. This acquisition represented a massive loss for investors in Bear Stearns securities and individuals whose retirement funds were held by institutional investors holding Bear Stearns securities. The Rise and Decline of Lehman Brothers and Its Murky Subsidiaries: Too Big to Save While assisting Enron in setting up its dicey subsidiaries, Lehman Brothers created its own dicey subsidiaries. To establish a presence in the subprime mortgage market, Lehman acquired and incorporated Aurora Loan Services as a subsidiary in 1997. In 2000, it acquired another subprime mortgage lender, BNC Mortgage LLC, which it also incorporated as a subsidiary. The reason for these acquisitions was to funnel mortgage loans from them 188

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to the parent company, where financial managers packaged them into financial instruments that were then sold to Fannie Mae, Freddie Mac, and other investors. Lehman’s Aurora subsidiary was among the most toxic corporate entities. It specialized in liar loans that it obtained through independent mortgage brokers, who “often didn’t have to meet any criteria to be a broker” and employed limited, or no, underwriting standards (Black 2010, 7). Like Enron’s traders, Aurora brokers were paid by volume, which created perverse incentives to sell as many loans as possible. Soon Lehman’s risk management department was overwhelmed by the need to assess the risk of the massive number of liar loans moving through the firm (Black 2010, 6). As a result, many loan applications contained false information on crucial criteria such as credit rating and income. Lehman often bundled these loans with prime loans and sold securities in them as prime. As the demand for securities increased, firms in this market created a race to the bottom in terms of asset quality. In fact, an independent subprime lender explained, the underwriting standards dropped so low that lenders knew there was a higher likelihood of default than repayment (Bitner 2008). Furthermore, as the housing market eroded, some builders became desperate to sell houses and paid most or all of the closing costs, making it even easier for home buyers to obtain loans. As the underwriting standards declined, individuals with poor credit ratings were able to obtain a mortgage with a down payment of only 5 percent or even lower. If a crisis occurred, it was a virtual guarantee that many would default. Lenders in Lehman’s subsidiaries used low underwriting standards to generate more loans and sold them to other Lehman entities, where they were packaged into financial instruments and sold to outside investors. Risk in the market continued to increase as mechanisms were created for homeowners who were unable to make their payments to refinance their loans, pushing the inevitable default into the future. Little information reached the market because decisions affecting the integrity of Lehman’s financial instruments were buried deep inside the corporation. By the time these financial instruments arrived on the market, they were so complex that even sophisticated investors could 189

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not ascertain the integrity or risk level of these derivatives. In fact, after loans were shuffled through several organizational entities and packaged and repackaged into different financial instruments, it became difficult to trace them back to the original owner. Given the financial rewards in the secondary mortgage market, this information remain buried deep inside the corporation because management was not likely to admit that they were perpetuating an accounting fiction. With a high portion of subprime and liar loans on their books, Lehman reported assets that were much higher than its actual assets because of the high probability that many homeowners would default. Financial malfeasance was perpetuated by perverse incentives that tied executive compensation to stock valuations. If management adjusted its reported assets to the actual value, the value of Lehman’s stock would drastically decline and stock options would become worthless, resulting in a massive loss of executives’ compensation and wealth. As the gap between actual and reported assets grew, management became increasingly vulnerable to allegations of fraud if they reported the gap. Unlike the malfeasance perpetuated at Enron, where traders might work their way out of earlier losses with future bets, it was almost certain that mortgages would default. Nevertheless, financial malfeasance at Lehman continued as the market for securities from these financial instruments remained strong, creating incentives for Lehman and its subsidiaries to refinance even more home mortgages because they collected fees and made profits on refinancing. By 2003, Lehman had increased its structural power to the point where it held a third of the secondary mortgage market in the United States at $18.2 billion in loans. As the subprime mortgage market expanded, so did Lehman’s investments in it, increasing its exposure in this market to more than $40 billion in 2004. In 2006, Lehman’s two subprime lending subsidiaries loaned approximately $50 billion. Like Enron’s practice of placing derivatives in its subsidiaries to morph into a financial company, Lehman used the same process to morph into a real estate hedge fund but continued to disguise itself as an investment bank. By 2008, Lehman Brothers held $680 billion in various financial instruments but had only $22.5 billion of its own capital to back it. 190

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This high-risk strategy was viable because most investment banks were organized as partnerships or private companies, lightly regulated, and permitted to engage in proprietary trading. A large portion of these financial instruments were in the mortgage market, and it was estimated that a 3 to 5 percent decline in the value of the underlying commodities would wipe out all of Lehman’s equity (Blackburn 2008). As the financial condition of the secondary mortgage market declined, Lehman closed its operations at BNC Mortgages. However, its financial condition continued to deteriorate largely because it kept many CDO tranches that it had securitized, which were rapidly losing value. In response to a loss of $2.8 billion in the second quarter of 2008, the parent company attempted a risky $6 billion stock offering. Unable to sell these securities at the expected value, Lehman’s stock lost 73 percent of its value. In addition to the twelve hundred employees Lehman eliminated when it shut down BNC Mortgages, the parent company laid off an additional fifteen hundred employees in 2008 (Anderson and Dash 2008). In a desperate strategy to survive, Lehman made a failed attempt to sell its assets and debt in Archstone, which at the time was the third largest real estate investment trust (REIT) in the United States. Lehman’s last hope was a potential acquisition by Korea Development Bank. After this transaction fell through, Lehman’s stock dropped an additional 45 percent to $7.79. In the absence of tangible assets to back its fictitious commodities, its liquidity disappeared and its lines of credit dried up. Unlike the response to assist Bear Stearns, the federal government did not attempt to save the much larger Lehman Brothers. In the absence of government intervention and no prospects of an acquisition, Lehman filed for bankruptcy protection on September 15, 2008. The bankruptcy proceedings were revised a week later when Barclays Bank offered to acquire the investment bank’s brokerage business and its midtown Manhattan skyscraper for $1.37 billion. Norman Holding, Inc. also acquired several of Lehman’s assets in Europe and Asia, including Hong Kong. But Lehman Brothers still could not meet its debt payments and declared the largest bankruptcy in US history, more than $600 billion, which far exceeded the previous record-high Enron and WorldCom bankruptcies during the previous financial crisis. 191

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The size of Lehman’s bankruptcy had widespread effects on the domestic and global economies. The S&P 500 lost nearly 300 points, a 3.4 percent drop in value in a single day. The almost one hundred hedge funds that used Lehman as broker immediately lost value. Many money market funds also had significant investments in Lehman. As a result, a share in large money market funds, which are not insured by FDIC, dropped below $1, which had not occurred since 1994. On top of this, Lehman owed Freddie Mac $1.2 billion. Lehman’s demise, resulting in a $737 billion reduction in collateral in the global securities lending market, sparked a selloff in the commercial MBS market. In total, more than seventy-six thousand people and institutions claimed losses related to Lehman’s collapse (Taibbi 2014, 168). During the bankruptcy investigation, examiners discovered widespread financial chicanery and malfeasance at Lehman. In cooperation with its external auditor, Ernst & Young, Lehman used Repo 105 accounting maneuvers: short-term agreements to pay down debt that bolster balance sheets. After the financial statements were filed, Lehman borrowed capital to repurchase these agreements in a maneuver that made the firm appear financially sound when it was not. When Lehman’s financial transactions were exposed, the New York attorney general filed a $150 million lawsuit against Ernst & Young for cooperating to commit accounting fraud. The accounting firm was permitted to settle in 2015 for $10 million. In 2013, Ernst & Young paid $99 million to settle an investor class-action lawsuit for Repo 105 transactions, which is very small in relationship to its profits from its role in the financialization commodities chain. Although the SEC also investigated Ernst & Young, an arbitration panel closed these cases in 2012 and 2014, respectively, largely because the 1994 legislation made it difficult to hold financial managers responsible for aiding and abetting white-collar crime. As the secondary mortgage market continued to weaken, Fannie Mae and Freddie Mac, the government’s off-balance sheet entities, were not able to cover their losses. Although the government guarantee no longer existed, the implicit guarantee became explicit on September 7, 2008, when the government bailed them out. The bailout indicated the depth of the crisis and accelerated the declining value of more SIV subsidiaries held by private banks, equity firms, and hedge funds. 192

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The bailout set off a panic: no one had known the extent of toxic assets held by banks and FIRE-sector firms in their SIV subsidiaries. Within days, trust disappeared, and banks would not loan capital to one another. Market contagion continued, and on September 17, General Electric, whose subsidiary GE Capital became a major participant in the secondary mortgage market, informed Hank Paulson, secretary of the treasury, that it would not be able to repay its short-term debt. Due to the immense structural power of the largest corporations, often blurred by the phrase “too big to fail,” political elites guaranteed $600 billion in commercial paper that GE used to finance day-to-day operations (Lenzner 2012) in an effort to avoid a catastrophic failure of financial markets. Credit markets nevertheless continued to falter, and short-term loans in credit markets were verging on coming to a standstill, setting off the 2008 financial meltdown (Financial Crisis Inquiry Commission 2011). Statistical Tools and Self-Deception of Big Data Analyses The financial crisis demonstrates that FIRE-sector traders, executives, and risk managers were driven by speculation and greed and oblivious to the realities in which the secondary mortgage market was embedded. They believed market fundamentalism and neoliberal ideology legitimated dispensing with the regulatory structure because they had a substitute, value at risk (VAR), a statistical technique that measures and quantifies risk exposure at multiple levels of the corporate hierarchy, including trading portfolios, corporate entities, and parent company risks. VARs use algorithms to model the probability of a loss at each level of the corporation and aggregate each level of risk to create a company-wide risk metric. A crucial feature of VARs, however, is that they are used to manage risk, not to limit it. Like the energy sector, investment and commercial banks had hired experts—engineers, mathematicians, computer scientists, and in some cases even rocket scientists—to develop their models. These experts developed computer programs that could speed through big data (e.g., thousands of loan applications) in a few seconds and sort them into risk levels. Although these mathematical models were not transparent except to the experts who developed them, no one paid attention to the lack 193

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of transparency until the 2008 crash, when the managerial class had to decipher the meaning of the models in a desperate attempt to save their corporations. The VAR approach to risk management presented many interrelated flaws. Immersed in the world of big data and confident in VARs, FIRE-sector firms failed to incorporate the size and complexity of the corporation into models. Instead of individual entrepreneurs operating in a transparent free market as described by Adam Smith, contemporary entrepreneurs by the 1990s operated deep inside large corporate structures that in some cases were virtually equivalent to the market (Lehman Brothers was one of them). On top of this, FIRE-sector firms were operating in secrecy: neither the information they used nor the decisions they made flowed into the markets. Worse, unlike the entrepreneurs Smith described, most contemporary entrepreneurial managers were using other people’s money. As the money flowed in from the secondary mortgage market, the banks widened the tolerance margins of the models, which increased risk. After all, executives reasoned, the housing market had not undergone a major failure since the Great Depressions. What were the probabilities of that happening again? But math-based models are only as good as the assumptions incorporated into them and the data they use. The risk-based model of this market failed to incorporate market contagion, where foreclosures and vacant houses due to overbuilding in a neighborhood generate fear among remaining homeowners, who then sell their houses for belowmarket prices, resulting in a downward spiral in housing prices. This situation exists because many managers reify markets by separating them from social behavior. Math-powered applications to measure market risk synthesized only the data identified in the VAR algorithms; most VARs contain no data on social behavior. Moreover, it is virtually impossible to reduce social behavior to algorithms and incorporate all the relevant information required to predict risk as people respond to a wide range of variables, in part because their social and economic characteristics vary. The relevant variables change by time and place and have interaction effects with variables not included in the model. Even if algorithms could 194

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identify all relevant variables affecting social behavior, a time lag exists between the creation of the algorithm and the behavior. Why Oversight Agencies Fail Some criminologists (Black 2010) and the authors of The Financial Crisis Inquiry Report (2011) maintain that regulatory agencies, especially the Federal Reserve Bank, the SEC, and the FBI, should have intervened prior to the crisis. In general, there is little to disagree with in this position; however, given the adoption of neoliberal ideology and market fundamentalism and the appointment of neoliberals to crucial oversight agencies prior to the 2008 crisis, there is little reason to believe that this was a realistic expectation. Beginning with the Reagan administration in the 1980s, the SEC, which is responsible for “enforcing disclosure requirements,” which are different from financial “safety and soundness” (Black 2010, 11), was stripped of much of its oversight power and capacity, including the financial and human capital necessary to conduct oversight. Nor did the FBI have the human capital to investigate financial malfeasance of the scope perpetuated by the FIRE sector because their capacity in this area was also weakened in 2001 “when 500 whitecollar specialists were transferred to national security investigation in response to the” 9/11 attacks (Black 2010). Then, the George W. Bush administration refused to allow the FBI to hire replacements. With regard to the Federal Reserve, which had both the human capital and the authority to carry out this kind of oversight, its leadership adopted neoliberal ideology to guide policy changes that created opportunities to engage in financial malfeasance. Furthermore, the long-term effects of the revolving door between corporations and the government eroded the independence of the government agencies from corporate influence. The failure to strengthen regulatory controls and agencies is troubling because the 2001 bankruptcy at Enron and other giant corporations had sent a clear warning of the risk associated with the same financial instruments used in the FIRE sector. The failure of political and economic elites to enact proper oversight resulted in the much large FIRE-sector crisis. The $63.4 billion Enron crisis and the somewhat larger 2002 195

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WorldCom crisis are small compared to the $600 billion bankruptcy of Lehman Brothers alone. The Energy Crisis and the Mortgage Crisis: A Comparison This historical analysis reveals important similarities and differences between the 2001 energy crisis and the 2008 FIRE-sector crises. Using the resources under their control to exercise structural and instrumental power, the managerial class transformed organizational and political-legal arrangements in ways that created dependencies, incentives, and opportunities to engage in speculative behavior with high-risk derivatives. Their power was enhanced and legitimated by neoliberal advocates inside and outside the state who pressured Congress to enact legislation that made it more difficult for regulators to monitor and oversee large, complex corporations. Information asymmetry at Enron aided top managers in their efforts to encourage employees to invest a large portion of their retirement savings in Enron stock. It is estimated that in late 2000, $1.3 billion of the $2.1 billion in Enron’s employee pension fund was invested in Enron stock (Fox 2003). In addition to losing their jobs, thousands of Enron employees lost most of their retirement savings. Although most large investors could absorb their losses, the working and middle classes could not, and many employees who were close to retiring had little opportunity to rebuild their retirement savings. Other members of working and middle classes not employed by Enron also lost substantial amounts of their retirement because the institutional investors, who managed their retirement funds had invested in Enron stock. As predicted, the Enron crisis was the tip of the iceberg (Prechel 2003). The historical analysis shows that crises are explained by multiple causes, some of which are constant and others that are time dependent. The “magnitude of any single cause’s impact depends on the presence or absence of other causal conditions” (Kalberg, 1994; Ragin, 1997, 37). Crises are affected by contradictions that emerge from the historically specific character of capital accumulation, capital-state relations, the state structure, the network of interests inside and outside the state, and the irrationality of capitalism. Most of the organizational and political-legal arrangements remained constant after the Enron crisis. 196

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However, the speculative behavior of adventure capitalists is a timedependent (historically contingent) variable. With few modifications in the organizational and political-legal arrangements after the Enron crisis, speculative behavior increased. Although the amount of capital siphoned off by Enron’s managerial class is unimaginable by average income earners, the amount is relatively small in relationship to the capital transfers to the managerial class in the FIRE sector through salaries, bonuses, stocks, and stock options before and after the 2008 financial crises. The Enron crisis was a missed opportunity to contain risk taking, speculation, and financial malfeasance by adventure capitalists in giant corporations. Multiple government investigations of Enron provided the evidence and opportunity for political elites to restructure the politicallegal arrangements to limit speculation. Instead, political elites were responsive to the structural and instrumental power of FIRE-sector firms that contributed more than $1 billion to PACs and spent $2.7 billion between 1999 and 2008 lobbying government officials to permit them to continue their speculative and risk-taking behavior at the public’s expense. Despite the exposure of many structural holes during the Enron investigations, few accounting rule changes occurred after the Enron crisis. Nevertheless, regulators did succeed at implementing FAS 133 to establish accounting and reporting criteria for derivative instruments, including those embedded in other contracts for hedging activities. This form of derivative also known as a prepay or forward contract, entailed agreements to deliver a product at a later date. This rule was a response to the rapid growth in the use of hedge instruments in the home mortgage derivatives markets. It requires that an entity recognize all derivatives as either assets or liabilities in financial statements and measure them at fair value. Prepays are used to hedge against the potential of adverse price moves (US Government Accountability Office 2003, 11). Unless prepays are set up in a way that eliminates parent company risk, they are loans (repayment occurs after the product is delivered) and must be treated as such. The rule, however, was not passed until December 2006, just before Bear Stearns and other corporations imploded. 197

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Resource-dependent networks among energy corporations and banks and among FIRE-sector corporations established motives and incentives for managers to illegitimately bridge structural holes. Corroboration occurred among corporate actors in part because the benefits from stock options and other payouts were so high and the potential for punishment so low. Deception went unreported in the various components of the network because the organizational and political-legal arrangements created information asymmetry, and decision making occurred deep inside the complex MLSF form, where they were far removed from oversight agencies and the investing public. The extent of the risk in these economic sectors prior to the crises cannot be fully known since many of corporate assets were off-balancesheet. Because Enron received the most attention in the energy sector crisis, its failure provided an opportunity for other energy companies to unwind their fictitious commodities. Many of these energy companies lost massive amounts of investor capital, but they did survive. Similarly, the acquisition of the failing Bear Stearns on March 16, 2008, provided six months for management to unwind fictitious commodities before the final meltdown on September 15, 2008, when Lehman Brothers filed for bankruptcy. Despite their similarities, there are important differences between these economic sectors. Unlike the FIRE sector, most energy corporations had revenues from physical assets such as pipelines, oil wells, and energygenerating plants to aid their recovery. In contrast, most FIRE-sector firms had few physical assets. A second difference is that FIRE-sector firms are linked to one another in the financialization commodities chain in ways that had direct consequences for their successes and failures. As long as there were no major breakdowns in the network, all parts of this resource-dependent network could survive. However, when Lehman Brothers imploded, trust within the network disappeared, and banks would not loan capital to one another, which locked up credit markets. Although normative standards changed over time (Vaughn 1996; Palmer 2013), norms that condoned financial chicanery and malfeasance emerged after banks and corporations mobilized politically to reconfigure the organizational and political-legal arrangements in ways that permitted 198

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speculative and high-risk behavior to occur. After norms condoning speculation, risk, and financial chicanery and malfeasance were established at Enron, they spread to other corporations as their survival was dependent on competing with Enron and other corporations engaging in financial malfeasance. When Enron imploded, these behaviors had spread to the FIRE sector.

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chapter 7

The Extent and Causes of Financial Malfeasance This chapter presents two separate quantitative analyses of the largest US corporations and the largest US FIRE-sector corporations to examine the extent to which organizational and political-legal arrangements explain financial malfeasance. As research in organizational studies becomes increasingly fragmented into different academic disciplines and subfields, the structures of large, complex organizations garner less attention (Prechel 2000; Zald and Lounsbury 2010). To fill the gap, this chapter continues to focus on social structure, which has been displaced in recent years in organizational and economic sociology by cultural analysis with a particular focus on institutional norms. Although cultural explanations are important, political-legal arrangements, enforcement structures, economic conditions, and other dimensions of the social structure affect managerial behavior. As the historical analyses in the previous chapters show, acts of malfeasance are buried so deep inside corporations that many of these acts are undetectable from outside the corporation. The central proposition in this chapter is that corporations’ organizational and political-legal arrangements create opportunities for managers to exploit asymmetric information to advance their firm’s capital accumulation agendas and their own self-interest. A core presupposition guiding this analysis is that state structures and corporate structures cannot be separated from one another in society because state policy gives form to corporate structures. Although corporations are the focus of the analysis, they cannot be separated from those who make decisions that collectively contribute to corporate behavior or their political embeddedness as organizational and politicallegal arrangements create dependencies, opportunities, and incentives for managers to engage in financial malfeasance. 200

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Historically, organizational sociologists gave little attention to whitecollar crime in the banking and FIRE sectors, in part because these sectors were considered to be extensively regulated (Schnatterly 2003, 592). However, neoliberal political-legal arrangements decoupled the FIRE sector from crucial oversight agencies. We now know that the energy and FIRE sectors used their instrumental power to financialize the economy and engage in value extraction by financial malfeasance. Therefore, it is important to understand both the extent of malfeasance in corporate American and the organizational and political-legal arrangements that explain it. Qua n t i f y i ng Org a n i z at iona l -Pol i t ic a l E c onom y T h e ory: De p e n de nc i e s , I nce n t i v es, a n d Opport u n i t ies Theories that focus on structures and networks maintain that when organizations are externally constrained and controlled, they become resource dependent, which itself causes a lack of autonomy and uncertainty that threatens organizations’ capacity to survive (Zald 1970; Zeitlin 1974; Pfeffer and Salancik 1978). Although skills and knowledge are important organizational resources, capital is crucial because capital dependence limits autonomy and threatens corporations’ survival. Capital dependence therefore affects corporate strategies and the management of finances (Palmer, Jennings, and Zhou 1993; Mizruchi and Stearns 1994). It also creates incentives for corporations to modify their structure and environment. Building on resource dependence theory, organizational-political economy theory posits that capital dependence creates incentives for corporations, and their managers, to engage in financial malfeasance. At the individual level, managers can engage in financial malfeasance to benefit directly or indirectly from salary and stock options for advancing their corporation’s capital accumulation agendas. At the organizational level, capital dependence on external stakeholders that control critical resources create incentives for managers to misrepresent their corporation’s financial statements. Among the most powerful stakeholders that emerged during the 1980s and 1990s were mutual funds, pension funds, endowments, hedge funds, and other large individual and institutional investors that 201

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acquired corporate securities. Organizational political economy posits that when management is unable to achieve desired levels of financial performance through legitimate means, they may turn to illegitimate means. This capital-dependent relationship creates incentives for corporate managers to maximize shareholder value; if they do not, institutional investors may disinvest from the company, withhold future investments, or attempt to replace top management. By the mid-1980s, shareholder activists began to pressure corporations to tie executive compensation to corporate performance so that it would align the interests of agents to principals, prompting managers to behave more like owners. This performance-based compensation strategy assumes that greater monetary rewards create the kinds of incentives that motivate managers to make decisions that advance the organizational goal of increasing shareholder value. However, when organizations establish incentives designed to ensure that their members conform to external expectations, these conditions may decouple means from ends (Cyert and March 1963) and create perverse incentives and motives for managers to misrepresent their balance sheets. Therefore, organizational political economy takes a critical approach to performance-based compensation and maintains that financial incentives can have the unintended effect of encouraging managers to use illegitimate means to achieve organizational goals. Social structures affect both the opportunity to commit malfeasance and the type of malfeasance committed. Illegitimate exploitation of information includes violating the intent of an accounting rule or understood practice such that the balance sheet is inflated or risk is concealed. Such behavior may include capital transfers among corporate entities that conceal losses or place debt or high-risk financial instruments in corporate entities intended for low-risk investments. As the historical analysis shows, organizational size and complexity are two critically important characteristics that create opportunities to engage in financial malfeasance as bounded rationality associated with them contributes to asymmetric information. To illustrate, Tyco International acquired seven hundred companies (Bogle 2006, 45) and almost tripled its revenues from $6.6 to $17.3 billion between 1997 and 2001 and used 202

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the multilayer-subsidiary form (MLSF) to disguise financial malfeasance. After the corporation began to fail and malfeasance became apparent, Tyco’s CEO and CFO were accused of stealing more than $150 million from the company. In 2007, they agreed to pay investors $3.92 billion, $464 million in legal fees, and $28.9 million in legal expenses. Illegitimate bridging of structural holes can emerge when two parts of the social structure are connected to ensure information symmetry and a change occurs in one part of the structure without a corresponding change in the other, or if it is assumed that the market fills the same or equivalent function as a previous part of the social structure (e.g., government oversight). These social structural arrangements can provide managers with newfound autonomy and opportunity that make malfeasance harder to identify. A core hypothesis of this study maintains that the transformation from the multidivisional form (MDS) to the multilayer-subsidiary form (MLSF) created multiple opportunities for financial malfeasance because the MLSF became decoupled from crucial components of the regulatory structure. One dimension of decoupling was the failure to modify the rules governing financial reporting, a justification based on the general accounting principle that consolidated financial statements combine “the financial statement of a parent company . . . with those of its subsidiaries, as if they were a single economic entity” (Counterparty Risk Management Policy Group III 2008, 40–41). Exploitable opportunities emerged because this structure permits managers to transfer capital among corporate entities that are hidden from investors and oversight agencies. This rule also permits management to exercise discretion when establishing, for example, the value of its wholly owned subsidiaries. Other decoupling included relaxing the rules governing communication between managers and investors: permitting investors to meet with management created opportunities for both parties to identify and articulate their mutual interests and goals (Krier 2005). Fortune 500 Research Design A data set was compiled consisting of the five hundred largest US publicly traded parent companies in 2001 as identified by Fortune magazine (2002b). 203

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Examining the population of the largest US corporations addresses the extent to which banks and nonbanks engaged in financial malfeasance. We identified 2002 as the sample selection year because several companies that engaged in financial malfeasance, including Enron, Tyco, and WorldCom, were eliminated from the Fortune 500 the next year. We then examined company financial restatements from 1994 to 2004 to compile an elevenyear data set. The Sarbanes-Oxley Act of 2002 created a unique opportunity to examine corporate financial statements by providing a window for management to refile financial statements without punishment. Sarbanes-Oxley created several incentives for executives to refile misleading statements, including requiring CEOs and CFOs to sign statements attesting to the accuracy of their firm’s financial restatements and making them personally responsible if their statements contained misleading information. In the event of falsely certifying the accuracy of a financial statement, executives were held personally responsible for up to $1 million and subject to a jail sentence of up to ten years for knowing of the violations and twenty years for willful violations. In addition, if a company was required to restate its financial statement due to misconduct, its executives could be forced to forfeit bonuses and profits obtained from selling company stock. These conditions limited the risk of underreporting. Because this measurement entailed self-identification by executives who misled investors, there was little risk of overreporting. Given the incentives and opportunities for executives to restate data without punishment together with punishments for failing to do so, it was unlikely that there were many cases where misleading financial statements were not restated. Several corporations were excluded from the Fortune list because they were partnerships, private companies, or subsidiaries of foreign corporation: partnerships and private companies were not required to adhere to the same financial disclosure requirements as public companies, and subsidiaries of foreign corporations could engage in different behaviors because their parent companies were governed by different political-legal arrangements. When two companies in the population merged during 204

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the study period, the company that obtained managerial control became the parent company. Given it was not possible to anticipate companies that went private or filed for bankruptcy after the study began, they were eliminated to maintain consistency in the population of corporations. The final population is composed of 464 companies. We also examined FIRE-sector firms in a separate analysis because they were at the heart of the 2008 financial crisis. This analysis covers the period between 2001 and 2008 in order to have a sufficiently long time frame to capture potential financial malfeasance. The study period ended in 2008 as corporations perhaps became more cautious and changed their risk-taking behavior after the financial crisis. The dependent variable for the FIRE sector is a dummy variable indicating whether the SEC filed an allegation against a company in a particular year, information obtained from the litigation database of corporate financial violations on the SEC’s website. Since the SEC makes an allegation against a corporation after it compiles evidence of financial malfeasance, we can assume the validity of the data. Most of these SEC allegations involved accounting violations but also included violations relating to information disclosure, market manipulation, and insider trading. The analysis focuses on the occurrence of a violation event rather than the count of events for two related reasons. First, once a firm is accused of one violation, it is subject to further scrutiny, and related violations are likely to be discovered. Thus, identifying multiple violations is in part a consequence of identifying the first event. Second, using a dummy dependent variable avoids the problem of companies with multiple violations in a particular year having undue influence on estimation results (e.g., one company in the sample had eleven allegations in a single year). A couple of clarifications about the FIRE-sector dependent variable are in order. There is a difference between an allegation by the SEC and an actual financial violation. In virtually all cases, the implicated corporations settled with the SEC while neither admitting nor denying whether they committed the violation. Moreover, our contact in the SEC informed us that the agency is conservative when filing allegations of financial malfeasance: they are not filed unless the agency obtains sufficient evidence to 205

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make a strong case. For these reasons, firms accused of violating SEC rules are likely to have committed financial malfeasance. Another problem relates to undercounting. Since the SEC files allegations only when it has a strong case, it is not possible to identify firms that committed malfeasance but the evidence did not reach SEC requirements. This SEC criterion suggests that the data provides a conservative estimate of financial malfeasance.1 Fi n di ngs FIRE-Sector Findings As expected, the number of alleged SEC violations increased during the study period as FIRE-sector firms shifted to the politically disembedded end of the embedded-disembedded continuum. In 1995, only one firm out of forty-seven (2 percent of the firms) had only one alleged violation. During the period of reregulation, the alleged violations increased and peaked in 1999 when allegations against nine firms with a total of twenty-one violations were filed by the SEC (16.7 percent of the 54 firms in that year). After the corporate failures in 2000, the number of alleged violations decreased to seven firms with nine allegations in 2003 (11.3 percent of the sixty-two firms in that year; see figure 7.1). This decline was expected as managers became more cautious after the public exposure of highly publicized cases of financial malfeasance in 2000 and shortly after. The analyses of the variables (not shown) in selected years (1995, 1999, and 2003) show that prior to the 2008 crisis, FIRE-sector firms were highly complex organizations with an average number of fifty-five subsidiaries in 1995. The number of subsidiary corporations under parent company control declined to about fifty in 1999 but increased to sixty-one in 2003. Meanwhile, mean dividends per share increased from forty-nine cents in 1995 to seventy-one cents in 2003. The data are consistent with the ascendance of the shareholder value thesis. In terms of executive compensation, the average top executive in the study group earned about $2.2 million in salary and bonuses in 1995 and about $3.7 million in 2003. More dramatic change occurred in the average value of the stock options granted to a top executive during the study period, which dramatically increased from about $1.4 million in 1995 to approximately $9 million in 1999 and in 2003. The regression shows that the more complex parent companies are, the more likely they are to engage in financial malfeasance (table 7.1). The results 206

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Figure 7.1. FIRE Sector Alleged Security and Exchanged Commission Violations.

suggest that a 10 percent increase in the number of subsidiaries increases a firm’s odds of committing a violation by about 6% (see table 7.1). This effect can become substantial since the number of subsidiaries controlled by parent companies in the study group varies from a couple of dozen to several hundred. The analysis also shows that size, which is measured by total assets of the firm in its natural logarithm form, is positively associated with financial malfeasance. For a 10 percent increase in assets, a firm’s odds of committing a violation increase by 10 percent. Thus, the largest FIRE-sector firms are more likely to engage in financial malfeasance. Because the study group includes only FIRE-sector Fortune 500 firms, the findings are not generalizable to smaller firms. Instead, this finding suggests that the largest FIRE-sector firms are more likely to engage in financial malfeasance than other relatively large firms. The analysis also supports the shareholder value argument that a lower dividend payout per share increases a firm’s odds of financial malfeasance. Hypothetically, a one dollar decrease in dividend payout increases a firm’s odds to violate securities laws by more than nine times. Placing this finding in context, dividend per share of the firms in the sample ranges from zero 207

Table 7.1. Statistical Model of FIRE-Sector Financial Malfeasance, 1995–2004 Model 1 Independent variables Number of subsidiaries (log)

0.656*

Total assets in millions (log)

0.987***

Dividend per share (in dollars)

-2.280**

Change in stock price (percent)

0.0001

Total salary and bonus of top executive in thousands

1.114**

(log)

(0.371)

Value of stock options of top executive in thousands

–0.040

(log)

(0.052)

(0.323) (0.286) (0.781) (0.002)

Control variables Organization age (in years)

0.005 (0.005)

Growth in assets (percent)

0.0003 (0.004)

Return on equity (percent)

–0.003

Clinton administration dummy (1995–2000)

0.520**

(0.027) (2.570) Intercept

–25.111*** (3.856)

Number of events

56

Number of firms

73

Number of company-year observations

552

*p < 0.05, **p < 0.01, ***p < 0.001 (two-tailed test). Source: Prechel and Zheng (2016).

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to two dollars in most cases and averages around 0.50 to 0.70 dollar per share in a typical year. This finding suggests that FIRE-sector firms that are more capital dependent and cannot pay higher dividends are more likely to engage in financial malfeasance. The analysis does not show that the value of stock options has an effect on a firm’s likelihood of engaging in financial malfeasance. A plausible explanation is that stock options provide returns to management over a long time period, whereas financial malfeasance is often due to rising stock values in the short term. The amount of salary and bonuses paid to the top executive is positively associated with a firm’s odds of financial malfeasance. The results show that all others being equal, a firm’s odds of violating securities laws increases by about 11 percent per 10 percent increase of executive compensation in the form of salary and bonus. With regard to the control variables, age does not have an effect on a firm’s likelihood of financial malfeasance. Since organizations tend to grow larger and more complex as they age, including the number of subsidiaries and organizational size, the age effect is likely eliminated. Therefore, organizational complexity and size, not age per se, increase a firm’s likelihood of financial malfeasance. This finding is consistent with other studies showing that change to the MLSF was not affected by age (Boies and Prechel 2002). This finding does not support a long-standing claim of population ecology theory that size inertia is an obstacle to change. Profits and growth were not significant, which suggests that other financial variables are better predictors of SEC violations. A dummy for the years of Clinton administration was included and had a significant positive effect, indicating that a Democratic administration is more likely to enforce securities laws. To summarize, the statistical analysis of the largest FIRE-sector firms supports the organizational political perspective showing that corporations with more complex organizational structures, larger size, lower dividend payment, and higher executive compensation in the form of salary and bonus are more likely to commit financial malfeasance. Fortune 500 Findings for Banks and Nonbanks The quantitative analysis is extended to the largest US corporations because the new political-legal arrangements permitted most corporations to create FIRE-sector subsidiaries and become market participants. 209

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Soon after Congress passed the Sarbanes-Oxley Act, corporate financial restatements increased substantially. Whereas widespread mergers and acquisition resulted in a decline in the number of corporations listed on the New York Stock Exchange between 1998 and 2002, the number of corporations that restated their financial statements increased from 83 in 1997 to 220 in the first six months of 2002. A total of 845 companies restated their financial statements between 1997 and 2002 (US Government Accountability Office 2002). Moreover, between 2002 and 2005, 16 percent of the companies listed on the three major stock exchanges announced restatements (Tillman and Indergaard 2007). The dependent dummy variable measures whether a corporation filed a restatement in a given year; it is coded 1 if it restated its data for the year and 0 if it did not. The analysis examines the year of the misstated data since that is when the malfeasance occurred. The data for restatements that occurred between January 1, 1997, and June 30, 2002, were obtained from the US General Accountability Office (GAO; US GAO 2002). To extend the longitudinal analysis, data were collected on restatements occurring between January 1, 1994, and December 31, 1996, and between July 1, 2002, and December 31, 2004, by replicating GAO’s (2002) methodology. When corporations restated several years of data with one announcement, the year of the restated data was coded as a separate event. The data include only restatements that occurred because of improper accounting, which excludes misstatements that occurred due to changes in accounting principles, the number of outstanding stocks, or the application of accounting standards (US GAO 2002). The analysis begins in 1994 because FASB issued a ruling that year requiring fuller disclosure of corporate balance sheets. The time period of the data ends in 2004, which gave management sufficient time to respond to the Sarbanes-Oxley Act strengthening of the Securities Act of 1933 and the Securities Exchange Act of 1934 by requiring management to provide investors with sufficient information to make informed investment decisions. Focusing on financial restatements is an innovative way to study financial malfeasance, which is difficult for researchers to observe. The analysis shows that over 21 percent of the largest US corporations restated their finances at least once, and some as many as seven times, during our study 210

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period. Widespread financial malfeasance shows that prior to the 2008 financial crisis, this behavior was not limited to a few “bad apples” as often presented to the public. These restatements represented huge losses for the investing public: between January 1997 and March 2002 alone, corporate financial restatements resulted in losses of approximately $100 billion in market capitalization (US GAO 2002). At the same time, the managerial class benefited substantially from misleading financial statements. For example, WorldCom’s chief financial officer took approximately $35 million from stock sales prior to public exposure of financial malfeasance (Economist 2002). The descriptive statistics in figures 7.2 and 7.3 support the proposition that the MLSF increased the risk of financial restatements. Figure 7.2 shows that during the study period, 5.6 percent of parent companies organized as an MLSF restated their finances, almost double the rate of those not so organized (3.2 percent). Figure 7.3 places the population into four quartiles based on their total number of subsidiaries, providing further support for the proposition that the risk of filing inaccurate financial statements is associated with increased complexity; corporations with more subsidiaries had a higher rate of financial restatements. Table 7.2 presents the exponentiated logistic coefficients, a transformation that allows an examination of the factor change in the odds that an event will occur, holding all other variables constant (Long 1997). Model 1 includes only the control variables (assets, age, divisions, longterm debt, and FIRE and New Economy (energy, telecommunications, and information processes sectors). Long-term debt has a statistically significant negative impact on the odd of restatement, and corporations in the telecommunications and information processing sectors, where there is a large share of new corporations, are more likely to restate their financial statements than are corporations in other sectors. Model 2 adds three capital dependence variables: the standard measure for capital dependence, return on equity, and two measures of capital dependence on shareholders, earnings per share, and change in share price. Earnings per share has a statistically significant negative impact on the odds of restatement. Return on equity and annual change in share price are not statistically significant. Controls for the telecommunications and 211

Figure 7.2. Percent of Corporations Restating Financial Statements by Multilayer-Subsidiary Form, 1994–2004.

Figure 7.3. Percent of Corporations Restating Financial Statements by Total Number of Subsidiaries (Quartiles), 1994–2004.

Table 7.2. The Odds That an Event Will Occur Variables

Model 1

Model 2

Model 3

Model 4

Intercept

.033**

.042**

.037**

.020**

(.206)

(.225)

(.230)

(.293)

1.000

1.000

1.000

(.003)

(.000)

(.000)

.941**

.942**

.941**

(.024)

(.024)

(.024)

.998

.996**

.996*

(.002)

(.002)

(.002)

1.042*

1.044*

(.019)

(.019)

1.003**

1.003**

(.001)

(.001)

Dependence and incentives Capital dependence Return on equity Capital dependence on shareholders Earnings per share Annual change in share price Management strategies to increase shareholder value Mergers and acquisitions Annual change in asset growth Opportunities Organizational structure Multilayer-subsidiary form

2.129**

Subsidiary

1.583* (.219)

(.236)

Political behavior PAC Contributions

1.002* (.001)

Control variables Total assets Age Number of divisions Long-term debt FIRE industry

1.000

1.000

1.000

1.000

(.000)

(.000)

(.000)

(.000)

1.002

1.001

1.002

1.001

(.002)

(.002)

(.002)

(.001)

.994

1.003

1.004

.993

(.022)

(.022)

(.022)

(.023)

2.664*

1.322

1.276

.966

(.478)

(.609)

(.612)

(.629)

1.108

1.142

1.205

1.051

(.255)

(.263)

(.261)

(.269)

t he e x t en t a nd causes of fina nci al m alfe asa nce

Table 7.2. The Odds That an Event Will Occur (continued) Variables

Model 1

Energy industry Telecommunications industry Informational technology industry Number of company years Likelihood ratio X

2

X 2 goodness-of-fit ratio

Model 2

Model 3

Model 4

1.115

1.267

1.304

1.182

(.243)

(.255)

(.256)

(.258)

2.695**

2.852**

2.611**

1.939

(.323)

(.379)

(.387)

(.400)

1.831** (.192)

1.837** (.199)

1.798** (.201)

1.848** (.203)

4,155

3,957

3,956

3,955

23.770**

33.195**

50.567

69.905**

.997

.992

.996

.994

*p