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No Pain, No Gain

Last fall, Williams Communications Group (WCG) looked like as good a bankruptcy candidate as any. The firm was supposed to make money by selling access to its 33,000-mile fiber-optic network to phone companies and Internet service providers. But a glut of fiber-optic cable had driven prices for that service down dramatically, while communications traffic was barely increasing. That left WCG's revenues at only a fraction of what had been expected when all its cable had been laid. To make matters worse, the company was straining under the $5 billion in debt it had used to build its huge infrastructure. And yet bankruptcy was nowhere on the horizon. Instead WCG initiated a fairly amicable renegotiation of the terms of its debt.

Only this February did the company's fortunes really head south. But once they did, the fall was precipitous. On February 20, WCG's creditors promptly walked away from their ongoing discussions with the company. One month later WCG announced it would have to consider bankruptcy; one month after that it filed for Chapter 11. According to the company's CEO, Howard Janzen, the reason for the reversal was simple: The ripple effects of two of the biggest accounting scandals in history, which had damaged the faith of creditors and investors. "I don't want to blame Enron and Global Crossing," Janzen told The Washington Post in March, "but the reality is ... if neither of those events occurred ... I do not think we would be here."

Now that WorldCom's collapse is headlining a second wave of corporate scandals, jittery investors and creditors are retrenching all over again. In recent weeks Adelphia, Tyco, and Xerox--among others--have all disclosed accounting irregularities, leading the Dow Jones to shed 1,400 points, or 14 percent of its value, since its mid-May rally. The wave of corporate restatements has also led to higher interest rates on corporate debt, pricing some firms out of the debt market as creditors worry that loaning them money might be a riskier proposition than they'd once thought. As a result, many commentators now share Janzen's concern that otherwise viable companies may be driven under by their creditors, causing a wave of bankruptcies and layoffs that could undermine an already fragile recovery. "[O]nce we had WorldCom and then Xerox, there's a straw that breaks the camel's back," observed University of Pennsylvania financial economist Jeremy Siegel on CNNFN last week. "[W]hen the news piles on, that's when this trust gets destroyed." As if on cue, the trade publication Wireless Week reported that industry CEOs feared they were "falling victim to overreaction by analysts, investors and ratings agencies in response to larger, and often unrelated, concerns." And these days newspapers are full of headlines like this one in the June 26 Los Angeles Times: "ECONOMY: MOOD HURT BY ACCOUNTING SCANDALS, JOB WORRIES."

But these pessimistic predictions may turn out to be only partly true. Yes, the recent spate of scandals will likely spark further bankruptcies, and, yes, that may hurt the economy in the short term. But like WCG, many of the companies that will go under probably have no real economic rationale for existing anyway--that is, actual profits or reasonable prospects for future profitability. Because such companies suck up capital that might otherwise flow to more productive endeavors, they create a long-term drag on the economy; it's only once they fall by the wayside that the economy can resume something resembling robust growth. If the latest revelations accelerate that process, something good may come from them after all.

As Washington Post columnist Robert J. Samuelson pointed out in a recent column, shoddy ethics are only the proximate cause of the accounting scandals. The real cause is shoddy economics. In the late '90s investors and creditors dumped bushels of money into companies with big plans to exploit regulatory changes and new technologies. The 1996 Telecommunications Act opened local telephone markets to competition; energy deregulation allowed pipeline companies to reinvent themselves as traders; exponential increases in Internet traffic created opportunities for companies like WCG to profit from the infrastructure that would carry it; and the World Wide Web gave rise to thousands of companies seeking to exploit e-commerce. With all this going on-- and Federal Reserve Chairman Alan Greenspan determined not to spoil the party by raising interest rates--it's no surprise thousands of new firms raised so much capital for their ventures. But despite some very real opportunities, all the new firms couldn't possibly survive. It would be years before there were enough customers to sustain all the new fiber-optic cable, long-distance telephone service, energy trading floors, and Internet pet stores that companies were furiously creating. In the meantime, the combination of so many firms and disappointingly few customers was driving prices through the floor--and with them, hopes of profitability. We now know that executives at companies like Enron and WorldCom- -and surely many others--recognized the inexorable logic of this equation years ago and responded by making up profits that didn't exist. Meanwhile, those who either refused or neglected to follow a similar path began going under in 2000, once investors realized that paying inflated prices for shares of unprofitable, debt-ridden companies didn't sound like such a bargain after all. After proliferating in the late '90s, more than 200 dot-coms failed. Over 500 more followed suit in 2001--including such can't-lose propositions as the Internet toy-selling pioneer eToys and the online grocer Webvan.

For all the pain the failure of these companies inflicted, it was undoubtedly necessary. The only way an economy can right itself in the aftermath of a bubble is when all the money and manpower that had been deployed inefficiently--which is to say, wrapped up in companies or other assets that weren't profitable and had little hope of becoming profitable--gets redeployed to more promising investments. On the eve of the 1990-91 recession, for example, U.S. banks found themselves stuck with billions of dollars' worth of bad loans, mostly on commercial real estate that had been bought at wildly inflated prices and which was suddenly worthless. Had banks kept floating money to developers who insisted they would one day make a profit (from office space, malls, etc.), it would have tied up capital that could have been--and ultimately was (albeit after a government bailout)--much more profitably invested elsewhere. It could very well have undermined the healthy economic growth of the mid-'90s. The problem this time around was that the liquidation cycle never completely ran its course. Today, for example, the bulk of the telecom industry's infrastructure is still in place. This is partly because dozens of uncompetitive and otherwise doomed firms have so far avoided bankruptcy. And it's partly because even among the 60-odd telecom companies that have declared bankruptcy since early 2001, many are still serving customers, thanks to the indulgence of their creditors. "[Bankruptcy alone] doesn't physically remove capacity from the marketplace," complains Credit Lyonnais telecom analyst Gabriel Lowy. "Even Enron's fiberoptic network still hasn't been decommissioned. " Worse, many of the companies that surrendered to last year's telecom shakeout are now emerging from bankruptcy proceedings with new lines of credit. One of the reasons for this stillborn liquidation process is the aggressiveness with which the Fed cut interest rates last year. In 1990 the Fed didn't really begin lowering rates until the recession began, and even then it did so exceedingly slowly. Though the federal funds rate, the key short-term interest rate, ultimately bottomed out at 3 percent in 1992, it was five months into the recession before it had fallen a single percentage point, from 8.25 to 7.25. This time around, the overall drop in the fed funds rate was comparable-- from 6.5 to 1.75--but it occurred in less than one year. And the Fed had cut interest rates a full percentage point one month before the recession even began.

The Fed's behavior was by and large defensible. If not for the aggressive lowering of interest rates, the spending on housing and consumer goods that kept the economy out of a deep recession could have collapsed. But lowering interest rates so aggressively isn't costless: Low interest rates make it easier for unprofitable businesses to stick around by amassing more and more debt. And the longer these companies do so, the longer it delays an economic recovery. The most common refrain among economists these days is that a healthy recovery hinges on businesses resuming investments in capital equipment-- investments that drove economic growth in the late '90s and that have been flat or declining for the last year and a half. "I sound like a broken record, but the question is, `When does investment pick up?'" says Ohio State University economist Stephen Cecchetti. The problem is that many of the same sectors that drove the investment boom in the '90s are the ones suffering from overcapacity and falling prices today. The only way these companies can begin investing again is if they become profitable again--and that will only happen once weaker competitors go out of business, excess capacity is scrapped, and prices for products and services start rising.

To see what happens when uncompetitive companies are permitted to stay afloat too long, one need look no further than Japan's experience over the last decade. Following the 1989-90 popping of Japan's real estate and stock market bubbles, the de facto policy of the Japanese government was to prop up businesses whose failure would cause massive unemployment and dislocation. According to Jim Grant, editor of Grant's Interest Rate Observer and a close watcher of Japanese finance, Japanese economic officials "implored and cajoled and bullied the complicit bankers into prolonging the sick lives of such [major] retailers as Sogo and Mycal." Thanks largely to this policy of not allowing banks to foreclose on bad loans, Japan has endured anemic growth over the past decade, with three recessions and unprecedented unemployment. "The intention was humane," says Grant, "but the outcome has been very costly."

Of course, there are important differences between the United States and Japan. Unlike the Japanese bubbles, ours was most pronounced in technology sectors--and it's much easier to "decommission" excess computers and fiber- optic cable than excess office buildings. Likewise, after Japan's bubbles burst, Japanese banks found themselves holding the majority of the bad loans that had funded all the ill-advised investments. Had they liquidated them all at once, it could have brought down the entire financial system and led to the sort of deflationary crisis that spawned the Great Depression. By contrast, the bad debt from America's technology boom is fairly widely dispersed, meaning everyone stands to lose a little but no one creditor will be wiped out. "This stuff was in investment funds, hedge funds, pension funds--we're not going to get defaults," says Cecchetti. But most importantly, unlike the Japanese, we don't make it a policy to bail out companies and industries long after their economic prospects have dimmed. That unprofitable U.S. companies will ultimately fail usually isn't a matter of if but when.

Indeed, for many months last year it appeared this process was happening right on schedule. Though the Fed had cut interest rates, most companies faced much higher effective prices for capital. (The Fed only sets the interest rate at which it loans money to banks and at which banks loan money to one another. The private-credit market determines the interest rates businesses actually face.) But by this spring that had begun to change, thanks to optimism that the economy was bouncing back much more quickly than expected. In April interest rates on short-term loans to businesses--so-called commercial paper--had fallen to fairly affordable levels even for risky borrowers, which allowed many marginal companies to keep themselves afloat despite flat revenue and a lack of profits. Even the rate for speculative grade, longer-term bonds (aka "junk bonds") was lower than it had been the previous August. But that all changed in late June, when word of WorldCom's impending profit restatement began percolating on Wall Street. In three days the spread on investment-grade bonds--that is, the difference between the interest rates less- risky businesses pay and the interest rates the government pays on similar bonds--jumped about 0.15 percentage points, something that hadn't happened since Enron rattled bond markets in February. Around the same time the spread on junk bonds jumped to 7.75 percentage points, a place it hadn't been since last year. And on June 26, the day after word of WorldCom's shenanigans first surfaced in the financial press, the junk bond market staged its worst showing ever (the market dates back to the mid-'80s), shedding 4 percent of its value. "I got an e-mail from one of our sales people," recalls Marty Fridson, chief high-yield strategist at Merrill Lynch. "He wrote, `Here's how much our bonds are down.' I e-mailed back, `Over what period of time? A month? A year?' He said, `No. This morning.'"

The economic effects of that squeeze were not hard to discern. Telecom workers accounted for more than 30,000 of the 95,000 layoffs in June, with most of the 30,000 coming after the WorldCom scandal broke. More layoffs-- possibly from battered telecommunications-equipment manufacturers--are sure to follow. Perhaps more significantly, the swoon added fuel to speculation that large telecom companies like Denver-based Qwest Communications--already straining under the weight of $27 billion in debt and Securities and Exchange Commission investigation--would fail to reach agreements with their creditors to keep themselves from defaulting. "A lot of people are going to throw in the towel on telecom," James Kenny, head of corporate bond trading at Bear Stearns, told The Wall Street Journal after sizing up the bond market developments.

Many market observers have since argued that this was a gross overreaction to the sins of one company. But the more you break down that overreaction, the more reasonable it looks. As Fridson notes, the carnage was almost entirely confined to the economy's lingering bubble sectors: telecom, cable, technology, and utilities. The bonds of most other industries actually appreciated that day. And after a few days the bond markets were discriminating among companies even within the problematic sectors. "Within [telecom bonds] there are differences between those companies that remain heavily indebted, such as France Telecom and Deutsche Telekom, and others that do not face such pressure on their credit ratings," The Financial Times reported on June 28. In the end, creditors' response to the WorldCom scandal seems less an irrational overreaction than a surprisingly rational reassessment of the considerable weakness that still exists in many troubled sectors of the economy. Once upon a time that was considered evidence of a well-functioning market.

This article originally ran in the July 22, 2002 issue of the magazine