Global Policy Forum

by Gretchen Morgenson

Thanks to a star-quality cast, the Enron wreck has been riveting theater. Greedy executives concocting transactions to inflate company earnings, grasping Wall Street bankers eager to assist, pliant accountants and analysts looking the other way — Broadway's finest could not have come up with a better script.

Yet while all eyes remain on Enron, a tragedy of identical plot but with far more damaging implications has been playing out on another stage. Unlike Enron's saga, this drama is not about a single, rogue company operating to enrich its executives. This tale is about an entire industry — telecommunications — that rose to a value of $2 trillion based on dubious promises by Wall Street and company executives of an explosive growth in demand for telecommunications services. When that demand failed to materialize, the companies were left with mountains of debt and little revenue.

Now, securities regulators are examining transactions among some telecom companies — Global Crossing and Qwest Communication are two — that may have been designed to pad inadequate revenue. Last week, Congress, too, started an investigation of the telecom mess, looking at how certain companies accounted for the deals they struck with one another and whether employees in the companies' 401(k) plans were treated fairly.

As they dig, they may discover a trait that distinguishes this financial mess from others: the role played by an extensive web of relationships among these companies. Because of many deep and tangled ties, telecom companies were able to show what looked like promising growth in the mania's initial stages. But when demand from consumers and corporate customers of the networks failed to emerge, the ties among the companies exacerbated their declines. When one company failed, other failures became almost inevitable.

It is unclear whether many of these interlocking relationships served any economic purpose. What is clear is that executives had incentives to forge them: by creating revenue, they helped keep the stock price up.

There is no doubt that the mess is large. Since the telecom sector peaked in the spring of 2000, some $1.4 trillion in investor wealth has evaporated, according to one analyst. More than 15 companies have filed for bankruptcy reorganization in the last year or so, including former highfliers like Global Crossing, which made the fourth-largest bankruptcy filing in American history in January, as well as 360 Networks, PSINet and Net2000 Communications. Many others in the industry are teetering.

Even companies that seemed solid and well diversified have been hurt. Lucent Technologies and Nortel Networks, both generous financiers to upstart telecom companies that bought their equipment, have had to write off billions of dollars in bad debts associated with their customers' failures.

Almost 400,000 jobs in the telecommunications sector have vanished as well, according to Challenger, Gray & Christmas, the job placement concern. And the bloodletting is not slowing: telecom companies cut some 61,000 jobs in the first two months of 2002, up 42 percent from the toll during the comparable period last year. Adding to the injury, many of the sector's 401(k) plans — filled as they were with company shares — are in tatters.

"The underpinnings of the emerging telecom bubble were a phenomenal miscalculation," said David Barden, a telecommunications analyst at J. P. Morgan. "At the time it seemed like a logical progression of history: cellular, the Internet, the new thing. It was bold, it was risky, it was expensive. And it was wrong."

In contrast to the implosion of Enron, which attracted front-page headlines, the disaster in telecommunications arrived stealthily. The failures occurred in slow motion over the last 18 months and have mostly involved smallish, lesser-known companies. But thanks to Enron, the haves and have-nots in the drama are depressingly familiar. Executives and shareholders lucky or prescient enough to get out early got rich as their companies' shares rocketed. Joseph P. Nacchio, chairman of Qwest, and Philip P. Anschutz, the co-chairman, have sold shares worth almost $2.3 billion since 1998. And James Q. Crowe, chief executive of Level 3 Communications, sold $115 million worth of stock from 1999 to 2001.

"Unlike the Internet, which was brand new, telecom had an aura of an established and understood technology," said Paul Elliott, an analyst at Thomson Financial. "This, in part, set the stage for this massive transfer of wealth to the new telecom barons, not only from gullible investors, but banks and lenders who presumably should have known better."

Workers and shareholders who did not get out were left without chairs when the music stopped. In the 401(k) at Qwest, for example, almost 40 percent of the assets were in Qwest stock at the end of 2000, the most recent filings available. Since then, the shares have lost almost 80 percent of their value. At Global Crossing, 29 percent of 401(k) assets were in the company's stock as of the end of that year.

The telecom turmoil isn't over. Two years after the bubble popped, many companies in the industry are still operating on the edge, even more heavily encumbered with debt as a portion of their capitalization than they were when their stocks were flying high. Many now have little equity value but still carry onerous levels of debt.

As a result, in recent months, Qwest, WorldCom, Sprint and AT&T have sharply reduced their operations, staffs and earnings forecasts. Smaller companies like XO Communications and Level 3 Communications are struggling to restructure the terms of their debt obligations to stave off bankruptcy. Just last week, Metromedia Fiber Networks warned that it might file for bankruptcy soon.

REGULATORS, meanwhile, are focusing their investigations on how telecom companies accounted for certain transactions in which competitors swapped capacity on their networks. At issue is whether companies artificially inflated their earnings by striking deals that had no economic value but that appeared to produce immediate revenues to both parties.

At the center of this debacle stand the usual Wall Street enablers. Investment bankers raised money from investors for far more telecom networks than were economically feasible. Brokerage-firm analysts, eager to help their employers win ever more securities offerings, drummed up investor interest in untested companies.

Because these companies had neither revenue nor earnings, telecom analysts devised new rationales, new metrics, to justify the purchase of already overpriced stocks — just as they did with Internet shares.

The most popular method was to value the companies based on the money they had put into their networks — money from investors, not money that the company had earned. Susan Kalla, a telecom analyst at Friedman Billings & Ramsey in New York, recalled when telecom shares were promoted by big brokerage firms as good values because they traded at prices that represented four or even five times what they had invested in plant and equipment.

That argument, she said, "presumed that every penny that every company invested would produce the same rate of return."

"They really thought that if you put in the latest, fastest thing, that was enough to drive the business," she added. "It was crazy."

But for all its similarities to other debacles, the one in telecom is remarkable in a particular way: the hundreds of interlocking relationships — all financial — among the industry participants that perpetuated the spread of the collapse. As Mr. Barden of J. P. Morgan explained: "It turns out that the amount of revenues generated inside the telecommunication industry by other telecom participants was such a large percentage of the total that a small number of bankruptcies fueled a larger number of bankruptcies and the entire emerging structure started to collapse."

Noting early on how intertwined the fortunes of telecom companies were, Mr. Barden published an extensive research report last April called "The Matrix." In it he identified 184 relationships among 49 telecom companies. The ties fell into four categories: commercial, which included deals like leasing capacity on one company's network by another; strategic, which involved investments in competitors; equity, which referred to the purchases of shares in another company; and vendor financing, in which one company provided funds so that another could buy its products.

At the time of the report, each company in Mr. Barden's telecom matrix had ties to an average of four others in the industry. But some had far more. Metromedia Fiber Networks, for example, had sold fiber to 21 companies, making it an important dealer of the commodity. But because most of these deals were long-term leases, Metromedia's fate was inextricably tied to the health of these companies. Five of them have filed for bankruptcy, and others are in danger of failure. So it is not surprising that Metromedia recently warned that a bankruptcy filing of its own might be near.

In 1998 and 1999, during the early days of the telecom gold rush, such relationships were crucial for start-up companies; they knew that networks were expensive to build and that investors who financed them would have only so much patience before they began to demand returns. Rapid growth in revenue was therefore necessary, Mr. Barden explained, and the quickest route to it was through sharing of the networks that were being laid.

For example, in a 10-year deal worth $500 million and signed in 2000, Exodus Communications agreed to send half of its traffic to a network owned by Global Crossing. Conversely, Global Crossing owned $1.9 billion of Exodus shares that it had received from the sale of a subsidiary, Global Center, to Exodus.

The Exodus network did not attract enough traffic, however, and the company filed for bankruptcy last October. The loss of the Exodus deal contributed to Global Crossing's problems, which came to a head in January.

In another pact, dating to December 1998, Winstar Communications agreed to pay Williams Communications $640 million over seven years to use one of its networks, while Williams was to pay $400 million over four years to Winstar for some wireless capacity. After Winstar declared bankruptcy last April, Williams Communications estimated that it would lose $70 million in revenue that it had already booked from April 2000 through last December. Struggling under $5.2 billion in debt, Williams warned last month that it might file for bankruptcy soon.

In November 2000, Level 3 Communications sold fiber infrastructure worth $250 million to Mc- LeodUSA. McLeod also owns fibers on Level 3's network, thanks to its acquisition of Splitrock Communications in 1999. McLeod filed for Chapter 11 bankruptcy protection in January, and Level 3 said recently that its declining revenue might violate terms of a bank covenant this year. That could ultimately force the company into technical default on some of its debt.

And just last week, Velocita, a private company led by Robert Annunziata, a former chief executive of Global Crossing, appeared to be in danger of defaulting on its debt. The company's plan to build a 20,000-mile telecom network was financed by, among others, Cisco Systems, which invested $200 million in the company and lent it an additional $285 million to help buy Cisco equipment.

While tying up with other companies in the industry helped all the players initially, the relationships also meant that most companies were offering the same services to potential customers. They could not differentiate themselves, and that can spell death when a field is crowded with competitors.

As the accounting for some transactions is being questioned, these relationships are causing additional problems for telecommunications companies. Two weeks ago, Qwest announced that it had been contacted by the Securities and Exchange Commission regarding its accounting treatment of long-term contracts it had struck to sell capacity on its high-speed voice and data networks to Global Crossing, whose accounting is also under investigation. Both companies say their accounting methods are proper.

Such swaps continued to be struck across the industry as recently as last year, long after the bubble began to lose air. Ms. Kalla estimates that telecom companies made swaps worth $2.5 billion in 2001. It is not yet clear how many of those swaps lacked a real business purpose. But some analysts wonder if these interlocking relationships were intended to overstate the true economic value of the businesses. Given that the companies were not generating nearly enough revenue to keep investors happy last year, there was certainly incentive to inflate results.

ULTIMATELY, it became clear that increased demand for telecom services from consumers or corporate customers was not going to build. So the revenue pool wound up fairly static — yet it had to be shared by many, many more hopefuls.

"Every one of these companies assumed they were going to be the success story," Mr. Barden said. "So every one of them bulked up with every fiber optic cable they could get their hands on, every switch, every salesperson. All these companies built for success, and most of them, given the economic size of the market, were doomed to failure. Because at the end of the day, the dollars coming into the system were just not growing fast enough."

Bad as things have been in telecom, the worst may not be over. Ms. Kalla says that while the regional Bell operating companies are well-positioned, business will become grimmer for long-distance carriers. "If the capital markets close down in a business that is hugely capital intensive, then there is enormous turmoil until they can get costs in line with revenues," she said.

James Challenger, the outplacement authority, said: "Many of these companies have been through multiple rounds of layoffs, yet the industry is leading the way in 2002. This suggests that the excesses of the late 90's have yet to be purged."

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