<nettime> WSJ: Washington Created WorldCom

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The Wall Street Journal
July 1, 2002
COMMENTARY
Washington Created WorldCom
By PETER HUBER

With WorldCom facing criminal fraud charges for a $3.9 billion bit of
accounting trickery it confessed to last week, the knives are out for its
corporate executives. But before the story runs away with us, let's
remember where fictitious accounting got its start: in Washington. WorldCom
was created by regulators who did exactly what WorldCom now confesses to
have done, only more so.

The private sector's accountants sometimes miss fraudulent bookkeeping; The
government's institutionalize it.

Government Accountants

WorldCom took today's expenses, and treated them as tomorrow's. At issue is
money WorldCom paid to local phone companies to help carry its customers'
calls. There doesn't seem to be much doubt that those bills were
misallocated -- when you pay for a cab ride at the end of the trip you
aren't buying a durable asset, you're settling a debt for service rendered.

But neither WorldCom nor the local carrier decides who owes who or how much
-- those charges are decided by the Federal Communications Commission. Much
of the telecom industry's current woe can be traced to government
accountants who set interconnection tariffs at levels completely divorced
from economic reality.

For the first 20 years of MCI's existence, FCC policy was to jigger the
tariffs to favor MCI, Sprint, and other smaller competitors over AT&T. For
good measure, the commission also suppressed price wars, with rules that
forced AT&T to keep its rates higher than it wanted to. This allowed the
long-distance upstarts to multiply and prosper. They set their own prices
just below AT&T's, and built out their networks.

It was this system that kept the competitive balloon aloft from the 1970s
-- when MCI got into the mainstream long-distance business -- until 1997,
when the then-$20 billion company agreed to merge into the $7 billion
WorldCom.

The year before, Congress had handed the FCC sweeping new authority to
force local carriers to lease parts of their networks to local competitors.
The commission's engineers itemized what the parts would be -- local
wiring, switching, trunk lines, and so forth -- and set a price. They could
have based the price on historical reality -- what it had actually cost a
phone company to build the element it was now required to lease. But they
chose instead to base it on what it would theoretically cost to build the
network going forward.

They took yesterday's capital outlays, in other words, and treated them as
tomorrow's. In an industry where technology is evolving fast, this made a
huge, ultimately ruinous, difference.

Government accountants' idea was to make it cheaper for competitors to
enter local markets. And the bargain-basement way to do that was to let new
competitors piggyback on an existing network, at a price below what it had
cost to build it. The regulators had been directed to deliver competition,
and presto, creative accounting let them show a quick profit on their
political books.

The scheme worked in long-distance markets in the 1970s and '80s, and it
worked in local markets for five years or so after the enactment of the
1996 Telecom Act. In the end, it worked too well. The incumbents lost
heavily, as they leased out more of their networks at tomorrow's
theoretical prices, rather than at yesterday's actual costs. Local markets
were crowded with new entrants who hadn't built much, if anything, in the
way of new facilities, but who were vying to deliver more local traffic,
and high-speed data traffic, to long-distance networks.

The craftiest of the new entrants even found ways to get the incumbent
carriers to pay them, under an obscure but lucrative set of "reciprocal
compensation" tariffs. They so perfectly matched their services to the
accounting rules that they could generate revenues by placing phone calls
to themselves.

Lo and behold, prices dropped and traffic volume rose fast. Internet
Service Providers (ISPs) contracted with intermediate players like
broadband providers Covad and Northpoint, who contracted in turn with
backbone Internet carriers like WorldCom. Long-distance carriers deployed
vast amounts of new fiber to carry the new traffic, as well as all the
additional traffic that was bound to come.

It couldn't last, and it didn't. By making entry artificially cheap for
everyone else, regulators attracted hordes of naive, spendthrift
competitors, which made competition unprofitable for all. Before long, many
of the new ISPs stopped paying their bills. They knew all the regulatory
accounting angles, it turned out, but they didn't know how to build a
network or provide service to a paying customer.

When some ISPs folded, it ruined Covad and Northpoint, one tier up in the
food chain. That, in turn, cut into the revenues of companies at the top of
the pyramid, like WorldCom, just when those carriers were facing a massive
glut of competitive long-distance capacity. Companies like Global Crossing
had figured -- incorrectly, this time -- that they could do to WorldCom
what MCI had done two decades earlier to AT&T.

Now the litigators are taking charge. Most of the bankrupt competitors have
only one asset left: a lawsuit against the incumbent carriers, whom they
now blame for sabotaging the entire regulatory scheme. Disappointed
investors file class actions against the bankrupt competitors. A federal
appellate court recently ruled that the customers of failing competitors
may also sue the incumbent carriers directly, so all the tangled details of
yesterday-and-tomorrow accounting rules are now fodder for treble-damage
class actions too. The rules are stupefyingly opaque, however, which may
perhaps explain why the Supreme Court declined to try to rewrite them
earlier this year. The whole mess will take years to untangle.

Conjuring Competition

WorldCom had more in common with Enron than Arthur Andersen. In telecom
markets, as in electricity markets, regulators concluded they could conjure
competition out of thin air by taking control of a sprawling network of
wires, switches, and nodes, and setting up schemes to determine who would
pay how much to move freight over it. But public networks are huge,
long-lived capital assets, and their underlying economics are very
complicated. Set interconnection prices too high, and nobody interconnects
at all. Set them too low, and you get so much interconnection it proves
ruinous all around.

There will be sonorous speeches in Washington for months to come, informing
us that more regulation is needed to prevent another WorldCom. But we might
have been spared the WorldCom debacle, and many smaller ones like it, if
the authorities had been more willing to let market forces control the
evolution of competition, and less eager to enlist creative accountants to
speed the process along.

-- 
Mr. Huber, a senior fellow at the Manhattan Institute, is a Washington
lawyer who represents Bell companies and other telecom concerns.

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