Washington Created WorldCom

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.