Wow this is great.  I think you wrote a great piece.  I hope it gets featured.

Okay maybe in the future we will (and should be saying) Enron'ed.  This would be used like we do Google today.  It makes it a verb..."I googled it".  So with this article you have coined Enron'ed it and I totally get it! 

It is scary.

Isn't moving money from a smaller shirt pocket to a larger pant pocket "kiting"?  And that is illegal.

I like your picture.  It is not the typical head shot.

Frank ....the key part of the whole post is this phrase: OFF-BALANCE SHEET ENTRIES. Do me a favor and read this, and let me know if it helps explain it.

Paige Rausch

paigerausch@earthlink.net 

Companies have used off-balance-sheet entities responsibly and irresponsibly for some time. These separate legal entities were permissible under generally accepted accounting principles (GAAP) and tax laws so that companies could finance business ventures by transferring the risk of these ventures from the parent to the off-balance-sheet subsidiary. This was also helpful to investors who did not want to invest in these other ventures.

Since the Enron scandal, however, companies that have any kind of off-balance-sheet items, whether justifiably or not, are being branded with a scarlet letter "E". This article will define some typical off-balance-sheet items and discuss whether they are "good" or "bad".

The term "off-balance-sheet" can refer to many things. Typically, it refers to separate legal entities (separate companies of which the parent holds less than 100% ownership) or contingent liabilities such as letters of credit or loans to separate legal entities that are guaranteed by the parent. GAAP allows these items to be excluded from the parent's financial statements but usually they must be described in footnotes. <!--[if !supportLineBreakNewLine]--> <!--[endif]-->

The Good
Off-balance-sheet companies were created to help finance new ventures. Theoretically, these separate companies were used to transfer the risk of the new venture from the parent to the separate company. This way, the parent could finance the new venture without diluting existing shareholders or adding to the parent's debt burden. These separate legal entities could be privately held partnerships or publicly traded spin-offs.

Sometimes the separate companies were created to pursue a business project that was a part of the parent's main line of business. For example, oil-drilling companies established off-balance-sheet subsidiaries as a way to finance oil exploration projects. These subsidiaries were jointly funded by the parent and outside investors who were willing to take the exploration risk. The parent company could have sold shares or borrowed the money directly, but the accounting and tax laws were designed to allow the project funding come from investors who were interested in investing in specific explorations rather than investing in the parent company.

Other times these separate companies were created to house businesses that were decidedly different from the parent's line of work (in order to unlock "value"). For example, Williams Co's, created Williams Communications to pursue the communications business. Williams Companies spun off Williams Communications, but the bankers required the parent to guarantee the debt of Williams Communications. Because Williams Communications was a new company, this is not an unusual request.

This use of off-balance-sheet entities is good in that it transfers risk from the parent's shareholders to others that were willing to take the business risk. Investors in Williams Companies (an energy resource company) may not have wanted to invest in a communications company, so management created a separate entity to house that business. Likewise, oil companies used off-balance-sheet entities to remove the exploration risk from their business to share it with others that wanted a bigger piece of the potential return from exploration.

The Bad
While GAAP and tax laws allow off-balance-sheet entities for valid reasons noted above, bad things happen when economic reality differs significantly from the assumptions that were used to justify the off-balance-sheet entity. Problems also occur when egos get too big.

In Williams's case, the decision to spin off the communications business was reasonable at the time. The parent had the infrastructure on which to build a communications network, but it was an energy company. By spinning off the subsidiary, it was not forcing its investors to take on the risk of a communications company, and it was able to take advantage of the market's demand for communication stocks. At the same time, the need to guarantee the debt of a new subsidiary is a reasonable request that bankers make in this type of transaction.

What went "wrong" was that economic reality differed from the assumptions that were used to justify the spin off. Dotcom mania resulted in over-capacity, causing problems for all telecommunications companies. The loan guarantee, which is never expected to be triggered, is now an issue for the company because of the recession and the slump in the telecommunications sector.

Enron exemplifies how ego can be the basis for the misuse of off-balance-sheet items. Here, off-balance-sheet vehicles appear to have been used to pump up financial results rather than for legitimate business purposes. What started as a plan to legitimately use off-balance-sheet vehicles morphed into ways to manufacture earnings as trades went bad. While one could argue that this is also a case of economic reality differing from expectations, the way management reacted to the situation allows us to classify it as an ego thing.

This financial engineering is usually fueled by the need to reach certain operating targets established by Wall Street or compensation plans. Once management succumbs to this "Dark Side", more time is spent on trying to game the system than trying to manage the core business. It is then only a matter of time before the house of cards falls.

Vicky,

That is my entire point. I hope you read Paige's post. The entire problem is this:

1) The idea of starting another company off books is fine

2) But couple that with an asterick, where the new company is 100% secured/backed by the parent bank in case of default (which people just assumed would never happen)

3) When the new company goes under, and the bank backing it never expected to be called out on it... everything goes to sh*t.

Hey Karen,

I didn't coin the phrase that put Enron and Banks as being the same. This stuff is out there, you just have to look for it. 

Very interesting - I had not heard about this. Also - you post about blaming the press made me think. I am guilty of that, and maybe I need to come at that from a different angle. Good job of making something pretty confusing sound fairly clear.

I just updated my blog post for a ten steps to descruction break down to make it all a little easier.

Travel outside the US I have seen the value of our dollar fall to laughable levels and yet at home in the us we keep calling ourself a super power .. I don't think that relates to dollar superpower

Frank, an interesting piece and food for thought, for sure.  Of course there are fears that this type of activity could lead to an Enron type disaster, or a bailout akin to the S&L debacle of the 80s.  Speaking of S&L crisis, some of those lawsuits are still going on.  For 2 years, I worked at a law firm representing major banks and thrifts still suing the Feds over the handling of the S&L meltdown.  Thanks for the information on the SIVs -- I'll have to explore your links further.

Thanks Brian,

The problem is, it might not be able to simply be a US bail out. SIVs are leveraged in a way, and in such unknown amounts that they could be large enough to collapse the dollar. If the US bails out, all that means is printing money. Our dollar is being kept up artificially. If the dollar gets devalued by 30-70%, the bailout will be nothing compared to a dollar collapse. Sounds crazy, but how crazy is it that ENRON isn't bad enough, but possibly EVERY LARGE BANK has their own Enron.

Enron lost $60 Billion in value.

The S&L bailout was $150Billion.

Moody's estimates the exposure being as large as  $400 Billion

When you leverage to make money, it can be wiped out overnight.

I just added to the blog, that these vehicles are levered 14 to 1.

What is particularly troubling about SIVs is that many large money market mutual funds (UBS, Schwab and Mogran Stanley among others you have heard of) have some sigificant SIV exposure.  Even at exposure levels of 1-3% of assets under mangement in the funds, MMMFs could "break the buck" if SIVs fail, or even they just suffer asset devaluation.  Just a few months ago BofA, Chase and Citi formed a superfund to repurchase some of these assets in an effort to prop up the asset values, but in the past week or so even that fund appears to be in trouble as potential investors have been hesitant to invest in it, if not avioding it altogether.  It hasn't been decided yet what, if anything, regulators are going to do with regards to this situation, but if assets continue to get downgraded by ratings agencies we would likely see more and more losses stemming from these vehicles, which would force the hand of regulators  to intervene.  That said, there is part of me that is getting the growing suspicion that some banks actually want these funds to fall in value so they can dump them on the way down to an artifical low and then pick them up at pennies on the dollar and ride the wave upward as the true value, net of hysteria pricing, manifests itself.  Then again, it could be a real problem.  Anyone have a crystal ball? 

did you all see the $50BILLION dollar bail out of SIVS??

http://online.wsj.com/article/SB119759010104328237.html?mod=hps_us_whats_news

This blog troubles me, its is correct but SIV's have the right to do swaps, essentially trading out bad assets for good ones even assets of other markets, i.e auto loans, credit cards etc. to keep the yield up above grade.  I spent alot of time running a private equity group and buying ABS especially RMBS is normal course for most major investment houses. 

The assets purchased are stratified into pools that have a yield.  Investors are sold a yield and the bank or fund makes the spread.  These investments are usually packaged as CMO (Collateralized Mortgage Obligations)or ABS (Asset Backed Securites, more than just mortgages)  and are placed into trusts.  The trusts have limited functions and authorites, swaps are usually one of the authorities. 

So why not swap?  Would you swap your good loans for bad one's then report those bad ones on your balance sheets therefore increasing your cash reserve requirements?  I think not.

The biggest investors for the banks were hedge funds.  The hedge funds used to buy the pools from traders at trading desks.  This was the secondary market.  The hedge funds have stopped buying and are no longer buying anything subprime.  Hence the collapse of the secondary market financing.  The banks have to keep cash to stay liquid under federal regs so more cash is taken away from lending.  Tighter lending requirements.

The same hedge funds that used to buy subprime, now buy what is termed scratch and dent or npm's (non performing mortgages) only now they do not buy them from the traders but go bank direct.  Why not traders?  Because the banks got greedy and opened their own in house trading desks in an attempt to cut wall street out.  The traders created the markets and kept things moving.  Without the traders the banks were now investing in their own partially funded SIV's consiting of CMO/ABS or CDO (Collatereralized Debt Obligations, 1st's, 2nd's 3rd's, other equipment) to fully fund the trust or SIV

The banks are now selling their bad paper to the same hedge funds that bought the subprime paper with guaranteed rates of return, a double whammy to the banks.  in my opinion the banks did this to themselves.

Will there be a bank bailout?  No but there may be acquisitions or mergers. 

Hey EJ,

I'm all for being corrected, but based on what you said, I didn't follow it.

1) Are you saying I am wrong somewhere?

2) Are you saying Off Balance Sheet Accounting is good and won't result in a collapse of the markets?

Tom? Your thoughts?

Not wrong just not complete.  Off balance sheet is okay if you understand the dynamics of the trusts and investments. 

Well it happened.

"Will there be a bank bailout?  No but there may be acquisitions or mergers"

HAHA.  EJ drank the Kool Aid.   

Tom:

Not one bank, if you even understand the strict definatition of bank, has been bailed out.  The banks have been taken over by the FDIC not bailed out!  Investment firms are getting bailed out, banks are merging like i said.  At least I understand the Kool Aid I drink!  Investment class 101, whats the difference between a bank, s&l, thirft, credit union, or bank holding company.  I guarantee you have no idea who regulates each without looking it up. 

He who has no name:

You pedantic d-bag. In light of this mess and the fact that we are in fact bailing out wall street and printing imaginary money at break-neck pace to get it done, does it really matter what the "strict" definition of bank is?