Posted tagged ‘financial system failure’

EU, Wall Street, and ENRON

February 22, 2010

Today’s Wall Street Journal headlines that the EU is worrying about practices that some countries used to conceal the actual amount of debt they were carrying. By concealing the correct amount of debt, these countries (read Greece, Italy, Spain, Portugal and maybe Ireland) could avoid the politically unpopular actions of deceasing spending or increasing taxes. (Sound familiar?) These countries were essentially “cooking the books”.

We are now just emerging from a near global melt down of the world’s financial system because an awful lot of the large global banking and investment community cooked their books. They bought and sold collateralized debt obligations (CDOs) (making juicy profits in the process), and then many doubled down by laying off their risk by purchasing or selling credit default swaps (CDSs) (generating again fat juicy profits). CDSs are an unregulated form of insurance that is suppose to mitigate risk associated with contracts a bank or firm owns. Wall Street was clearly using them to artificially make their books look better so that they could leverage their actual assets even further. When the housing bubble burst and the economy soured, too many people began to default on their mortgage payments. This caused banks to have to lower their book’s CDO values (and therefore their overall asset value), try to raise more capital, and ultimately to call on their CDS partner to pay up. Surprise, surprise, these issuers of CDS did not have enough money to pay. In the midst of this chaos, in stepped Uncle Sam to help save the US banking and probably the world’s banking system (at tax payers’ expense).

ENRON played a game that also cooked the books. They created off shore corporations for the sole purpose of parking “debt” (that was being used to generate earnings), and claimed that these off shore entities did not need to be consolidated in the official ENRON books (even though they were consolidating the earnings!). No one called them on this practice and after much borrowing, ENRON imploded.

There is always the possibility that any business or firm can fail. Someone may build a better mouse trap or modernity may simply make something no longer necessary, and in both cases a company could fail.  Accordingly, debt and debt leveraging practices, long known, have been established with prudent limits to confine and minimize the occasion of failures. ENRON, Wall Street, and now the EU are examples where entities knowingly pushed limits, no one called them out, and found themselves way over the line.

All these examples contain the smell of seeking a free lunch, greed, and ineffective oversight. Government regulators failed, and private accounting and rating firms were complicit. The Obama Administration can learn from these three events and take steps to prevent a reoccurrence. Well, at least until some new greedy entrepreneur offers investors a “new” free lunch and regulators are fast asleep.