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Crisis Enron-related?

January 28, 2008...3:22 am

The Subprime Mortgage Crisis Has Nothing In Common With Enron

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One needn’t google ‘subprime mortgage and Enron’ to see examples of the comparison; they are floating through the culture like germs. The comparison reached a tipping point when former SEC chairman Arthur Leviit warned that the write-downs were just beginning and that, “as with Enron, banks failed to disclose in their balance sheets the special purpose structures which held subprime debt.”

Journalists and bloggers immediately attached themselves to the ideas that: 1.) the subprime housing crisis has something in common with Enron and 2.) Enron failed to disclose their special purpose structures in their balance sheets. Both of these are false, and as a premiere market executive, Levitt should know better. For the record, Enron’s special purpose entities were fully disclosed in their balance sheets, as well as 10K and 10Q forms. This is simply not debatable.

But because Enron is the great-grandaddy of business scandals, it is easy (and lazy) to accuse the former energy company of all manner of crimes, and to compare it to current roblems as a point of reference.

Either one believes that Enron was corrupt and it slid into bankruptcy under the weight of its own malfeasance, or you believe that market forces were at work that disadvantaged Enron. Which is it for the housing crisis? Are all mortgage companies corrupt? Or is there a market force at work here causing a sort of spiral effect? If adjustable rate mortgages adjust out of the borrower’s ability to afford, the borrow defaults on the mortgage, the mortgage company writes it off with a handsome pay-back from the federal government. Unlike the mortgage industry, Enron’s business had no backup. In the waning days of Enron, when Ken Lay called his friends in the Administration, nobody was willing to help. There was no ‘federal oil and gas marketing company’ for them to look to when things went awry.

Mortgage companies buy personal debt. Enron was a gas marketer. Two entirely different business models were at work. While Enron’s business involved hard assets, credit, trading, retail and wholesale products, the business of lending is … well, lending. Mortgage companies use consolidated capital to make loans to individuals it believes will pay the money back with interest, thereby making a profit. When that fails to happen, nothing much happens; they simply sell the bad loan back to Fannie Mae, Freddie Mac, or Ginnie Mae. The mortgage companies then recoup their losses.

Never in their wildest dreams would Ken Lay or Jeff Skilling imagine snookering the public so flagrantly.

The subprime market is risky on its face. Mortgages issued to those a company knows and in some instance actually targets should be intelligently hedged to protect itself from the good chance that the bad loans will default. That does not seem to be case. Where Enron hedged, mortgage companies only prayed.

In January 2008, the chief accountant of the Securities and Exchange Commission, Conrad Hewitt, blessed a banking-industry plan to modify thousands of troubled mortgages to address concerns over subprime mortgages. The ruling was met with relief by homeowners eager to hold on to their homes, and it was also cheered by banks who would rather collect on the debts than write off a default.

Hewitt assured auditors, regulators and the banking industry that he would not object to continued off-balance sheet treatment for securitized loans, even if the banks that supposedly sold all rights to the loans are now changing their terms.
This is the central principle at the heart of securitization. The loans have been sold to investors. By allowing a change of terms, it risks undermining both legal and accounting claim that banks no longer control them.

“The basic underlying principle…is that assets transferred to a securitization trust should be accounted for as a sale, and recorded off-balance-sheet, only when the transferor has given up control, including decision-making ability, over those assets.” If the bank still effectively controls the loan, wrote Hewitt, then it can’t use off-balance-sheet accounting.

This brings up another comparison to Enron. Specifically: the Nigerian barge deal, in which Enron sold its interest in two Nigerian barges to Merrill Lynch, and which the government contends was fraudulent. The case is still being litigated. The government contends that it was not a ‘true sale’ because Enron allegedly assured Merrill Lynch that Enron would buy back its interest in six months and that Merrill Lynch would not lose money. The fact remains that while the barges were under the control of Merrill Lynch, Merrill Lynch would be liable for the loss of the barges if, for instance, they’d sunk, caught fire, or met with pirates. Ostensibly they would also be entitled to any profit made by the barges while in its control.

Do we really have to ask: what is ownership? Apparently we do. Since banks are exerting the right to control the terms of loans they’ve already sold, they are no longer the bank’s. Trying to re-write the terms now seems too little, too late. The origin of the problem was the mortgage lender who looked at the assets to debt of potential buyers, saw the fact that the buyer could not afford the house, but approved the loan anyway.

Banks chuffing off these deliberately-made bad loans, even in the face of all the evidence demanding prudency, seems a much more deliberate act of fraud than anything Enron might have done.

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