Saturday, March 21, 2009

Mark to Market + Derivatives ruined Enron and American Banks

Just a preface to this blog, there's complex information so I've bolded, italicized and colored items of importance. Yes, it's mind numbing however the details are important to the conclusion. By highlighting a few things, I'm hoping to make this understanding as simple and clear as possible.

The point of this blog is to explain why Mark to Market does not guarantee more accurate accounting.

People defend the bailouts because "Mark to Market keep banks honest and accountable for reality". It really makes no difference. Enron used it. They still managed to cook the numbers. Ken Lay went to prison for accounting fraud. The CEO's of the financial institutions that traded fraudulent derivatives are being protected by the government. They both used derivatives and the mark to market transactions.
**excerpt on Mark to Market accounting in Enron:

"Under one of its so-called "bundled contracts", EES agreed to supply 15 Quaker plants with their energy needs, from natural gas and electricity to workers who would maintain boilers and pipes and procure spare parts. Enron guaranteed Quaker it could save $4.4m from its 1999 energy bill.
For its own part, Enron forecast a $36.8m profit over the 10-year deal and used mark-to-market accounting to book $23.4m of that before it had ever turned on Quaker's lights.
Under accounting rules, such treatment is permitted for commodities, such as natural gas and electricity. But the rules are more restrictive when it comes to services - such as boiler maintenance and parts procurement, for which no forward markets exist. Profits from these activities are supposed to be booked on a more conservative "accrual" basis, whereby a fraction of the profit is realised each year as it comes in.
Enron's problem was that almost all the profits projected for the Quaker deal were derived from services, not commodities. How did it manage to book them up-front?
The company used a questionable method called "revenue allocation". The net effect of this highly complex treatment was to redefine as commodities some of the money Quaker was paying for services and therefore create more profits that Enron could book up front.
Under the system, Enron's internal accountants created a new category called "allocated revenues". These were based not on what Quaker had historically paid for energy commodities and its service contracts, but on figures that Enron claimed reflected the open market value of the commodities and services.
This revaluation made a significant difference to the reported worth of the contract. Enron would have earned only a small margin supplying gas and power to Quaker based on the original revenue figures it used to calculate the deal. These activities could have actually been loss-making with Quaker's annual discount. Instead, revenue allocation allowed the company to claim an immediate hefty profit on the deal. Asked if such a move is illegal, the former Enron accountant says: 'It's certainly skirting the edge. It's very, very aggressive.'"

Now we apply derivatives in Enron's equation (as read in the beginning of the article), "Such transactions, many with other Enron-related entities, may have helped the group in two ways, according to accountancy experts. They helped to reduce debt temporarily, but also created price benchmarks - the so-called "estimated fair value" used in its accounts - so the company could assign generous values to assets ranging from power plants to derivatives.
Frank Partnoy, a professor at the University of San Diego School of Law who has studied Enron's derivatives transactions, told a committee last month: "

Derivatives, he added, were also used to "hide speculator losses it suffered on technology stocks, hide huge debts incurred to finance unprofitable new businesses, including retail energy services for new customers, [and] inflate the value of other troubled businesses, including its new ventures in fibre-optic bandwidth".

For some assets, such as shares trading in transparent markets, there is little or no leeway in defining the "fair value" of the holding. The asset is "marked to market" at the quoted price and a loss or gain is included in net income.

Now let's review. Derivatives were "also used to:

1. hide speculator losses it suffered on technology stocks, and
2. hide huge debts incurred to finance unprofitable new businesses"
3. created price benchmarks aka. Estimated fair value based on the market price... aka. Mark to Market accounting.

Mark to Market procedure known as "revenue allocation" was used to:

1. allow the company to claim an immediate hefty profit on the deal
2. hide the small margin based, loss incurring numbers on the original revenue figures it used to calculate the deal.
Enron entered into derivatives transactions with these entities to shield volatile assets from quarterly financial reporting and to inflate artificially the value of certain Enron assets.

So with that being said, the use of derivatives by banking and non-bank institutions is under question. The topic came up in Congress about suspending Mark to Market accounting (to relieve the taxpayers of the $700 bailout TARP burden) when the head of the SEC rejected the proposal.

I'm tickled pink by the SEC because they refused to regulate the derivative market (so I'm told) yet they still get the final say in what method is used for accounting of these derivatives. I think the taxpayers should get the final say. If the shareholders don't want AIG, Bear Stearns, WAMU and so on...why are the taxpayers forced to buy them? When do the 300 million taxpayer owners of these firms get appointed as the Board of Directors? When do we get to vote for a change of management? We should be allowed to get these CEO's fired. Instead, Chris Dodd wrote in their bonuses and blamed it on Obama.

The banks and non-bank lenders such as Countrywide used the derivatives to finance ARM loans. Somehow the GDP miracuously rose to $13 trillion when the trade deficit was at record highs ($700 billion plus interest payables), offshoring and outsourcing were costing Americans their jobs and the value of the US Dollar was lowering to the relative value of the Canadian dollar.

Financial engineers created this vehicle and it was known that derivatives were NOT MONITORED BY THE SEC. Why? I'm not sure yet. However, fraudulent derivatives were traded in the markets, and THEY WERE ALLOWED TO DO SO. The government is actively protecting the CEO's from the shareholder retaliation. The largest shareholders have the right to sue or as a member of the Board of Directors; the influence to can a CEO. Why was the government protecting them? Why is the government bailing out the banks when they knowingly screwed themselves? Our leaders conciously pursued these crazy financial crimes.

The question is WHY? Why did we cook America's financial statements? What was the government hoping to come of this? They were paid well to heist our piggybanks.

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