Monday, June 23, 2008

The Worse Than Enron Sweepstakes

The piece below is something that I stumbled across back in March when the sub-prime mess was really beginning to build up steam. Now, as we sit here some three months later and the layers of the onion have revealed even more greed-filled headlines, what Mr. Donlon had to say seems even more appropriate.

Even on a topic about which I feel as strongly as I do on this one, I wouldn't normally post another source's entire article, but in this case I decided to make an exception because (a) I couldn't figure out what to leave out because it all seemed to fit together so well, and (b) I thought it important to expose readers to Donlon's intellect if he was someone about whom they had not heard. See if you don't agree that he is voice we could use more of.

Déjà Review

By J.P. Donlon

Here we go again. The fallout from the subprime mortgage mess has led to another burst asset bubble. Led by Citigroup and Merrill Lynch we have seen the financing of real estate get ahead of itself to the point where the banking system has come face to face with a heady balance sheet problem. There is $900 billion (out of a total of $9 trillion in mortgage debt) in subprime paper on the balance sheets of the world’s banks, investment houses, hedge funds, and mutual funds. In total there are 2,500 different subprime bond issues. Not all these have gone bad. But we may not know for some time the extent of the mess. The extent of miscalculated risks has already seen almost $100 billion in shareholder assets disappear. The fear is that falling housing prices will only make credit troubles worse as it reduces any incentive to keep paying the mortgage.

All of this will take time to work out. But in the meantime the finger pointing has begun. Why in a post Sarbanes-Oxley world has this been allowed to happen? Writing the City Journal, former financial analyst Nicole Gelinas, and a past contributor to Chief Executive, asks whether additional regulation makes us any safer or perversely lulls investors into a false sense of security about their investments.

“In the end, Sarbanes-Oxley has just made it easier for ambitious government attorneys to criminalize bad business judgment and complex accounting in hindsight,” she writes. “Further, in their focus on strengthening legal enforcement, the feds have passed up opportunities to create commonsense protections for investors. Worse still, the government has instilled investors with false confidence by implying that they can rely on prosecutors, not prudence, to protect their market holdings. Now the housing and mortgage meltdown—which could hurt the economy far worse than Enron did—is reminding investors that no law or regulation can protect them from economic disruption.”

Just as the bond rating agencies awarded Enron high ratings suggesting that investors could safely lend to the doomed company, critics today believe that the same culprits are likely at fault in today’s credit mess. New York Attorney General Andrew Cuomo’s office is looking into how the ratings agencies assigned top triple-A ratings to many bonds backed by risky subprime home loans. He wants to know if the firms asked for and received information that would have warned them about specific risks associated with home mortgages. At this point the AG hasn’t filed any charges against the ratings firms.

But the larger question looming over the subprime mortgage mess is this: Will government throw more regulation at the problem in an effort to be seen as “doing something” when the evidence strongly suggests that this will do little or nothing to stave off the next debacle? Despite decades of bitter experiences - from Mexico in 1982 to Asia in 1997 and Russia in 1998 - financial institutions still bow to fads and fashions. They act herd-like in conformity with "lending trends". They shift assets to garner the highest yields in the shortest possible period of time.

The government treated the implosion of Enron as though it were somehow unique when in fact it was fairly routine. When one strips away the Fastow spin, the company overstated the value of its assets and understated the extent of its liabilities. The only difference is that the investment community was only too eager to go along with the scheme because it was in their interests to do so or at least not to look under too many rocks. But as Gelinas points out investors began deserting Enron before the regulators took notice, proving that the market effectively weeds out bad companies and ultimately bad investments.

This begs another question: What is normal business practice in the midst of a bubble? When a company hits an air pocket does it tell its shareholders about the risk of failure or does one say one is merely going through a bad patch and things will right themselves soon enough? If one is a CEO one should have one’s defense attorney close to one’s elbow. The SEC has several investigations into the lending practices at Countrywide Financial, which has become the poster child for the current mortgage crisis. If any charges are filed one can be certain that prejudices will run higher. An Enron juror was quoted as saying, “pure greed motivates all CEOs. Some get caught; most don’t.” Enron was just a flashy energy company. Multiply by 10 the outrage and sense of “payback” at a mortgage crisis trial

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