This morning I received a wake up call about the passage of time, and the inexplicable willingness of investors to forgive (and forget) the unforgivable.  Mark Hulbert’s commentary on MarketWatch.com, “Can you believe Wall Street?  Ten years ago, infamous Enron began to crumble,” struck a nerve.  Having poured my blood, sweat and tears into litigating on behalf of Enron investors, I was struck both by Mr. Hulbert’s cursory analysis of the question and that few financial journalists have taken up the issue.

Accordingly, Mr. Hulbert has inspired me to write about some of my own observations over the past decade since Enron’s collapse.  Consider this Part 1 of a multi-part series that I will publish as my time permits.

Structured Financing and Hiding Liabilities Off Balance Sheet:  Does the transaction really serve a legitimate purpose?

To understand anything about the Enron fraud, you have to focus on the link between Enron and Wall Street.  As the plaintiffs in the Enron litigation alleged, Enron cooked its books with the help of structured financing transactions that Wall Street banks devised.  For background stories on Wall Street’s role, see (for example) these releases by the U.S. Securities and Exchange Commission (here) and (here).

In the wake of Enron’s collapse, Wall Street promised reforms.  Citigroup publicly declared it would not sell such structured finance deals to its clients any longer.  In December 2002, Citigroup’s Charles Prince testified in front of a Congressional sub-committee that Citigroup created a new “transparency policy” to govern structured financings.  Prince went on to state:

Citigroup would execute material financing transactions for companies that were not going to be recorded as debt on their balance sheet if, but only if, that company agreed to clearly disclose the net effect of the transaction on its financial condition. We announced this net-effect rule for two reasons: first, to encourage companies to account for financing in a transparent manner, so that investors can adequately assess the net effect of the transaction on the financial condition of the company; and, second, because we simply did not wish to be a party to transactions that failed to meet a high standard of transparency.

Despite the lessons seemingly learned from Enron’s collapse, Wall Street banks continued to perform (and utilize) structured financings in a way that hides a company’s true financial condition.

Writing about the topic recently (here), Professor Frank Partnoy and former Chief Accountant of the SEC Lynn Turner commented on the common link between Enron and the financial collapse of 2008-2009:

And then, of course, there was Enron, with off-balance sheet derivatives exposure that, as one of us testified at the first Senate hearings on Enron’s collapse, “made Long-Term Capital Management look like a lemonade stand.”

The most recent financial crisis was no different. Financial institutions built up hundreds of billions of dollars of exposure to subprime mortgage markets without disclosing these assets and liabilities on their balance sheets.

Partnoy and Turner go on to specifically single out Citigroup’s use of off-balance sheet entities as particularly problematic:

Citigroup’s recent filing reports $292 billion of “significant” unconsolidated VIEs. These VIEs are the nieces and nephews of Enron’s Special Purpose Entities, or SPEs. The VIEs have debts, but – like Citigroup’s swaps and other derivatives – the VIEs are referenced only in a footnote. They are not part of Citigroup’s actual balance sheet, and Citigroup does not record its interest in or maximum exposure to these entities.

Because banks do not report these assets and liabilities in any comprehensible way, regulators and market participants cannot understand the banks’ exposure to risk. Instead, the banks’ approach to off-balance sheet liabilities has made their financial statements virtually useless.

Partnoy and Turner go on to write that Citigroup’s federal bailout was, in large part, necessitated by its off balance sheet liabilities that had not been transparently disclosed:  ”Citigroup’s losses on off-balance sheet transactions swallowed up the rest of its balance sheet.”

So what happened to Citigroup’s pledge — made in the wake of Enron’s collapse — that it would adhere to a strict code of transparency as it concerned the use of structured financing and off-balance sheet entities?

To be sure, Citigroup is not alone here.  As alleged by plaintiffs in ongoing securities actions, AIG, Lehman, Bear Stearns and many others had massive, undisclosed off-balance sheet exposure to the mortgage market that ultimately caused their collapse.

Sadly, the lessons learned from the Enron fraud — and the use of structured finance to deceive — were not heeded, and another generation of investors has suffered incredible losses as a result.

This entry was posted on Thursday, September 15th, 2011 at 2:23 am and is filed under Uncategorized.