Enron

Participants Ali Akbar

Rida Ameen

The Islamia University Bahawalpur

BS Economics & Finance

Semester 7th

Financial Crisis

A situation in which the value of financial institutions or assets drops rapidly. A financial crisis is often associated with a panic or a run on the banks, in which investors sell off assets or withdraw money from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution.

If left unchecked, the crisis can cause the economy to go into a recession or depression.

Global Financial Crisis(GFC) In the last five years or so the world has experienced what

many like to call the ‘worst financial crisis since the great depression’. Although this crisis started in earnest in 2007, experts say that that the setting for a crisis began about a decade before, and that the signs were there all along.

The credit crunch

The global financial crisis (GFC) or global economic crisis is commonly believed to have begun in July 2007 with the credit crunch, when a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis.

Causes of the financial crisis

Skeptics of capitalism have also taken the time to claim that this crisis underscores the notion that capitalism was in fact a disaster from the word go, and that it was only a matter of time before this would be realized.

Capitalism is an economic and political system in which a country's trade and industry are controlled by private owners for profit, rather than by the state.

OR A system of economics based on the private ownership of capital and production inputs, and on the production of goods and services for profit.

The current crisis has been characterized by a threat of collapse of financial institutions, with governments moving in to provide bailouts to help these institutions survive.

The sub-prime crisis and housing bubble Subprime mortgages are a financial instrument designed to

facilitate home ownership for low and modest income households. Most subprime mortgages are adjustable-rate mortgages and are refinanced relatively frequently. Mortgage banks raise funds for making subprime loans mainly by securitization. Once subprime mortgage loans are originated, they are pooled and packaged into a variety of mortgage-backed securities and sold to various institutional investors in the United States and abroad.

Subprime mortgages worked as designed while house prices were rising during 1996-2005. But as U.S. interest rates began to rise in early 2004 due to the tightening monetary policy of the Federal Reserve, house prices stopped rising and began to decline in 2006. Subsequently, subprime borrowers started to default, spreading risk among investors and eroding the bank capital base in the United States and abroad.

The collapse of Lehman Brothers

The fall of Lehman Brothers on September 14, 2008 marked the beginning of a new phase in the global financial crisis.

Lehman Brothers was a key player in the United States real estate businesses. From 2004 to 2006, Lehman Brothers experienced a 56 percent surge in revenues from housing business. So the sub-prime crisis put the Lehman Brothers to death, when investors demanded withdrawal of their investments.

Lehman Brothers crashed, suffering mainly from liquidity problem for its heavier investment in mortgage-based securities that are least liquidate & highly risky.

Consequences of GFC

Many stock exchange markets have suffered too, as some have been on the brink of total collapse due to huge losses and rapidly decreasing values of institutions and stocks.

The housing industry, for example, has suffered a great deal, both in the United States and in other parts of the world. Home values have dropped at unprecedented rates, leading to foreclosures and evictions.

The level of unemployment has been on the rise throughout that period, effectively rendering a large part of the world population poor, and reducing consumer wealth.

Overcoming GFC

Facing the severe credit crunch and economic downturn, the U.S. government took forceful actions to save the banking system and stimulate the economy.

The Bush administration-implemented Troubled Asset Relief Program (TARP) was enacted in October 2008. Seven hundred billion dollars of the TARP fund was injected into the financial system to buy nonperforming assets and mortgage-related securities from banks and also to directly strengthen banks' capital reserves.

The Obama administration, in turn, implemented an $850 billion economic stimulus program to boost economic activities and create jobs.

Many governments around the world, notably the U.K., France, Germany, China, and Korea, implemented similar stimulating measures.

In addition, to prevent future financial crises and costly bailouts, the U.S. government adopted much tighter rules of finance in July 2010.

The new rules prohibit banks from making risky investments with their own money, which may endanger the core capital of banks.

Consumer Financial Protection Bureau would be set up to protect consumers from predatory lending.

Financial Stability Oversight Council of regulators chaired by the Treasury secretary would be responsible for carefully monitoring the systemic risk.

EnronWall Street Darling Enron was an American energy, commodities, and

services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 20,000 staff and was one of the world's major electricity, natural gas, communications, and pulp and paper companies, with claimed revenues of nearly $111 billion during 2000. Fortune named Enron "America's Most Innovative Company" for six consecutive years.

Collapse of a Wall Street Darling

By the fall of 2000, Enron was starting to crumble under its own weight.

CEO Jeffrey Skilling had a way of hiding the financial losses of the trading business and other operations of the company; it was called mark-to-market accounting.

This is used in the trading of securities, when you determine what the actual value of the security is at the moment. This can work well for securities, but it can be disastrous for other businesses.

In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though it hadn't made one dime from it. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer these assets to an off-the-books corporation, where the loss would go unreported.

Such type of accounting created the attitude that the company did not need profits, and that, by using the mark-to-market method, Enron could basically write off any loss without hurting the company's bottom line.

Fraud: What Was the Scheme? The mark-to-market practice led to schemes that were designed to hide

the losses and make the company appear to be more profitable than it really was.

In order to cope with the mounting losses, Andrew Fastow, a rising star who was promoted to CFO in 1998, came up with a devious plan to make the company appear to be in great shape, despite the fact that many of its subsidiaries were losing money. That scheme was achieved through the use of special purpose entities (SPE).

An SPE could be used to hide any assets that were losing money or business ventures that had gone under; this would keep the failed assets off of the company's books. In return, the company would issue to the investors of the SPE, shares of Enron's common stock, to compensate them for the losses.

This game couldn't go on forever, however, and by April 2001, many analysts started to question the transparency of Enron's earnings.

The Shock Felt Around Wall Street

By the summer of 2001, Enron was in a free fall.

CEO Ken Lay had retired in February, turning over the position to Skilling, and that August, Jeff Skilling resigned as CEO for "personal reasons."

By Oct.16, the company reported its first quarterly loss and closed its "Raptor" SPE, so that it would not have to distribute 58 million shares of stock, which would further reduce earnings.

This action caught the attention of the SEC.

A few days later, Enron changed pension plan administrators, basically forbidding employees from selling their shares, for at least 30 days.

Shortly after, the SEC announced it was investigating Enron and the SPEs created by Fastow. Fastow was fired from the company that day.

In addition, the company restated earnings going back to 1997. Enron had losses of $591 million and had $628 million in debt, by the end of 2000.

The final blow was dealt when Dynegy (NYSE:DYN), a company that had previously announced would merge with the Enron, backed out of its offer on Nov. 28. By Dec. 2, 2001, Enron had filed for bankruptcy.

Important terms Bottom Line Bottom line refers to a company's net earnings, net income or earnings per

share (EPS). Bottom line also refers to any actions that may increase/decrease net earnings or a company's overall profit. A company that is growing its net earnings or reducing its costs is said to be "improving its bottom line".

Special Purpose EntityAlso referred to as a "bankruptcy-remote entity" whose operations are limited

to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.

A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating.