Subprime Lending, Housing Bubble, Dot-Com Bubble, Enron, WorldCom and Obamacare

Posted by PITHOCRATES - August 14th, 2012

History 101

Dot-Com Companies used Venture Capital and Proceeds from their IPOs to pay their Expenses as they had no Revenue

The economy in the Nineties boomed.  President Bill Clinton and the Democrats say it was their policies of higher taxes on the rich that made it all happen.  At least that’s the argument you hear today in their arguments for returning to the Clinton era taxes on the wealthy.  Because it gave us the incredible economic explosion of the Nineties.  And balanced the federal budget.  But was the economy really that good?  No.  It wasn’t.  A lot of bad things happened in the Nineties.  Including something we’re still suffering from today.  The Subprime Mortgage Crisis.  Which gave us the Great Recession.

The Clinton administration told lenders to approve more mortgages for poor and minority applicants or face action from his justice department.  Lenders were not approving these applicants for reasons like lack of income and a poor credit history.  Common of people who lived in poorer sections of town because they didn’t have the income and credit history to move to a less poor section of town.  To avoid action from Clinton’s justice department lenders turned to subprime lending to qualify the unqualified.  To help these lenders unload these toxic mortgages off of their balance sheets the federal government’s GSEs Fannie Mae and Freddie Mac bought them and resold them to unsuspecting investors.  And we all know how well that turned out.  A great housing bubble blowing up.  Subprime Mortgage Crisis.  And the Great Recession.

The Nineties also gave us the dot-com bubble.  A lot of Internet start-up companies with soaring stock prices for products they never sold.  They had no revenues.  But speculators were so anxious to get in on the next Microsoft that they ran up these stock prices into the stratosphere.  And with nothing to sell these dot-coms used venture capital and proceeds from their initial public offerings (IPOs) to pay their expenses.  Giving away what they had for free.  Hoping to build brand awareness.  And to figure out a way to actually make money on the Internet.  Even cities joined in the speculation.  Spending tax dollars to build high-tech infrastructure to attract the dot-coms to their cities.  And businesses came to their cities.  Built buildings.  Filled them with employees earning good money.  It was the dawn of the new high-tech, Internet-based world.  But when all of the investor money ran out they still didn’t have anything to sell to pay their bills.  The bubble burst.  People lost their jobs en masse.  And all those new buildings sat empty in cities burdened with debt and a shrunken tax base.  While students who went to college to get degrees to let them join the dot-com world found no one was hiring when they graduated.  As few were hiring during the ‘dot-com’ stock market crash and recession of 2000-2002.

Enron Cooked their Books to Overstate Sales and Assets and Underreport Liabilities

Enron came of age in the Nineties.  They were in the electricity and natural gas business.  In both distribution and generation.  They were also into other businesses.  Too many to list.  But the energy business took off in the Nineties thanks to deregulation.  And Enron became a darling of the stock market.  With its stock price rising about 300% during the Nineties.  The value of its stock was worth about 70 times earnings.  Meaning that investors saw nothing but further growth in Enron.  Why?  Because the Clinton administration was taxing the rich at higher tax rates?  Not quite.  It’s because they cooked their books.

Investors like to see strong earnings.  Lots of assets on the balance sheet.  With not so much debt (i.e., liabilities).  So Enron strived to give investors what they wanted.  By the aforementioned cooking of their books.  Using mark-to-market accounting.  As opposed to historical cost accounting.  Where you buy an asset.  You post it to the balance sheet for the value you paid for it.  Then forget about it.  Mark-to-market, on the other hand, notes the ‘fair value’ of those assets.  If an asset grows in value a company adjusts it books to reflect the current, higher value.  Making their books more attractive to investors.  To look better on the liability side they created a lot of shell companies and special purpose entities.  Posting liabilities on these off-balance-sheet companies instead of their own books.  The combination of higher asset values and underreporting of liabilities made Enron look very strong financially.  And strong revenue growth just made investors drool.

Enron traded.  They bought and sold products and services.  Providing risk management for its clients.  Think of an airline buying a contract for jet fuel for one year to lock in low prices.  How you record this transaction on your books depends on what you’re buying and selling.  If you’re a stock broker you record only your fees as revenue.  Not the value of the stock.  If you’re a retailer you record the value of what you sell as revenue.  Enron recorded their trading like a retailer would.  Which greatly increased their revenues from these trades.  They also used mark-to-market accounting on future revenue streams.  Instead of using the retailer method of recording sales and costs for a period they would calculate the value of a contract for future sales and record them as current revenue.  Pulling future revenues into the current accounting period.  This sent revenues soaring.  Increasing some 700-800% during the Nineties.  Much of which was a house of cards built upon shady accounting practices.  Long story short, they couldn’t keep cooking the books.  And the house of cards collapsed.  The stock price fell back to earth.  And landed with a thud.  Becoming worthless.  People went to prison.  Workers lost their jobs.  And their pensions.  Valued at some $2 billion (though they got a little of that back).  Shareholders lost some $74 billion.  Their accountant, Arthur Andersen, went out of business for their involvement.  And Enron went bankrupt.  The biggest bankruptcy ever.  Until WorldCom.

The Obama Administration borrowed Accounting Practices from Enron and WorldCom to Score Obamacare

WorldCom became a telecommunications titan by buying other companies.  And then with the largest merger in U.S. history when it merged with MCI Communications in 1997.  It was huge.  And it posted huge sales.  Accordingly, its stock price rose.  As the dot-com bubble burst WorldCom’s stock price fell.  As did a lot of telecoms.  To prop up their falling stock price they, too, turned to shady accounting practices.  Inflating both revenues and assets.  And like Enron they couldn’t keep up the scam.  And the fallout was similar to Enron.  Only bigger.  Interestingly, they even had the same accountant.

But it’s just not corporations playing with their accounting practices.  Even the government gets into the action.  Case in point Obamacare.  The magic number for the cost of Obamacare over 10 years was a trillion dollars.  The same cost of the Iraq War and the War in Afghanistan.  As the wars end Obamacare takes over that spending.  Making it ‘revenue neutral’.  Well, health care for everyone without adding any new government spending would be hard to say ‘no’ to.  So how do you keep it below the cost of these wars?  You borrow accounting practices from Enron and WorldCom.

The original CBO scoring of Obamacare came in at $940 billion.  They based this on the data the Obama administration gave them.  Which included 10 years of new taxes (or spending transferred from war spending to Obamacare spending).  But only 6 years of benefits.  So that $940 billion only covered 6 years of Obamacare in that 10 year period.  Greatly underreporting the costs of the program.  No one knew it at the time.  Because they fast-tracked this bill through Congress before anyone had a chance to read its two thousand pages.  So they had their CBO scoring below a trillion.  And with some shady backroom deals, voila.  Obamacare became law.  CBO has since revised their number to $1.76 trillion that includes 9 years of benefits.  Bringing it to about $2 trillion if you cover all ten years.  And closer to $3 trillion if you put back the $741 billion or so taken from Medicare.  So the government cooked the books to conceal the true costs of Obamacare.  With the true cost being approximately 300% more than they promised the American people it would cost.  This $2 trillion scam is greater than the Enron and WorldCom scams.  But the government suffers no fallout for their gross misrepresentation like Enron and WorldCom did.  Because when they do it it’s just politics.

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Accounting Shenanigans

Posted by PITHOCRATES - August 13th, 2012

Economics 101

Two Important Accounting Principles are the Realization Principle and the Matching Principle

Accounting isn’t exciting.  It’s dull.  And tedious.  Anyone who struggled to get a trial balance to balance knows this well.  But accounting is a necessary tedious.  Someone has to put those numbers into the proper accounts.  Correctly.  Down to the penny.  Because only then can you prepare financial statements that are useful to business owners.  As well as investors.

When we post these numbers correctly we can produce the income statement.  Or as some call it the profit and loss statement.  Or P&L.   Which tells you whether you made a profit or a loss for an accounting period.  And some of the most important accounts on the income statement are income accounts (or revenue accounts).  The money they get when they sell their goods or services.  And expense accounts.  But not all expense accounts.  They’re all important but some are particularly important.  The expenses used to specifically generate that revenue (the cost of sales).  Production labor.  Production material.  The labor and material that make the things a business sells.  These expenses are variable.  They go up and down with sales.  As opposed to fixed overhead.  Which remains the same regardless of sales.

We have to define the accounting period carefully.  It can be annually.  Quarterly.  Even monthly.  The smaller the period the more useful information for business owners.  Investors study a company’s quarterly statements.  As well as annual statements.  The shorter the accounting period, though, the more careful the posting to the accounts is.  Because of two accounting principles.  The Realization Principle.  And the Matching Principle.   Which places revenue into the accounting period it occurs.  And then matches the expenses to the revenue it created into the same accounting period.  So when you subtract expenses from revenue in that accounting period you get the gross profit for that accounting period.  Given a measure of how business was during that accounting period.  If business was good there is revenue remaining after subtracting all variable expenses and all fixed expenses.  If sales are down there may be a gross profit.  But there may not be enough left over to pay the fixed overhead costs.  Resulting in a business loss.  For that accounting period.

The Smaller the Accounting Period the Greater the Math required to apportion Revenues and Expenses

When businesses ‘cook’ their books they are making business results look differently from what they actually are.  Perhaps the most common way to ‘cook’ the books is to violate the Realization Principle and Matching Principle.  Such as moving revenue or expenses to other accounting periods instead of where they belong.  If a business needs better business results for investors they may realize revenue early.  Or push expenses out to a subsequent accounting period.  Thereby increasing profitability for the one period better than it actually is.  As revenue will be greater and expenses will be smaller.

As an example consider a now common summer business model.  Selling ice-cold water at traffic intersections.  You need some cases of bottled water.  Ice.  And a cooler.  If you buy all the water in July but sell some of it in August you have to split the expense of the water between these two months.  If you don’t your expenses will exceed your revenue in July because it includes water purchased for both July and August.  You would subtract two months of water expense from one month of water sales.  Making July business show an operating loss.  While August would subtract no water expense from August sales making August more profitable than it actually was.  However, if you combine the two months together there will be no misrepresentation of the accounting data.  As you would subtract two months of water expenses from two months of water revenue.

This is why larger accounting periods are easier to post.  As they get smaller you have to do a lot of math to apportion these revenues and expenses into the proper accounting periods.  And sometimes mistakes happen.  Honest mistakes.  A business could have felt they had a good month but their income statement shows a loss.  Or the month could be far better than you feel it should be.  If you look hard enough you can often find a timing error.  Revenues or expenses appearing in the wrong period.  Such as recording a down payment as revenue.  It’s not.  A down payment is a liability.  Because it is a prepayment for you something owe someone at a later date.  And it’s at that later date when you can realize that down payment as revenue.

As you Pull Revenue Up and Push Expenses Out each Subsequent Accounting Period Starts with a Larger Operating Loss

But some businesses cook their books.  And once they start it becomes more difficult with every accounting period.  Which is why most companies that do cook their books fail.  And they fail big.  Here’s why.  If you realize revenue early in this period instead of next period (where it belongs) the following accounting period will underreport revenue.  Worse, the expenses to produce that revenue are still in that period.  When you subtract the properly reported expenses from the underreported revenue it will result in an operating loss.  Unless they cook the books in the following period, too.  By pulling revenue into that period from another period.  Or pushing out expenses to a later period.

The problem is when you keep doing this it makes the following accounting period more difficult to ‘fix’.  For as you pull revenue up and push expenses out each subsequent accounting period starts with a larger operating loss.  And if a business is having problems (which they typically do when they start cooking their books) actual revenue for that period will be depressed as well.  So as they go through subsequent accounting periods beginning operating deficits grow larger in the face of falling revenues.  To keep the scam going they have to take it up a notch.  Taking things ‘off balance sheet’ (basically ignoring some bad financial information).  Creating a shell company to dump bad financial data on.  And other accounting shenanigans.  The bigger the scam, though, the harder the fall.  And there is always a fall.  Think Enron.  And WorldCom.

But it’s just not businesses that cook their books.  Government does, too.  Especially when they want to pass unpopular and costly programs.  They will send the financial data for a program to the Congressional Budget Office to score.  To determine the cost over a 10 year period.  But to make the program less expensive and more palatable to the taxpayers they will cook that data.  Their bill may include new taxes over the ten year period.  But benefits may kick in a few years after the new taxes start.  So you may have 10 years of taxes paying for only 8 years of benefits.  But everyone thinks it’s 10 years of benefits.  Making the program appear less costly than it actually is.  Of course when they get caught in their accounting shenanigans nothing happens.  They just say, “Oops.  We goofed.  Shucks.  Looks like we’ll have to raise taxes.”  Not quite the same thing that happens in the private sector.  Just ask those who were running Enron.  And WorldCom.

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