derivative swap synthet

see CDS  disambiguation

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file:///C:/Users/patmc/Downloads/Partnoy.pdf

ENRON : CORPORATE FIASCOS AND THEIR IMPLICATION

Enron and the Derivatives World

Frank Partnoy* 1

I am submitting testimony in response to this Committee’s request that I address

potential problems associated with the unregulated status of derivatives used by Enron

Corporation.

I am a law professor at the University of San Diego School of Law. I teach and do

research in the areas of financial market regulation, derivatives, and structured finance.

During the mid-1990s, I worked on Wall Street structuring and selling financial in-

struments and investment vehicles similar to those used by Enron. As a lawyer, I have

represented clients with problems similar to Enron’s, but on a much smaller scale. I

have never received any payment from Enron or from any Enron officer or employee.

I. INTRODUCTION AND OVERVIEW

Enron has been compared to Long-Term Capital Management, the Greenwich,

Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of derivatives

and was rescued in September 1998 in a private bailout engineered by the New York

Federal Reserve. For the past several weeks, I have conducted my own investigation

into Enron, and I believe the comparison is inapt. Yes, there are similarities in both

firms’ use and abuse of financial derivatives. But the scope of Enron’s problems and

their effects on its investors and employees are far more sweeping.

According to Enron’s most recent annual report, the firm made more money trad-

ing derivatives in the year 2000 alone than Long-Term Capital Management made in

its entire history. Long-Term Capital Management generated losses of a few billion

dollars; by contrast, Enron not only wiped out over $70 billion of shareholder value,

but also defaulted on tens of billions of dollars of debts. Long-Term Capital Management employed only 200 people worldwide, many of whom simply went on to start

new hedge funds after the bailout, while Enron employed 20,000 people, many of

whom have been fired, and many more of whom lost their life savings as Enron’s stock

plummeted last fall. In short, Enron makes Long-Term Capital Management look like

a lemonade stand.

It will surprise many investors to learn that Enron was, at its core, a derivatives

trading firm. Nothing made this more clear than the layout of Enron’s extravagant new

building in which the top executives’ offices on the seventh floor were designed to

overlook the crown jewel of Enron’s empire: a cavernous derivatives trading pit on the

sixth floor.

I believe there are two answers to the question of why Enron collapsed, and both

involve derivatives. One relates to the use of derivatives “outside” Enron, in transac-

tions with some now-infamous special purpose entities. The other—which has not

been publicized at all—relates to the use of derivatives “inside” Enron.

What are derivatives? They are complex financial instruments whose value is based

on one or more underlying variables, such as the price of a stock or the cost of natural

gas. Derivatives can be traded in two ways: on regulated exchanges or in unregulated

over-the-counter (“OTC”) markets. My testimony involves the OTC derivatives mar-

kets, the focus of Enron’s activities.

Sometimes OTC derivatives can seem too esoteric to be relevant to average inves-

tors. Even the well-publicized OTC derivatives fiascos of a few years ago—Procter &

Gamble or Orange County, for example—seem ages away. But the OTC derivatives

markets are too important to ignore, and are critical to understanding Enron. The size

of derivatives markets typically is measured in terms of the notional values of con-

tracts.

Recent estimates of the size of the exchange-traded derivatives market, which

includes all contracts traded on the major options and futures exchanges, are in the

range of $13 to $14 trillion in notional amount. By contrast, the estimated notional

amount of outstanding OTC derivatives as of year-end 2000 was $95.2 trillion. And

that estimate is most likely an understatement. In other words, OTC derivatives markets, which for the most part did not exist twenty (or, in some cases, even ten) years

ago, now comprise about 90 percent of the aggregate derivatives market, with trillions

of dollars at risk every day. By those measures, OTC derivatives markets are bigger

than the markets for U.S. stocks.

Enron may have been just an energy company when it was created in 1985, but by

the end it had become a full-blown OTC derivatives trading firm. Its OTC deriva-

tives-related assets and liabilities increased more than five-fold during 2000 alone.

:{And, let me repeat, the OTC derivatives markets are largely unregulated.}: Enron’s

trading operations were not regulated, or even recently audited, by U.S. securities

regulators, and the OTC derivatives it traded are not deemed securities. OTC deriva-

tives trading is beyond the purview of organized, regulated exchanges. Thus, Enron—

like many firms that trade OTC derivatives—fell into a regulatory black hole.

After 360 customers lost $11.4 billion on derivatives during the decade ending in

March 1997, the Commodity Futures Trading Commission began considering whether to regulate OTC derivatives. But its proposals were rejected, and in December 2000

Congress made the deregulated status of derivatives clear when it passed the Com-

modity Futures Modernization Act. As a result, the OTC derivatives markets have

become a ticking time bomb, which Congress thus far has chosen not to defuse.

Many parties are to blame for Enron’s collapse. But as this Committee and others

take a hard look at Enron and its officers, directors, accountants, lawyers, bankers, and

analysts, Congress also should take a hard look at the current state of OTC derivatives

regulation. (In the remainder of this testimony, when I refer generally to “derivatives,”

I am referring to these OTC derivatives markets.)

II. DERIVATIVES “OUTSIDE” ENRON

The first answer to the question of why Enron collapsed relates to derivatives deals

between Enron and several of its 3,000-plus off-balance sheet subsidiaries and partner-

ships. The names of these byzantine financial entities—such as JEDI, Raptor, and

LJM—have been widely reported.

Special purpose entities might seem odd to most investors, but they actually are

very common in modern financial markets. Structured finance is a significant part of

the U.S. economy, and special purpose entities are involved in most investors’ lives,

even if they do not realize it. For example, most credit card and mortgage payments

flow through special purpose entities, and financial services firms typically use such

entities as well. Some special purpose entities generate great economic benefits; oth-

ers—as I will describe below—are used to manipulate a company’s financial reports to

inflate assets, to understate liabilities, to create false profits, and to hide losses. In this

way, special purpose entities are a lot like fire: they can be used for good or ill. Special

purpose entities, like derivatives, are unregulated.

The key problem at Enron involved the confluence of derivatives and special pur-

pose entities. 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. These derivatives included price swap derivatives (described be-

low), as well as call and put options.

Specifically, Enron used derivatives and special purpose vehicles to manipulate its

financial statements in three ways. First, it hid speculator losses it suffered on technol-

ogy stocks. Second, it hid huge debts incurred to finance unprofitable new businesses,

including retail energy services for new customers. Third, it inflated the value of other

troubled businesses, including its new ventures in fiber-optic bandwidth. Although

Enron was founded as an energy company, many of these derivatives transactions did

not involve energy at all.

A. Using Derivatives to Hide Losses on Technology Stocks

First, Enron hid hundreds of millions of dollars of losses on its speculative invest-

ments in various technology-oriented firms, such as Rhythms NetConnections, Inc....

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:{:{see gr}:eat recession

from-enron-to-the-financial-crisis-with-alan-greenspan-in-between

us news world rept

Enron was only a prelude to the current market meltdown.In the wake of the Enron bankruptcy—which was briefly the biggest failure in U.S. history—two key lessons were obvious: Financial regulators needed lots more funding and personnel, and derivatives markets that were allowed to operate without proper regulatory oversight and reporting paved the way for financial engineers to privatize profits and socialize costs.Today, less than seven years after Ken Lay and his accomplices drove their once solid company into the ground, the United States is facing a financial disaster that makes Enron look quaint.

The bankruptcy of Lehman Brothers Holdings, America's fourth-largest investment bank, involves a whopping $613 billion in debt. When Enron failed, it claimed assets of just over $63 billion.The implosion of Lehman—along with the federal takeovers of mortgage giants Fannie Mae and Freddie Mac and insurance behemoth AIG—is symptomatic of the same lack of oversight that existed in December 2001 when Enron failed. And that lack of oversight can most easily be understood by looking at the budget of America's single most important financial regulator, the Securities and Exchange Commission, which oversees financial markets worth tens of trillions of dollars.

In 2001, the SEC's budget was $437.9 million. In March 2002, the General Accountability Office issued a report that said that the shortage of money and manpower at the SEC had forced the agency to "be selective in its enforcement activities and...lengthened the time required to complete certain enforcement investigations." So what has happened since then? Precious little. Yes, the agency has a substantially larger budget today than it did during the Enron era. For this year, its spending authority is $906 million. And for 2009, the agency's budget is projected to increase slightly, to $913 million.But here's the howler: The number of enforcement personnel, the people who go after the financial engineers, is expected to decline.

That's right. Despite the trillion-dollar meltdown now underway, the number of SEC enforcement personnel will decline from 1,209 this year to 1,177 in 2009. In all, the SEC expects to have 3,771 employees next year. For comparison, the Smithsonian Institution budget for 2009 includes funding for 4,324 employees.That's not meant as a slap at the Smithsonian. It houses a myriad of the nation's most treasured objects. But the SEC actually guards the nation's treasure. And yet, Congress treats it like a bastard stepchild. Indeed, Congress doles out more than five times as much money for corn subsidies ($4.9 billion in 2006, the most recent year for which data are available) as it does for the SEC.}:

Those pitiful numbers lead us to the innumerable problems posed by derivatives, the same financial instruments that led to the chaos at Enron, which before it failed operated a huge—and almost completely unregulated—derivatives exchange business. According to the Bank for International Settlements, the global derivatives market is now worth some $676.5 trillion. That's $676,500,000,000,000. That's a fivefold increase over the value of derivatives that were traded in 2003. Further, that $676.5 trillion is 51 times America's current gross domestic product.In 2002, the world's smartest investor (and my pick for president this year), Omaha billionaire Warren Buffett, issued his annual letter to the shareholders of Berkshire Hathaway. In it, he called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Few people heeded Buffett's warning. In fact, some of America's most important financial players dismissed him out of hand. In September 2002, Federal Reserve Chairman Alan Greenspan, Treasury Secretary Paul O'Neill, Securities and Exchange Commission Chairman Harvey Pitt, and James Newsome, chairman of the Commodity Futures Trading Commission, sent a letter to a pair of U.S. senators in which they declared that financial derivatives were not a danger. Instead, they said that derivatives "have been a major contributor to our economy's ability to respond to the stresses and challenges of the last two years."

Further, they declared that a then pending Senate proposal to regulate derivatives could increase "the vulnerability of our economy to potential future stresses."In June 2003, Greenspan again defended derivatives. In another letter to members of the Senate, Greenspan—this time bolstered by Treasury Secretary John Snow and Securities and Exchange Commission Chairman William Donaldson as well as Newsome—declared:

Businesses, financial institutions, and investors throughout the economy rely upon derivatives to protect themselves from market volatility triggered by unexpected economic events. This ability to manage risks makes the economy more resilient, and its importance cannot be underestimated. In our judgment, the ability of private counterparty surveillance to effectively regulate these markets can be undermined by inappropriate extensions of government regulation.

Back in 2002, in *Pipe Dreams*, my book on the Enron disaster, I wrote that reforms were needed to deal with derivatives. I quoted one financial analyst who called derivatives "Wall Street's dirty secret." I recommended that "derivatives dealers should be required to post agreed-upon amounts of capital to collateralize their trading positions" and that "the derivatives marketplace must be made more uniform, with policing by regulators who can establish price limits, listing requirements, and other trading parameters.

"I don't repeat that to brag about any foresight on my part. Many other people were arguing for the same types of reforms. The point is that the warning signs left by the Enron mess could not have been more clear. The derivatives mess created by Bear Stearns, Lehman Brothers, and the others occurred because of a regulatory vacuum where none of the players were required to post collateral to back up their positions or to disclose to investors the size of their huge derivatives positions. That lack of oversight has spawned a financial crisis that will reverberate through the global economy for years to come.

.Thousands of people are losing their homes. Thousands more are losing their jobs. Taxpayer money is being used to bail out private companies that were headed by corporate bosses who routinely helped themselves to multimillion-dollar pay packages. And all of it is happening because the Bush administration and Congress refused to heed the lessons of Enron.

Robert Bryces latest book is Gusher of Lies: The Dangerous Delusions of "Energy Independence."*

Tags: Treasury Department, Federal Reserve, Wall Street, Enron, Alan Greenspan

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https://www.alternet.org/2021/05/black-monday/

HNN

In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as"Black Monday," the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its total value. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06. This was the greatest loss Wall Street had ever suffered on a single day.

According to Facts on File, an authoritative source of current-events information for professional research and education, the 1987 crash"marked the end of a five-year 'bull' market that had seen the Dow rise from 776 points in August 1982 to a high of 2,722.42 points in August 1987." Unlike what hapopened in 1929, however, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the '87 crash.2

Many feared that the crash would trigger a recession. Instead, the fallout from the crash turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. According to Facts on File,"The worst economic losses occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry."3

A number of explanations have been offered as to the cause of the crash, although none may be said to have been the sole determinant. Among these are computer trading and derivative securities, illiquidity, trade and budget deficits, and overvaluation. Below we have quoted representative analyses.

CAUSE #1: DERIVATIVE SECURITIES

Bruce Bartlett, senior fellow with the National Center for Policy Analysis of Dallas, Texas:

Initial blame for the 1987 crash centered on the interplay between stock markets and index options and futures markets. In the former people buy actual shares of stock; in the latter they are only purchasing rights to buy or sell stocks at particular prices. Thus options and futures are known as derivatives, because their value derives from changes in stock prices even though no actual shares are owned. The Brady Commission [also known as the Presidential Task Force on Market Mechanisms, which was appointed to investigate the causes of the crash], concluded that the failure of stock markets and derivatives markets to operate in sync was the major factor behind the crash.

CAUSE #2: COMPUTER TRADING

In searching for the cause of the crash, many analysts blame the use of computer trading (also known as program trading) by large institutional investing companies. In program trading, computers were programmed to automatically order large stock trades when certain market trends prevailed. However, studies show that during the 1987 U.S. Crash, other stock markets which did not use program trading also crashed, some with losses even more severe than the U.S. market.

CAUSE #3: ILLIQUIDITY...

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https://www.alternet.org/2020/05/whistleblower-wall-street-has-engaged-in-widespread-manipulation-of-mortgage-funds

no lnx

Pro Publica May 16, 2020

33

Among the toxic contributors to the financial crisis of 2008, few caused as much havoc as mortgages with dodgy numbers and inflated values. Huge quantities of them were assembled into securities that crashed and burned, damaging homeowners and investors alike. Afterward, reforms were promised. Never again, regulators vowed, would real estate financiers be able to fudge numbers and threaten the entire economy.

Twelve years later, there’s evidence something similar is happening again.

Some of the world’s biggest banks — including Wells Fargo and Deutsche Bank — as well as other lenders have engaged in a systematic fraud that allowed them to award borrowers bigger loans than were supported by their true financials, according to a previously unreported whistleblower complaint submitted to the Securities and Exchange Commission last year.

Whereas the fraud during the last crisis was in residential mortgages, the complaint claims this time it’s happening in commercial properties like office buildings, apartment complexes and retail centers. The complaint focuses on the loans that are gathered into pools whose worth can exceed $1 billion and turned into bonds sold to investors, known as CMBS (for commercial mortgage-backed securities).

Lenders and securities issuers have regularly altered financial data for commercial properties “without justification,” the complaint asserts, in ways that make the properties appear more valuable, and borrowers more creditworthy, than they actually are. As a result, it alleges, borrowers have qualified for commercial loans they normally would not have, with the investors who bought securities birthed from those loans none the wiser.

ProPublica closely examined six loans that were part of CMBS in recent years to see if their data resembles the pattern described by the whistleblower. What we found matched the allegations: The historical profits reported for some buildings were listed as much as 30% higher than the profits previously reported for the same buildings and same years when the property was part of an earlier CMBS. As a rough analogy, imagine a homeowner having stated in a mortgage application that his 2017 income was $100,000 only to claim during a later refinancing that his 2017 income was $130,000 — without acknowledging or explaining the change.

It’s “highly questionable” to alter past profits with no apparent explanation, said John Coffee, a professor at Columbia Law School and an expert in securities regulation. “I don’t understand why you can do that.”

In theory, CMBS are supposed to undergo a rigorous multistage vetting process. A property owner seeking a loan on, say, an office building would have its finances scrutinized by a bank or other lender. After that loan is made, it would be subjected to another round of due diligence, this time by an investment bank that assembles 60 to 120 loans to form a CMBS. Somewhere along the line, according to John Flynn, a veteran of the CMBS industry who filed the whistleblower complaint, numbers are being adjusted — inevitably to make properties, and therefore the entire CMBS, look more financially robust.

The complaint suggests widespread efforts to make adjustments. Some expenses were erased from the ledger, for example, when a new loan was issued. Most changes were small; but a minor increase in profits can lead to approval for a significantly higher mortgage.

The result: Many properties may have borrowed more than they could afford to pay back — even before the pandemic rocked their businesses — making a CMBS crash both more likely and more damaging. “It’s a higher cliff from which they are falling,” Flynn said. “So the loss severity is going to be greater and the probability of default is going to be greater.”

With the economy being pounded and trillions of dollars already committed to bailouts, potential overvaluations in commercial real estate loom much larger than they would have even a few months ago. Data from early April showed a sharp spike in missed payments to bondholders for CMBS that hold loans from hotels and retail stores, according to Trepp, a data provider whose specialties include CMBS. The default rate is expected to climb as large swaths of the nation remain locked down.

After lobbying by commercial real estate organizations and advocacy by real estate investor and Trump ally Tom Barrack — who warned of a looming commercial mortgage crash — the Federal Reserve pledged in early April to prop up CMBS by loaning money to investors and letting them use their CMBS as collateral. The goal is to stabilize the market at a time when investors may be tempted to dump their securities, and also to support banks in issuing new bonds. (Barrack’s company, Colony Capital, has since defaulted on $3.2 billion in debt backed by hotel and health care properties, according to the Financial Times.)

The Fed didn’t specify how much it’s willing to spend to support the CMBS, and it is allowing only those with the highest credit ratings to be used as collateral. But if some ratings are based on misleading data, as the complaint alleges, taxpayers could be on the hook for a riskier-than-anticipated portfolio of loans.

The SEC, which has not taken public action on the whistleblower complaint, declined to comment....

some lenders interviewed for this article maintain they’re permitted to alter properties’ historical profits under some circumstances. Others in the industry offered a different view. Adam DeSanctis, a spokesperson for the Mortgage Bankers Association, which has helped set guidelines for financial reporting in CMBS, said he reached out to members of the group’s commercial real estate team and none had heard of a practice of inflating profits. “We aren’t aware of this occurring and really don’t have anything to add,” he said.

The notion that profit figures for some buildings are pumped up is surprising, said Kevin Riordan, a finance professor at Montclair State University. It raises questions about whether the proper disclosures are being made.

Investors don’t comb through financial statements, added Riordan, who used to manage the CMBS portfolio for retirement fund giant TIAA-CREF. Instead, he said, they rely on summaries from investment banks and the credit ratings agencies that analyze the securities. To make wise decisions, investors’ information “out of the gate has to be pretty close to being right,” he said. “Otherwise you’re dealing with garbage. Garbage in, garbage out.”

The whistleblower complaint has its origins in the kinds of obsessions that keep wonkish investors up at night. Flynn wondered what was going to happen when some of the most ill-conceived commercial loans — those made in the lax, freewheeling days before the financial crisis of 2008 — matured a decade later. He imagined an impending disaster of mass defaults. But as 2015, then 2017, passed, the defaults didn’t come. It didn’t make sense to him.

Flynn, 55, has deep experience in commercial real estate, banking and CMBS. After growing up on a dairy farm in Minnesota, the youngest of 14 children, and graduating from college — the first in his family to do so, he said — Flynn moved to Tokyo to work, first in real estate, then in finance. Jobs with banks and ratings agencies took him to Belgium, Chicago and Australia. These days, he advises owners whose loans are sold into CMBS and helps them resolve disputes and restructure or modify problem loans.

He began poring over the fine print in CMBS filings and noticed curious anomalies. For example, many properties changed their names, and even their addresses, from one CMBS to another. That made it harder to recognize a specific property and compare its financial details in two filings. As Flynn read more and more, he began to wonder whether the alterations were attempts to obscure discrepancies: These same properties were typically reporting higher net operating incomes in the new CMBS than they did for the same year in a previous CMBS.

Flynn ultimately collected and analyzed data for huge numbers of commercial mortgages. He began to see patterns and what he calls a massive problem: Flynn has amassed “materials identifying about $150 billion in inflated CMBS issued between 2013 and today,” according to the complaint.

The higher reported profits helped the properties qualify for loans they might not have otherwise obtained, he surmised. They also paved the way for bigger fees for banks. “Inflating historical cash flows creates a misperception of lower current and historical cash flow volatility, enables higher underwritten [net operating income/net cash flow], and higher collateral values,” the complaint states, “and thereby enables higher debt.”

Flynn eventually found a lawyer and, in February 2019, he filed the whistleblower complaint. The complaint accuses 14 major lenders — including three of the country’s biggest CMBS issuers, Deutsche Bank, Wells Fargo and Ladder Capital — and seven servicers of inflating historical cash flows, failing to report misrepresentations, changing names and addresses of properties and “deceptively and inaccurately” describing mortgage-loan representations. It doesn’t identify which companies allegedly manipulated each specific number. (Spokespeople for Deutsche Bank and Wells Fargo declined to comment on the record. The complaint does not mention Barrack or his company. )

The SEC has the power to fine companies and their executives if fraud is established. If the SEC recovers more than $1 million based on Flynn’s claim, he could be entitled to a portion of it.

When Flynn filed the complaint, the skies looked clear for the commercial mortgage market. Indeed, last year was a boom year for CMBS, with private lenders in the U.S. issuing roughly $96.7 billion in commercial mortgage-backed securities — a 27% increase over 2018, which made it the most successful year since the last financial crisis, according to Trepp. Overall, investors hold CMBS worth $592 billion.

Flynn’s assertions raise questions about the efficacy of post-crisis reforms that Congress and the SEC instituted that sought to place new restrictions on banks and other lenders, increase transparency and protect consumers and investors. The regulations that were retooled included the one that governs CMBS, known as Regulation AB. The goal was to make disclosures clearer and more complete for investors, so they would be less reliant on ratings agencies, which were widely criticized during the financial crisis for lax practices.

Still, the opinion of the credit-ratings agencies remains crucial today, a point reinforced by the Fed’s decision to hinge its bailout decisions on those ratings. That’s a problem, in the view of Neil Barofsky, who served as the U.S. Treasury’s inspector general for the Troubled Assets Relief Program from 2008 to 2011. “Practically nothing” was done to reform the ratings agencies, Barofsky said, which could lead to the sorts of problems that emerged in the bailout a decade ago. If things truly turn bad for the commercial real estate industry or if fraud is discovered, he added, the Fed could end up taking possession of properties that default.

CMBS can be something of a last resort for borrowers whose projects are unlikely to qualify for a loan with a desirable interest rate from a bank or other lender (because they are too big, too risky or some other reason), according to experts. Underwriting practices — the due diligence lenders do before extending a loan — for CMBS have gained a reputation for being less strict than for loans that banks keep on their balance sheets. Government watchdogs found serious deficiencies in the underwriting for securitized commercial mortgages during the financial crisis, just as they did in the subprime residential market.

The due diligence process broke down, Flynn maintains, in precisely the mortgages he was worried about: the 10-year loans obtained before the financial crisis. What Flynn discovered, he said, was that rather than lowering the values for properties that had taken on bigger loans than they could pay off, their owners instead obtained new loans. “Someone should have taken the losses,” he said. “Instead, they papered over it, inflated the cash flow and sold it on.”

For commercial borrowers, small bumps in a property’s profits can qualify the borrower for millions more in loans. Shaving expenses by about a third to boost profit, for instance, can sometimes allow a borrower to increase a loan’s size by a third as well — even if the expenses run only in the thousands, and the loan runs in the millions.

Some executives for lenders acknowledged to ProPublica that they made changes to borrowers’ past financials — scrubbing expenses from prior years they deemed irrelevant for the new loan — but maintained that it is appropriate to do so. Accounting firms review financial data before the loans are assembled into CMBS, they added.

The financial data that ProPublica examined — a sample of six loans among the thousands Flynn identified as having inflated net operating income — revealed potential weaknesses not readily apparent to the average investor. For those six loans, the profits for a given year were listed as 9% to 30% higher in new securities than in the old. After they were issued, half of those loans ended up on watch lists for problem debt, meaning the properties were considered at heightened risk for default.

In each of the six loans, the profit inflation seemed to be explained by decreases in the costs reported. Expenses reported for a particular year in one CMBS simply vanished in disclosures for the same year in a new CMBS.

Such a pattern appeared in a $36.7 million loan by Ladder Capital in 2015 to a team that purchased the Doubletree San Diego, a half-century-old hotel that struggled for years to bring in enough income to satisfy loan servicers, even under a previous, smaller loan.

The hotel’s new loan saddled it with far greater debt, increasing its main loan by 60% — even though the property had landed on a watchlist in 2010 because of declining revenue. Analysts at Moody’s pegged the hotel’s new loan as exceeding the value of the property by 40.5% (meaning a loan-to-value ratio of 140.5%).

Filings for the new loan claimed much higher profits than what the old loan had cited for the same years: The hotel’s net operating income for two years magically jumped from what had previously been reported: 21% and 16% larger for 2013 and 2014, respectively.

Such figures are supposed to be pulled from a property’s “most recent operating statement,” according to the regulation governing CMBS disclosures.

But, in response to questions from ProPublica, lender Ladder Capital said it altered the expense numbers it provided in the Doubletree’s historical financials. Ladder said it wiped lease payments —$700,608 and $592,823 in those two years — from the historical financials, because the new owner would not make lease payments in the future. (The previous owner had leased the building from an affiliated company.)

Ladder, a publicly traded commercial real estate investment trust that reports more than $6 billion in assets, said in a statement, “These differences are due to items that were considered by Ladder Capital during the due diligence process and reported appropriately in all relevant disclosures.”

Yet when ProPublica asked Ladder to share its disclosures about the changes, the firm pointed to a section of the pool’s prospectus that didn’t mention lease payments, or explain or acknowledge the change in income.

The Doubletree did not fare well under its new debt package. Revenues and occupancy declined after 2015 and by 2017, the hotel’s loan was back on the watch list. The hotel missed franchise fee payments. Ladder foreclosed in December 2019, after problems with an additional $5.8 million loan the lender had extended the property.

The Doubletree loan was not the only loan in its CMBS pool, issued by Deutsche Bank in 2015, with apparently inflated profits. Flynn said he was able to track down previous loan information for loans representing nearly 40% of the pool, and all had inflated income figures at some point in their historical financial data.

There was also a noticeable profit increase in two loans Ladder issued for a strip mall in suburban Pennsylvania. The mall’s past results improved when they appeared in a new CMBS. Its 2016 net operating income, previously listed as $1,101,207 in one CMBS, now appeared as $1,352,353 in another, data from Trepp shows — an increase of 23%. The prospectus for the latter does not explain or acknowledge the change in income. The mall owner received a $14 million loan.

Less than a year after it was placed into a CMBS, the loan ran into trouble. It landed on a watchlist after one of its major tenants, a department store, declared bankruptcy.

Ladder said it excluded $203,787 in expenses from the new loan because they stemmed from one-time costs for environmental remediation of pollution by a dry cleaner and a roof repair. Ladder did not explain why the previous lender did not exclude the expense also.

The pattern can be seen in loans made by other lenders, too. In a CMBS issued by Wells Fargo, a 1950s-era trailer park at the base of a steep bluff along the coast in Los Angeles reported sharply higher profits — for the same years — than it previously had.

The Pacific Palisades Bowl Park received a $12.9 million loan from the bank in 2016. The park reported expenses that were about a third lower in its new loan disclosures when compared with earlier ones. As a result, the $1.2 million in net operating income for 2014 rose 28% above what had been reported for the same year under the old loan. A similar jump occurred in 2013. (Edward Biggs, the owner of the park, said he gave Wells Fargo the park’s financials when refinancing its loan and wasn’t aware of discrepancies in what was reported to investors. “I don’t know anything about that,” he said.)

Flynn said he found that for the $575 million Wells Fargo CMBS that contained the Palisades debt, about half of the loan pool appeared to have reported inflated profits at some point, when comparing the same years in different securities.

Another of the loans ProPublica examined with apparently inflated profits was for a building in downtown Philadelphia. When the owner refinanced through Wells Fargo, the property’s 2015 profit appeared 23% higher than it had in reports under the old loan. Wells bundled the debt into a mortgage-backed security in 2016.

The building, One Penn Center, is a historic Art Deco office high-rise with ornate black marble and gold-plated fixtures, and a transit station underneath. One of the primary tenants, leasing 45,000 square feet for one of its regional headquarters, happens to be the SEC. The agency declined to comment

==

https://www.alternet.org/wrong-lesson-we-learned-enron-led-directly-2008-crash

benke HNN

Recently Jeffrey Skilling, the former CEO the infamous Texas energy company Enron, was quietly released from prison and placed into a halfway house. To some, the news might offer a satisfying conclusion to the Enron story. The details of the company’s 2001 collapse, involving a massive accounting fraud, were so outlandish that Skilling’s prison term seemed as if justice had been served. After all, many Enron employees lost their retirements when the company went under. The problems with Enron, though, are bigger than the few people who went to jail as a result. The company’s collapse was ultimately enabled by a number of business trends that developed during the late twentieth century and which are still with us today. Indeed, Enron was a warning sign about the dangers of the very financial derivatives that threatened the entire global economy ten years ago.

Skilling’s time at Enron reveals how the influence of Wall Street transformed U.S. business at the end of the twentieth century. In the late 1990s, Enron was celebrated in the business press for pioneering a new style of business. This success was largely attributed to Skilling, who had first come into contact with Enron when he was a consultant for McKinsey. As part of his work for the Texas energy company Skilling created a new business model for the natural gas pipeline company through the creative application of financial derivatives.

At the time, the gas industry was in desperate need of a new approach to business. In the mid-1980s, natural gas deregulation ushered in sweeping changes for the industry. While in the past there had been strict rules that determined both the price of gas and how companies could operate, after deregulation, any company could contract with a pipeline to transport natural gas and, significantly, gas prices were no longer set by regulators. For gas pipeline companies such as Enron, this meant finding entirely new ways to operate. Skilling helped solve this problem by drawing inspiration from the innovations taking place on Wall Street. By offering a range of different derivatives deals, Enron’s customers were able to secure gas supplies at fixed and predictable prices. This, of course, was welcome news to industrial buyers of natural gas.

Skilling’s early work for Enron was enormously successful. Now at Enron fulltime and convinced that this business model could be applied to a range of different industries, Skilling pushed the company into areas beyond natural gas. Offering a comparison to the art world, Skilling told interviewers for a business school case study that Enron’s “paint” and “brush stroke” were now being applied to a larger “canvas.” Indeed, that Enron had just introduced financial derivatives related to changes in the weather reveals just how big that “canvas” was that Skilling had in mind. The influence of Wall Street could also be felt inside the company.

Skilling changed job titles inside the company to match those found inside large investment banks. As a glowing Fortune magazine feature noted, the new job titles implied that each employee was “part of a portfolio” which would allow Enron’s leadership to tinker with employee assignments just as bankers did with stocks and bonds. With Enron, the financialization of the American economy seemed to have reached its pinnacle.

Ironically, Skilling’s early success with adopting banking practices also contained the seeds of Enron’s eventual ruin. Despite his belief that his business strategy could be applied to many different industries, Enron had trouble repeating its early success with derivatives. However, through the combination of complicated derivatives deals (often with strange names like “Nighthawk” and “Osprey”) and “mark-to-market” accounting – a method that was typically used for banking - Enron was able to hide losses on many of these new businesses. When the company did finally unravel at the end of 2001, there was widespread public outrage.

Enron’s bankruptcy, then the largest in American history, meant a swift reversal of Skilling’s public image. No longer seen as a business visionary, Enron’s CEO now seemed to be nothing more than a con man. On Capitol Hill, an impulse towards reform followed Enron’s failure. Sarbanes-Oxley, the major piece of legislation that emerged from the Enron scandal, focused more on accounting transparency than systemic change. Michael Oxley, the late congressman who coauthored the law, worried that the Enron scandal sent the message that “somehow the game is rigged against the average investor” and that the government needed to act in order to “restore confidence in the markets.” When President Bush signed Sarbanes-Oxley into law, Washington largely declared the affair over. Prison sentences for many, including Skilling, were handed down over the next several years. This spectacle of handcuffed executives, as some have ruefully noted, was missing after the 2008 crash.

However, neither congressional action nor criminal prosecution slowed the financialization of the American economy. On the contrary, the lack of any widespread economic disruption after Enron’s failure provided some with a false sense of comfort. While doing business with the doomed company, New York investment banks had taken out credit default swaps in case the company collapsed. To at least some policymakers, it seemed as though these new derivatives had worked. In particular, Alan Greenspan argued that Enron’s collapse was proof that “the combination of deregulation and innovation in the financial sector” had created a more fundamentally sound and secure economy. There was no need, in his estimation, to regulate credit default swaps because banks had been free to develop flexible strategies for managing risk. 

Greenspan’s conclusion is one of the more tragic ironies of Enron’s history. Indeed, the next scandal brought about by financial derivatives would have much bigger consequences. That a post-Enron crisis caused by financial derivatives threatened the entire global economy should be a stern warning that have we did not learn the broader lessons of the Houston company’s collapse. Stopping the next crisis will require more than punishing bad actors. Rather, what we need now is a sustained conversation about the power and influence finance has over much of the economy.

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