Now that we have an understanding of what off balance sheet entities are and some of their potential uses we can take a look at how they were used by the Banks involved in the Subprime Financial Crisis and try and gain a better understanding of where the potential problems arose.

The first thing that it is important to understand is that because many financial institutions are so highly regulated, an additional factor is added into the equation when banks operate these types of entities. In short, banks are required to keep a certain amount of capital on the books (referred to as reserves) to cover their outstanding liabilities. They are audited regularly to make sure that they keep the appropriate levels of capital in place and are also restricted as to the type of financial activities they can participate in.

By forming off balance sheet entities the banks get out from under the regulatory umbrella and put themselves in a position where they can engage in more speculative activity than would otherwise be possible. With this in mind the main question that people are asking as a result is should these activities have been regulated in the past and if so what should be done about the future. While I think the answer to the first part of that question is pretty clear, the what do we do now part of the question is yet to be answered.

The second thing that it is important to understand is that there are many questions as to if these off balance sheet entities are really “off balance sheet” the risk of potential loss to the parent company is supposed to be off balance sheet as well. This of course begs the question of if this was the case then how come the parent companies are now taking such huge hits to their earnings as a result of losses in these entities?

The answer to this question is that in order to obtain financing for the off balance sheet entities many of the banks in effect guaranteed the debt that the entities raised by agreeing to be the lender of last resort should the entity get into trouble and need financing. While I don’t think this was well understood by most people at the time, what this effectively did was transfer the risk of these entities off the parent company’s balance sheet and into the market and then back onto the balance sheet with the lender of last resort agreement.

As I mentioned in my last article off balance sheet entities became famous with the fall of Enron who used these entities to hide debt and inflate earnings. Because of this we are now hearing the word Enron mentioned over and over again in association with the whole subprime financial crisis. While there are definitely some questions to be answered, some of which may result in legal action, at this stage of the game anyways it seems that, unlike enron which committed outright fraud, most if not all of these firms were operating from within the realm of the law. With this in mind in my opinion what you are likely to see is some pretty drastic changes in regulation relating to banks’ abilities to use these entities but not jail sentences being handed out as was the case with Enron.

In our next lesson we will look at the accounting rules and the role that they play so we can better understand how this happened and the role that they are still playing.

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A Simple Explanation of the Subprime Crisis
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