[David Waring]

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From my subprime series there have been three subjects that seem to warrant more attention, and on which I find very little clear and concise information on. So with this in mind I am starting a three lesson course series today on intermediate to advanced suprime financial crisis topics. In this series we will cover:

1. The basics of Off Balance Sheet Entities

2. How these entities were used by the banks and why Enron is constantly brought up in connection with this.

3. The role that accounting rules are playing in the crisis

4. What the fed is doing to try and fix the crisis

As I touched on in my second video in my subprime series these pools of debt are held in what are known as off balance sheet entities, also referred to as conduits, Special Purpose Vehicles (SPV’s) and Structured Investment Vehicles (SIV’s).

These entities have been around for a long time and have been used for both legitimate and illegitimate purposes both of which we will examine further in this series.

The legitimate purpose of off balance sheet entities is to give companies the ability to separate out the risk associated with differing parts of the same type of business or different lines of business all together. As pointed out in an article from Investopedia.com on the subject, an example of this type of entity being used legitimately is by oil drilling companies who form off balance sheet entities for their oil exploration activities. This gives them the ability to finance new oil exploration, the part of the business with the highest risk/reward profile with money from new investors interested in this type of higher risk/reward profile while shielding existing investors from this part of the business.

Off balance sheet entities are often formed to start or spin off divisions of a company that are completely different from the parent companies line of business. The example Investopedia.com gives here is when Williams Company, an energy resources company, formed an off balance sheet entity to separate out a new division of the company which focused on the communications industry. The goal of doing this type of thing is to shield the existing shareholders who invested in an energy company from having to participate in the risk associated with the new communications company.

So as the above to examples seem like reasonable ways that many companies could use off balance sheet entities then why is there so much suspicion surrounding these entities. The first reason is that because these entities are off balance sheet they are talked about only in the footnotes of the financial reports and as not much information is disclosed it makes it easier for companies take advantage of the rules or operate in an illegitimate manner when using these entities.

This is what we saw with Enron who used off balance sheet entities to hide debt and inflate their earnings a fraud which resulted in multiple jail sentences for their executives and the largest bankruptcy in US History.

As the problems that we are now facing in the financial markets have mostly originated form these entities there are also now a lot of questions and suspicion surrounding the banks use of these entities which will be the topic of our next lesson.

[inapcha]

Dave,

I found this resource quite useful ( all 16 videos). Please share with others if you feel the same, as its content will help understand our discussion more. Thank you

Crash Course Chapter 7 | Chris Martenson