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CONFIDENTIAL

Financial Executives International N.E. Wisconsin Chapter

Presented by:

Christopher M. Cutler

www.mcguirewoods.com

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CONFIDENTIAL

The Enron Investigation• People remember the following from the case:

– Criminal cases against Ken Lay and Jeff Skilling

– Andrew Fastow’s partnerships (LJM and LJM II)

– Off Balance Sheet Debt through SPEs

– The Nigerian Barge transaction involving Merrill Lynch

– The California energy crisis

– The downfall of Arthur Andersen

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• What people don’t remember (or know) about the case:

– The abuse of accounting rules through structured finance transactions involving securitizations and derivatives – especially “prepays.”

The Enron Investigation

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The Motivation Behind Enron’s Fraud• Enron delivered smoothly growing earnings (but not cash flows). Wall

Street took Enron on its word but didn’t understand its financial statements.

• It was all about the credit rating. Enron was a BBB+ trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its credit rating was AA.)

• In its last 5 years, Enron reported 20 straight quarters of increasing income.

• Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business known as “wholesale energy operations and services.”

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Operating Cash Flow Created

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Why Didn’t Anyone Catch Them?

• No one compared Enron’s quarterly cash flow figures with what it reported at its fiscal year end.

• Example - Enron reported $100 million in operating cash flow for the first 9 months of fiscal year 2000.

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CONFIDENTIAL

So Who Got Blamed for Enron’s Downfall?

• Ken Lay, Jeff Skilling, Andrew Fastow, and a couple other corporate officers.

• Certain Employees in Enron’s Broadband Unit

• Merrill Lynch Bankers

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CONFIDENTIAL

What About Everyone Else?

• Arthur Andersen?

• Enron’s finance and legal departments?

• Wall Street Banks?

– Derivatives Market?

• Credit Rating Agencies?

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CONFIDENTIAL

Our Government’s Response

• The Sarbanes-Oxley Act of 2002

– Audit Committee Changes

– Section 404

– The Public Company Accounting Oversight Board

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CONFIDENTIAL

What our Government Didn’t Do

• Did not regulate derivatives

• Did not sufficiently regulate credit rating agencies

• Did not limit investing activities of financial institutions

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CONFIDENTIAL

The Regulatory Backlash

• Section 404(a) of the Sarbanes-Oxley Act

• PCAOB Constitutional Challenge

• Move to International Financial Reporting Standards

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Why The Subprime Market Grew – Securitization Market

• The growth of the securitization market for Mortgage Backed Securities (MBS), specifically “non-agency” MBS.

• Issuance of “non-agency” MBS grew from $157 billion in 2000 to $1.2 trillion in 2006.

• Overall issuance of subprime “non-agency” MBS grew from $96 billion in 2001 to $483 billion in 2006.

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Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

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Why the Housing Bubble Burst

• The Federal Reserve raised interest rates 17 times since 2004.

• 50% of ARM originations over the past four years have been subprime.

– 80% of 2005 subprime originations were ARMs, most were 2/28 hybrids.

– Nearly 2 million subprime ARMs reset at the end of 2008, with monthly payment increases of 30% or more.

• Home prices fell throughout the country, delinquency and default rates soared, and foreclosures spiked to record levels.

• Value of subprime MBS and CDOs linked to subprime assets dropped.

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CONFIDENTIAL

The Meltdown - Imploded Lenders• Alliance Bancorp• Choice Capital Funding• Premier Mortgage Funding• Stone Creek Funding• FlexPoint Funding• Starpointe Mortgage• Freestand Financial• Wells Fargo Correspondent

Alternative• Altivus Financial• ACT Mortgage• Aegis Mortgage Corp.• Ownit Mortgage Solutions• Quality Home Loans

• New Century Financial Corporation

• Fremont General Corp.• Ameriquest Mortgage• Southstar Funding• Oak Street Mortgage, LLC• ResMAE Mortgage Corp.• People’s Choice Financial Corp.• American Home Mortgage

Investment• LoriMac, Inc.• First Magnus Financial• Silver State Mortgage• Sunset Direct Lending

Plus about 275 More!

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CONFIDENTIAL

The Meltdown – Wall Street Banks

Company 2008 Writedowns (Bil)

Citigroup $55.1

Merrill Lynch $51.8

UBS $44.2

HSBC $27.4

Wachovia $22.5

Bank of America $21.2

WAMU $14.8

Morgan Stanley $14.4

Deutsche Bank $10.8

Overall Total $501.1

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THE BAILOUTS

• AIG - $182.5 Billion in Bailout Money ($40 Billion TARP TARP)

• $105 Billion in Preferred Equity in 8 Banks - TARP

• Citigroup and Bank of America - $45 Billion - TARP

• Community Banks - $92 Billion - TARP

• The Big 3 - $24.8 Billion - TARP

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CONFIDENTIAL

FAS 157

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Major Financial Institution Level 3 Assets

Six largest Wall Street firms, the value of their Level 3 asset holdings relative to firm equity:

Morgan Stanley $88.2 billion, 250% equity

Lehman Bros. $34.7 billion, 160% equity

Bear Stearns $20.2 billion, 155% equity

Goldman Sachs $51 billion, 130% equity

Citigroup $135 billion, 105% equity

Merrill Lynch $27.2 billion, 70% equity• FASB 157 - Level 3 Assets

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What’s the Impact?• Harder for Businesses to Access the Credit

Markets

• Stagnation in Everything– Our Economy– Our Social Programs (Social Security and

Medicare)– Technological Growth

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More Regulation is Coming!

• Regulation of Mortgage Lending

• More Regulatory Enforcement

• Oversight of Unregulated Financial Markets

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