Arnold Kling

Accounting Scandals II

Arnold Kling, Great Questions of Economics
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CNNFN offers some data that shows accounting fraud rising.

The number of fraud cases investigated by the Securities and Exchange Commission jumped 41 percent in the last three years, according to agency data...

I listened to the PBS News Hour on the radio last night, and they were pointing out that the profit restatements by Enron were relatively small. This begged a question, which was asked, but not answered:

Why did the company go bankrupt? If they had shown large profits in the past, and they only restated some of them, what was the big deal?

My guess is that the answer is that Enron was operating like a hedge fund. It was trying to earn profits from complex, leveraged transactions in illiquid markets involving swaps. A swap is an illiquid version of a derivative. A derivative is an option or futures contract whose value is derived from that of an underlying asset. A swap is a contract between two private parties that has the financial characteristics of a derivative. However, swaps are not traded on the market, and hence are not liquid.

When your strategy relies on swaps, everything depends on your borrowing cost remaining stable. If your borrowing cost goes up, the deals that were winners at the time they were negotiated are losers today.

Restating profits meant that Enron went down a rung in creditworthiness, which raises their borrowing costs, which was fatal to their strategy. That is why former Treasury Secretary Robert Rubin and other Enron pleaders were calling Federal officials and asking for help. With some kind of government guarantee to bolster their credit rating, Enron might have survived. But evidently the Bush administration rebuffed the approaches by Enron and let them fail.

Discussion Question: Should a company that engages in complex swap transactions be required to disclose the sensitivity of the firm's net worth to a hypothetical increase in its cost of borrowing?

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