In Enron's natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would reflect "... true economic value." Enron became the first non-financial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract was signed, income was estimated as the present value of net future cash flows. Often, the viability of these contracts and their related costs were difficult to judge. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports. While using the method, income from projects could be recorded, which increased financial earnings. However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor pointed out, "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income." Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections.So, Enron signs a contract with the Widget Corporation, a 10-year deal that will bring in $10 billion. Instead of reporting $1 billion on its balance sheets for each of the ten years - the actual net gain it received that and each subsequent year - it reported the full $10 billion. In order to make up the lost reported revenue in subsequent years, however, it had to keep looking for new contracts, and kept reporting the income in this same fashion. Not only were reported net earnings erroneous. The actual cash-on-hand, the capitalization of the company, was wrong. Instead of receiving a check for $10 billion from Widget, they received and could only use $1 billion.
The SEC did approve this particular bit of legerdemain for one aspect of their business - energy trading. Enron, however, was a diverse company, and the practice spread to all areas. In essence, they were their own bubble - overvalues not the least because they claimed to have a certain amount of capital reserves they did not in fact possess. One $10 billion contract might have been easy enough to cover. Soon, however, all its business dealings were accounted for this way. When audited by Arthur Andersen, they insisted this accounting method was legitimate (it was, in one of its businesses) and that, in fact, their reported income was accurate. Andersen was duped, or perhaps went along with the charade.
How does this relate to the collapse of the mortgage-financing industry? I am still at a loss as to how smart investors would view a liability - and a mortgage, whatever else it might be, is just that, a debt owed - as an asset. Yet, they are routinely sold from the originator, bundled together, and sold on the open market as assets. In the 2000's this practiced was supported by no less than a statement from the President of the United States that home-ownership was a goal of federal policy. Mortgages, then, became not only a hot item with a certain safety net - mortgage default in the US has historically been relatively low - but with the backing of the federal government. It became a seller's market. The goal was increasing home-ownership. Banks, real estate firms, and other mediators were aggressively pursuing all sorts of potential customers. Once the pool of safe home-buyers dried up - those folks who would have qualified for a mortgage in any market - they started pursuing more and more marginal customers. No money down was offered. The variable-rate mortgage became commonplace, where the change in rate came in the future, at some time perhaps when the customer may be in a more secure financial situation. Interest-only mortgages seemed to promise low payments, but actually created much of the problem. Without any principal included, no equity could be accumulated; such mortgages were actually worthless in a financial sense.
In this seller's market - like the energy market that Enron controlled - the price of the commodity being sold went up, so the situation arose where more and more marginal customers were chasing after products, the price of which was climbing out of any realistic assessment of value, but also their ability to afford. The whole system teetered. As defaults began to increase, in 2007, the mortgage-backed securities held and traded by the large investment houses and banks (now indistinguishable thanks to Gramm-Leach) shrank in value, then disappeared.
The various stages differ. Enron was a single company, but did control enough of a particular market to have an impact, particularly on pricing. The end of Governor Gray Davis' term in office in California was in no small way due to Enron's price-manipulations of energy, and absent a regulatory regime, no effective controls. Absent a regulatory regime over the various financial products during the housing boom, investment houses and insurance companies that promised to cover potential losses (think American International Group, which died when Lehmann Brothers went south) had no floor beneath them. In both cases the free market worked to create not just volatility but instability, precisely because pricing control rested in the hands of either a single actor (Enron) or a few such actors (the investment banks, plus Citigroup, Goldman Sachs, a few others). While Enron died not least because of fraudulent accounting practices, claiming all sorts of profits and capital reserves it simply did not have, the housing bubble worked in much the same way, driving up the value of properties, creating a situation on paper where their value exceeded any reasonable estimate.
I'm not sure if these similarities offer any insight. They do, for me at any rate, point out that free markets, outside any regulatory framework or control, end up bringing about their own instability. In this sense, regulation of markets, setting all sorts of legal and administrative barriers, in effect keep capitalism afloat, a point most economists accepted during the Depression when it was noted that, far from overturning capitalism, Roosevelt's New Deal saved it from itself. Despite years of stagnant economic activity, except of course for the investment banks bailed out by the Bush Administration that are enjoying record profits, there is the general notion abroad that any attempt to regulate the financial markets will result in economic stagnation, while free markets are our only hope. How this can be, I do not know.
Enron died not least because, with the markets it controlled deregulated, there was no one looking over their shoulder. Arthur Andersen's audits, while legally required, were not themselves checked because going through the motion of an audit was enough to satisfy the requirements of the SEC. The investment houses, seeing an opportunity and operating in a favorable market condition - the so-called "ownership society" - also acted outside any effective regulatory control. Both created a situation of unsustainable market volatility that could only lead to a settling of accounts. In Enron's case, once the actual value of their capital reserves became clear, the value of the company crashed. Once increasingly marginal mortgages started to default in greater numbers, the value of mortgage-back securities, the investments made with them as collateral, and the insurance backing them all collapsed.