Throughout most of the history of America, assets were valued by either the amount of money they made you or the amount of money someone would by them for. Not too long ago, the smartest guys in the room came up with an idea to value things by what we want them to be versus what they really were. Believe it or not, that is why we are never going to get a significant rate increase in the US, unless it is forced upon us by the markets… and when that rate increase does occur – BAM! Let me explain in more detail.
Enron was a diversified energy company and at its demise was the largest corporate bankruptcy in American history. In the beginning, Enron’s natural gas business was substantial and its accounting had been straightforward, ie. the cost to supply gas was matched with the revenues to delivering gas to customers in plain vanilla, discrete time periods (ex. quarters). Then this financial engineer named Ken Skilling joined the company and changed all of that. Now, the energy trading business used mark-to-model accounting, with the reasoning that such accounting represented “true economic value. Enron became the first non-financial company to use the method to account for its complex long-term contracts, although it’s arguable that the contracts were financial in nature.
The Enron mark-to-model accounting requires that once a long-term contract was signed, income is estimated as the present value of net future cash flow. You see, the problem with that is that there aren’t too many of us that can predict the future very accurately, thus measuring future cash flows now is akin to counting ass haird on a pink unicorn. Alas… I digress. Enron proceeded with this methodology anyway, and as you may have guessed, dramatically misleading results ensued (misleading to investors and shareholders, that is).
Modeled accounting DCF income would be recorded from these projects, but actual cash never arrived. In order for Enron to show rising earnings, they had to juice up the assumptions in the models, thus more accounting income was booked, but there was no cash to back it up. Never fear, the SEC approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. Not being enough paper income for Enron, further boldened by the ruling and apparent support of the SEC, it then extrapolated its mark to model accounting methods and fictitious earnings methodology to other areas in the company. Why? Because Wall Street demands increasing accounting earnings over increasing economic value, so Enron simply used its models to help Wall Street realize its wishes. It was during this time that Enron actually emboldened the financial sector to get model-creative.
In July 2000 (year, right about dot.com bubble burst time), Enron and that other well known energy sector company – Blockbuster Video (why didn’t anyone ask???) – signed a 20-year contract to introduce on-demand entertainment to various U.S. cities by year-end (you know, something like today’s Netflix streaming service). It only took a few pilot projects for Enron to recognize estimated profits of more than $110 million from the deal. When the network failed to work (as you knew it would when an energy company with shady accounting practices gets into the media distribution business), Blockbuster withdrew from the contract. Despite Blockbuster’s exit, Enron continued to book future (modeled) profits on a deal that actually and at the present resulted in a loss.Eventually, the Ponzi scheme collapsed, along with everything attached to it. Enron’s execs got into a lot of trouble, but the banking industry and many other industries took note and said, “Hey it may not too wise to push face broadband, but the SEC and FASB ok’d the mark to fantasy thing. This was 2000. The rest is simply history.
In reviewing the chart below, be aware of the following facts:
- The data is taken from the Federal Reserve… Don’t shoot the messenger
- The primary input variable in most mark to model contraptions is the prevailing risk free interest rate – the same (not so) risk free rate that the world’s central banks (including the Fed) are trying to so hard to synthetically suppress.
- The world’s banks (and the US banks in particular) are responsible for funding companies, both through whole loans and through securities markets. If those banks’ shrivel (ahem, Deustche Bank), then the loans shrivel as well. That’s why the ECB has spent hundreds of billions of EUR to prevent. You know how that has turned out, right? If not, reference “ECB’s Own Data Shows QE Program As Utter Failure, Largest Banks Dwindle, Depositor’s Capital Eyed for Bail-Ins“
- If banks hit a cyclical and/or structural downturn, or if rates spike, or if regulators decide to outlaw lying about what’s on the books… Watch out below…
Next up, I will show all how Veritaseum was designed to enable individuals and companies to sidestep much if not most of this nonsense. You see, Veritseum allows zero trust transactions while enabling all to retain full control, custody, possession and ownership of your assets. You can’t mark to model, or mark to fantasy, because the reality is always there in your face all to see.