Financial Executives International N.E. Wisconsin Chapter

1. Financial Executives International N.E. Wisconsin Chapter Presented by: Christopher M. Cutler www.mcguirewoods.com

2. 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

3. The Enron Investigation • 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.”

4. 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.”

6. Operating Cash Flow Created

7. 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.

8. 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

9. What About Everyone Else? • Arthur Andersen? • Enron’s finance and legal departments? • Wall Street Banks? • Derivatives Market? • Credit Rating Agencies?

10. Our Government’s Response • The Sarbanes-Oxley Act of 2002 • Audit Committee Changes • Section 404 • The Public Company Accounting Oversight Board

11. 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

12. The Regulatory Backlash • Section 404(a) of the Sarbanes-Oxley Act • PCAOB Constitutional Challenge • Move to International Financial Reporting Standards

14. 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.

15. Step 5 Step 1 Step 3 Step 2 Step 4 Step 6

17. 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.

18. 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! The Meltdown - Imploded Lenders

19. The Meltdown – Wall Street Banks

20. 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

21. FAS 157

22. 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

23. 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

24. More Regulation is Coming! • Regulation of Mortgage Lending • More Regulatory Enforcement • Oversight of Unregulated Financial Markets

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