Be wary of off balance sheet items

The major reason behind Enron's ability to go on so long even if it was essentially bankrupt was its ability to move things off their balance sheet. The accounting profession learned a lesson from this and changed the rules making it much more difficult to hide problems. However, they did not change the rules for banks.

As long as banks could demonstrate that any off balance sheet item held no risk for the bank itself, then they could create off balance sheet entities, which they called structured investment vehicles (SIV). What the banks did was have the entity borrow short term money via 'commercial paper' and invest it in long term assets, usually credit card debt and mortgages. The banks charged the entity good size fees and made a fair amount of money. Things were fine as long as the entities could borrow money short term and make money investing long term.

The problem started when the interest rate available in the commercial paper market rose a fair distance above the yield on Treasuries due, in no small measure, to the problems in the subprime area and the dawning realization that maybe the housing boom might not go on forever.

Banks had to acknowledge that in the light of day they really hadn't transferred all risk to the entities; the bank was on the hook. The question is when the problem will end. Will the Treasury and the major banks be able to put together their bail-out fund? Will the fund work if it only buys highly-rated debt? Will the fund be able to meet demands for bailing out lower-rated debt? We watch and wait.