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In the midst of record high oil prices, a near meltdown of the banking sector, a loss of confidence in the stock market, a mortgage crisis and rising inflation, we find ourselves feeling rather helpless. As the overall economy suffers, business activity will likely slow leaving a dearth of opportunities for most of us in the business and legal community. So what can an able bodied professional like you do to manage this crisis? Educate yourself. That’s right. Knowledge is power and taking advantage of any downtime to build up your personal balance sheet will help you understand the current situation and, hopefully, allow you to add more value when opportunities present themselves. To start you out, here is a quick guide to what any professional should know about the current economy:

Where to begin? To understand the current situation, it’s important to consider the following process:

Bad mortgages weak banking sector weak stock market high commodity prices inflation weaker stock market higher commodity prices higher inflation job losses economic collapse.

Of course, the above chain of events paints a rather bleak picture of the future and for the most part, is a worst-case-scenario assessment. Where we go from here is something I’ll leave to the economic prognosticators (who, by the way, are usually wrong). Rather, I’ll simply attempt to clarify the forces at work and you can predict what might happen next.

Mortgage crisis—Basically, too many loans were issued to individuals who at any other point in time would not have qualified for these loans. These loans were packaged and sold to other investors who were virtually unaware of the risks associated with them. These bundled loans were termed collateralized debt obligations (CDO’s) and valued based on their future expected payments. This method of valuation, often termed mark-to-market accounting, creates innumerable accounting problems but most importantly, can mislead the investor because what you see may not be what you get. So when a company such as Citigroup states $30 billion worth of these loans on their balance sheet (what you see), what you get in 2008 is more like $5 billion.

Bank failures—The traditional economic belief is that when the banks fall, so do other aspects of the economy. Banks serve as an engine for growth providing consumers and corporations with the capital needed to expand. As the banks continue to report bad news including write downs of mortgage backed assets and worse, overall liquidity problems, investors lose faith in the sector. And as investors lose faith in the sector, they lose faith in the economy. When investors lose faith in the economy, what do they do? They sell stock. If companies are expected to suffer, their stock will be worth less. So if investors sell their stock, where do they invest their money? These days, oil!
Oil crisis—Investors, and more specifically commodities speculators, have invested heavily in oil futures due to a shortage of other compelling investment opportunities. Combine this with increasing demand for oil in emerging markets and tensions in the Middle East, and you have the perfect formula for sizeable gains in black gold. Real estate values have fallen and the stock market has fallen leaving investors with few other investment opportunities. Few will dispute the fact that the surge in oil, as well as other commodities, is creating a bubble. Nonetheless, the impact of this momentum is widespread. Specifically, higher fuel costs leads to higher costs in just about everything else. And overall higher costs lead to inflation. If inflation is prolonged, it impacts not only the consumer, who buys less, but the corporation, who may earn less. And if corporations suffer, job losses will mount.

That’s it in a nutshell. Clearly there’s much more happening behind the scenes but this should be enough to get you through your next water cooler discussion. And as bad as it sounds, signs of hope are emerging. Banks are beginning to show better than expected earnings (which isn’t saying much), oil prices are coming down, speculators are facing possible restrictions on their trading activities, and the government has pledged its support for some of the largest financial institutions. So stay tuned, it may or may not get better from here but it will most definitely get more interesting.

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What a week it has been. The collapse of Bear Stearns stirred up memories of another corporate collapse not too long ago. Does the name Enron ring a bell? I remember Bruce Willis’s character remark in Die Hard II, “How can the same thing happen to the same guy twice?” How can the same guy find himself rescuing hostages on two separate occasions and how can two multibillion dollar corporations collapse due to financial instruments that are not what they appear to be? The first part of this is easy: Hollywood doesn’t have to explain anything. The second part is somewhat more complex.

Enron and Bear were both involved in valuing financial instruments using mark-to-market accounting. What that means is each company would list items on its balance sheet based on estimates of value. A general rule in the finance world is that valuation is more art than science and ultimately the only true value of anything is what a buyer and seller agree on. So what happens when you do not have a buyer and seller? You estimate the value using one of several methods of valuation. More often than not, the method employs a technique whereby the returns of the asset are projected many years into the future. Basically, they look at what will be earned or what cash will be generated each year over the course of many years. Then, they use a discount factor to assess what these projected funds would be worth in today’s dollars. The total of these discounted projections forms the value of the asset. In the case of Enron, they were estimating returns from oil and gas rights over many years and in the case of Bear, they were estimating returns from mortgage based derivatives. Well guess what? When the projections appear overly aggressive, the overall value is called into question as is the entire capital structure of the company. This can cause creditors, vendors, customers and shareholders to panic. And what starts as a debate over accounting estimates turns into an entire company collapse.

To be fair, Enron was doing things far more insidious than misstating values which is why the company not only collapsed but several of the individuals responsible for this are now in jail. At this point, Bear can only be accused of not truly understanding what it did and did not have. But there are some striking similarities in that both companies were presenting a picture of their financial performance based on some very aggressive assumptions. So Hollywood does not have to explain anything and it would appear that neither does corporate America.