Mortgage Servicing Fraud
occurs post loan origination when mortgage servicers use false statements and book-keeping entries, fabricated assignments, forged signatures and utter counterfeit intangible Notes to take a homeowner's property and equity.
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KPMG faces fallout from New Century
Court examiner cites improper accounting that goosed results, bonuses. E-mail warned: Don’t 'pi$$ off' client.

At nearly 600 pages long, the bankruptcy court report last week on the collapse of New Century Financial alleges in voluminous detail that the mortgage lender went to extreme lengths to violate accounting principles to mask the impact of mortgages being repurchased after defaulting. And its auditor, KPMG, ultimately looked the other way. Indeed the report, according to experts, shows that efforts to roll back regulatory reforms aimed at accounting fraud are misguided.

“It’s Enron and Arthur Andersen all over again,” said former Securities and Exchange Commission chief accountant Lynn Turner, noting key elements of the case: auditing specialists’ opinions being overridden by management and accounting partners, a high-profile board of directors, financial engineering of off-balance-sheet assets and what seems to be the complicity of a major accounting firm’s national office. “In the end, the firm [KPMG] acquiesced to what were just flat-out errors in the financial statements.”

Court-appointed examiner and former Securities and Exchange Commission investigator Michael Missal has also likened New Century’s collapse to that of Enron, and has complained about difficulties in obtaining information from the company and from KPMG. He filed this report last month, but until last week it had been under seal.

At the top of New Century’s list of problems was its accounting for the re-serve for losses associated with loans it would have to repurchase. New Century was obligated to buy back certain loans if borrowers defaulted on them soon after a sale.
Under generally accepted accounting principles, the company had to establish a loss reserve for such repurchases, but the company did not take into account the interest it would have to pay to compensate investors on repurchases or the losses it would itself take by bringing the loans back onto its balance sheet. As a result, it underestimated the cost and value of such loans.

This accounting error alone—and there were several others—led New Century in the third quarter of 2006 to understate its repurchase reserve by 1,000% and report a $63.5 million profit when it should have recorded a loss. The report also alleges that as a result, the bonuses New Century CEO Robert Cole, chief operating officer Brad Morrice and CFO Edward Gotschall received that year were inflated by at least 300%. (See “Subprime Bigs Inflated Income,” FW, May 7.)

Mr. Missal found other accounting misdeeds in the following areas: hedge accounting, allowance for loan losses, mortgage servicing rights, amortization of loan origination fees and costs, and goodwill.

But New Century had lots of help from its auditor, KPMG, according to the Missal report. In 2006 the audit firm signed off on a New Century repurchase reserve based on the assumption that the company would need to buy back about $70 million in loans sold in the fourth quarter of 2005. However, KPMG’s internal work papers showed New Century would need to repurchase about $140 million in loans from that period.

Specialists at KPMG allegedly raised concerns about some of the accounting practices but were talked down by the engagement team working directly with New Century. When one KPMG specialist raised objections the night before New Century’s 2005 annual report was to be issued, a KPMG engagement partner wrote back in an e-mail: “As far as I am concerned, we are done. The client thinks we are done. All we are going to do is pi$$ everybody off.”

A KPMG spokesman said the firm “strongly disagrees” with the report’s findings related to the audit firm, and expects “an objective review of the facts and circumstances will affirm our position.”

Dan Gagnier, a spokesman for New Century, would not comment on the report’s allegations or the status of other probes into the company.

The bankruptcy report suggested that both New Century and KPMG could be held liable for negligence and fraud in court. Several class-action lawsuits already are in play against the companies. A U.S. Supreme Court ruling earlier this year could limit shareholders’ ability to sue third parties such as KPMG, however.  Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.

On the other hand, the report could strengthen the hand of critics of proposals to ease auditing and accounting standards. The report’s allegations of a pliable KPMG paints a wholly different picture than the one recently portrayed by a Treasury Department committee that is studying the sustainability of the auditing profession. Several members of the committee have said that auditors have been “cracking down” on corporations and that auditors should bear less liability in order to improve audits and reduce costs.

A draft report from the committee, which may suggest such reduced liability, may be published next month, sources say.

The bankruptcy court report may also weaken the hand of those seeking easier accounting standards for mortgage lenders. Financial Accounting Standard 140 requires companies to calculate repurchase reserves at the time of sale at fair value, and FAS 5 states that a liability for loss contingencies, such as early payment default, should be put on the balance sheet if it’s probable and reasonably estimated.

When the liquidity crisis worsened in January, SEC chief accountant Conrad Hewitt asked the Financial Accounting Standards Board to allow banks to modify loans without having to put those loans back on their books. But FASB has taken no action along those lines.

“The SEC’s liberal interpretation [of FAS 140]…has left a hole you can drive a truck through,” said Richard Dietrich, chair of the accounting department at Ohio State University. While not defending KPMG, he noted that some of what it’s accused of might be considered legitimate if the work were being done now, given the SEC’s current guidance on the accounting standard.

Others think the standards are too easy on the banks as they currently stand. Sen. Jack Reed (D-R.I.) last month sent letters to FASB and the International Accounting Standards Board slamming the “lax accounting standards” of FAS 140 and FIN 46R. He criticized the lack of transparency of bank balance sheets and is expected to grill the SEC during a hearing this week before the Senate Banking Committee.

In a letter several weeks ago, FASB’s investor technical advisory committee recommended the standard-setter revise FAS 140. Mr. Turner, who sits on that committee, said the previous iterations of the accounting standard, FAS 77 and FAS 125, did not work either. “They’ve swung at this three times…they’ve struck out and need to start over again.” FW

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Examiner's report may put KPMG on the hook in New Century mess 3/27/2008
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More Totally Useless Auditors: New Century Financial

posted on: March 31, 2008    

The KPMG engagement team acquiesced in New Century’s departures from prescribed accounting methodologies and often resisted or ignored valid recommendations from specialists within KPMG. At times, the engagement team acted more as advocates for New Century, even when its practices were questioned by KPMG specialists who had greater knowledge...

And on and on for almost 600 pages. Compulsory reading for anybody thinking of ponying up that $200 million that Bruce Rose’s Carrington Capital Management, which bought New Century’s mortgage servicing business out of bankruptcy, is looking for. Worthwhile reading for anybody wondering about how the credit crisis started, or just how much things have changed since David Duncan was marching to Andy Fastow’s drum i.e. damn all.

In a related development, KPMG has applied to the Public Company Accounting Oversight Board to change its name to KRAP.

Inquiry assails accounting firm in lender’s fall
by Vikas Bajaj
The New York Times Mar. 27 2008

Final report of Bankruptcy Court Examiner (pdf file)
In re: New Century TRS Holdings Inc
(via The New York Times)

Carrington asks for $200m to replace bank loans [$$]
by James Mackintosh
The Financial Times Mar. 24 2008

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good work gumshoe!  I would be proud to work with you!  exposing the violations of GAPP, to those that were both investors and victims.
very welll done!
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A Lender Failed. Did Its Auditor?
Published: April 13, 2008

ALTHOUGH he had been with the mortgage lender New Century Financial for only two months, Tajvinder S. Bindra had spent a good part of late 2006 and early 2007 pelting the company’s controller and a member of its auditing firm, KPMG, with questions about the company’s accounting.

Frustrated by their responses and staring down a deadline to close New Century’s year-end books, Mr. Bindra, the company’s chief financial officer, told both men that he needed written assurances from KPMG that New Century’s bookkeeping was proper, according to accounts of the discussions.

But KPMG balked. A few weeks later, on Jan. 31, 2007, KPMG and New Century’s own accountants stunned the company’s board by revealing that the lender had incorrectly calculated its reserves for troubled home loans. That mistake was likely to cost New Century $300 million, wiping out all of its profits from the second half of 2006.

Two months later, New Century, one of the largest subprime mortgage lenders in the country, would be bankrupt.

New Century’s collapse ushered in a series of failures among mortgage lenders — ultimately rocking global financial markets, forcing banks around the world to write down or take losses on nearly $250 billion in mortgage-linked securities and sending the nation’s housing market into a tailspin.

As homeowners, shareholders and federal investigators pick through the subprime wreckage, many have asked how effectively front-line financial monitors carried out their duties. Ratings agencies responsible for signing off on the creditworthiness of securities, and regulators responsible for overseeing banking practices and safeguarding the entire financial system, have already been roundly criticized for not sounding alarms earlier.

Now, attention is turning toward yet another steward of financial reporting ensnared in the subprime debacle: accounting firms.

While accounting firms don’t exert legal or regulatory authority over their clients, they do bestow seals of approval, the way ratings agencies do. People in the financial industry, as well as investors, have reason to believe that a green light from an auditor means that a company’s accounting practices have passed muster.

Accounting practices drew increased scrutiny after Enron collapsed and its auditor, Arthur Andersen, went out of business in 2002 amid a federal prosecution. Analysts say the mortgage crisis may not result in criminal charges against auditors, but it is certain to renew interest in how accountants conducted themselves.

The interpretive waltz between a company and its auditor, of course, can be complicated and open to varying perceptions. But New Century’s accounting and KPMG’s review of the mortgage lender’s financial statements offer a window onto some of the problematic practices that helped lead to the mortgage bust.

A recently unsealed report by an examiner for the United States Bankruptcy Court in Delaware raises the question of whether New Century’s accounting obscured an early signal that the mortgage freight train was about to run off the rails.

New Century’s accounting methods let it prop up profits, charming investors and allowing the company to continue to tap a rich vein of Wall Street cash that it used to underwrite more mortgages. Without the appearance of a strong bottom line, New Century’s financial lifeline could have been cut even earlier than it was.

“It would have had widespread repercussions for the lenders who were buying loans from New Century,” Zach Gast, an analyst at the research firm RiskMetrics, said about the possible impact of an earlier profit warning from the lender. “It may have even accelerated the whole downturn of the subprime market.”

Still, some accounting experts question how appropriate it is to take auditors to task for judgment calls that, even in hindsight, are hard to make.

“I think it’s a stretch to blame everything on the accounting profession,” said David Aboody, a professor of accounting at the University of California, Los Angeles. “What does the S.E.C. want? Does it want an auditor who tries to predict the future? Or does it want an auditor to record what is clearly going on at the time?”

ANALYSTS say that auditors, because of in-depth knowledge of complex accounting rules and first-hand relationships with corporate management, are there to push back, examining how executives calculate numbers and assessing the financial health of enterprises.

In New Century’s case, the court examiner, Michael J. Missal, concluded that KPMG was not skeptical enough and that the lender’s creditors could pursue negligence and negligent misrepresentation claims against the auditor. But the examiner did not accuse KPMG of fraud or intentional wrongdoing. The examiner said he also “did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation.”

KPMG strongly contests any suggestion that it was derelict in its duties or that it went overboard trying to retain a well-paying client. It resigned from its New Century engagement shortly after the lender filed for bankruptcy, and it never completed the audit of the lender’s statements for 2006, the year in which New Century’s accounting was at its most improper, according to the examiner.

KPMG says that it’s unclear whether the examiner’s conclusions are derived from objective evidence available at the time it worked for New Century, or simply represent assumptions that are now being made in hindsight.

“The examiner was appointed by the court to identify potential lawsuits in a bankruptcy case,” said Kathleen M. Fitzgerald, a KPMG spokeswoman. “Consistent with that charge, he has prepared an advocacy piece, which has many one-sided statements and significant omissions. In the end, the examiner concluded that the bankruptcy estate may be able to file a lawsuit against KPMG for negligence — a claim we strongly dispute — and a claim even the examiner notes in his report for which KPMG has strong defenses.”

Even so, the examiner’s report has signaled to some analysts that something may have gone seriously awry in KPMG’s relationship with New Century.

“Allegations that an auditing firm didn’t engage in due professional care and made recommendations that are inconsistent with GAAP must be taken very seriously,” said Kathleen M. Hamm, a former senior enforcement official at the Securities and Exchange Commission, referring to the “generally accepted accounting principles” that public companies must follow. Ms. Hamm is now a managing director at a consulting firm, the Promontory Financial Group.

The examiner’s investigation is also the latest in a string of embarrassing episodes for KPMG. In March, Xerox and KPMG settled a securities lawsuit relating to decade-old accusations of accounting manipulations. And KPMG has been criticized for its audit of the Federal National Mortgage Association, after it was revealed that the company, known as Fannie Mae, had overstated its earnings by billions of dollars over several years.

And, finally, nearly three years ago, federal prosecutors came within an eyelash of filing criminal charges against KPMG over dubious tax shelters it set up for clients, leading to a deferred prosecution agreement and a wrenching internal investigation.

“For KPMG, this comes on the heels of all of the tax-shelter stuff, and they just got rid of having a court-appointed examiner, so this is difficult for them,” said Jack Ciesielski, editor of The Analyst’s Accounting Observer, a trade publication.

FROM the 11-story glass-and-steel tower that housed its headquarters in Irvine, Calif., New Century ruled during the recent housing boom as one of the nation’s largest lenders to individuals with weak, or subprime, credit.

The company’s three founders, Robert K. Cole, Edward F. Gotschall and Bradley A. Morrice, met while working at the same mortgage bank in the early 1990s. [Plaza Home Mortgage/ Option One Mortgage Corporation] They founded New Century in 1995, and KPMG became the company’s auditor.

At the epicenter of the subprime boom, New Century and its founders grew wealthy as the company’s stock soared. The company churned out billions of dollars worth of subprime mortgages, many of which it then sold to Wall Street banks. And, quarter after quarter, it generated robust earnings.

Behind the scenes, however, the exlplosive growth at New Century shot beyond the company’s internal controls and policies as well as the managerial abilities of some of its key executives, the bankruptcy court examiner concluded.

For instance, the examiner said in his report that the company did not have a formal policy spelling out exactly how to calculate reserves it might need to repurchase loans if Wall Street rejected them. The lender also used simple spreadsheets to evaluate its own mortgage securities holdings, the examiner said. KPMG flagged some of these shortcomings to the management, but because KPMG considered them to be “inconsequential,” they were not reported publicly, according to the examiner’s study.

The relationship between New Century’s executives and board and KPMG also became strained as early as the end of 2005, the examiner report said.

Some members of New Century’s board were uncomfortable with what they believed was a lack of acumen displayed by certain accounting and financial managers at the company. Others, like the director Richard A. Zona, appeared to have had early concerns about whether the company was being conservative and thorough enough in various aspects of its accounting.

In one of two resignation letters that Mr. Zona drafted in late 2005 but never submitted to the board, he called New Century’s management team “dysfunctional.” A former vice chairman of U.S. Bancorp and a former partner at Ernst & Young, Mr. Zona told the examiner he had not left the board because other directors persuaded him to stay.

A lawyer representing New Century’s former directors said Mr. Zona and other directors declined to comment.

According to the report, Mr. Zona and some of his fellow directors did ask New Century’s management and KPMG whether the lender was setting aside enough money to repurchase loans rejected by Wall Street.

In 2005 and 2006, the number of mortgages sent back to New Century skyrocketed as some borrowers became delinquent in payments as early as the first few months after taking out a loan, indicating shoddy lending practices, according to the report.

On the evening of Sept. 7, 2006, a senior New Century executive, Kevin Cloyd, sent an e-mail message to the chief executive, Mr. Morrice, and Patti M. Dodge, the company’s chief financial officer, saying, “We got our teeth kicked in with regard to repurchase requests in Aug. and thus far in September,” according to the examiner’s report.

An hour later, Mr. Morrice sent a livid e-mail response, criticizing Mr. Cloyd for the timing of this revelation, especially because it came shortly “after sending a positive report” to New Century’s board.

Yet the very next day, New Century issued a press release about its August lending levels, which it said had climbed 9 percent from July. Saying it had “strict underwriting guidelines” and “skilled risk management,” the company asserted in the release that the increase in repurchases because of early-payment defaults at the end of August “has been modest.”

Despite the internal misgivings, the company made no effort to recall or correct the press release, according to the examiner’s report. Mr. Cloyd did not return phone calls. Ms. Dodge could not be reached. And a lawyer representing Mr. Morrice did not return calls.

Although New Century sold more than $40 billion in loans in the first nine months of 2006, it had reserved only $13.9 million as of Sept. 30 that year to repurchase loans, according to the firm’s securities filings. Those filings were not audited by KPMG, but they were reviewed by the firm.

The reserve was woefully inadequate, according to the examiner’s report. By the end of September 2006, New Century already had $400 million in pending repurchase requests — meaning that the $13.9 million it had set aside represented just 3.5 percent of that troubled pool of loans. Officials in New Century’s accounting department and on the KPMG audit team told the examiner that they were not aware of the rising backlog of repurchase claims.

The examiner asserted that New Century had made two glaring errors in how it calculated its repurchase reserves: first, it assumed that it would be asked to buy back only loans sold in the previous three months, though it was fielding requests for loans it sold as much as a year earlier.

“New Century and KPMG each share responsibility for failing to correct the repurchase reserve calculation methodology that permitted the backlog claims to be excluded from the repurchase reserve through all accounting periods,” the examiner’s report said. He said New Century provided information to KPMG officials that showed pending repurchase claims totaled $188 million at the end of 2005, adding that that “should have made KPMG investigate the issue.”

But Ms. Fitzgerald said KPMG determined that the reserve for 2005 was appropriate and added that the “examiner’s report itself makes clear that even if the entire $188 million of repurchase claims were separately considered, the estimated result would have been only $8 million of increased reserves against reported net income of over $400 million.”

Second, in the summer of 2006, the company simply stopped estimating the losses on loans it would have to buy back, a breach of standard accounting practices, according to the examiner.

New Century’s low reserve levels, meanwhile, were catching the attention of outside analysts. In reports in November and December of 2006, Mr. Gast of RiskMetrics said he believed that the company was setting aside far too little to buy back loans. The reports created a stir at New Century, and the accounting department prepared a rebuttal.

Settling into his new job, Mr. Bindra, the chief financial officer who succeeded Ms. Dodge in November, raised the issues in Mr. Gast’s report with New Century’s controller, David Kenneally, and the KPMG partner in charge of New Century’s audit, John Donovan, according to the examiner’s report and interviews with former New Century executives who requested anonymity because of their concerns about being entangled in litigation.

Until late January, according to the report, Mr. Kenneally defended the company’s reserve calculations. After that, the report said, Mr. Donovan told him that a further accounting review showed that New Century had made a mistake.

Mr. Kenneally’s lawyer declined to comment, and KPMG declined to make Mr. Donovan available for comment. Mr. Bindra’s lawyer also declined to make him available.

By underreserving, New Century was able to show still-rising profits in the second quarter and declining, yet positive, earnings in the third quarter of 2006. Had New Century been more conservative about its reserves, second-quarter profits would have been halved and it would have reported a loss in the third quarter, the examiner determined.

Eventually, these problems burst into public view. In March 2007, after New Century disclosed that it would need to restate its earnings and would probably be shown as unprofitable during the last six months of the previous year, its lenders pulled the plug on the company. In April, it filed for bankruptcy.

But some experts say that regardless of what KPMG did, New Century would have collapsed.

“The business model of New Century depended on real estate values that would continue to go up and certainly not go down,” said Roman L. Weil, an accounting professor at the University of Chicago Graduate School of Business. “The economic model here is what is at fault. It’s the cause of what happened, not anything that KPMG did.”

AMONG the “Big Four” auditing firms, KPMG is the smallest. Yet it is the go-to auditor for banking and financial services firms and real-estate investment trusts like New Century, according to Audit Analytics, an independent research firm. Deloitte & Touche and Ernst & Young also have many financial services clients.

KPMG is the auditor for such prominent mortgage players as Wells Fargo, Citigroup, HSBC Finance, Countrywide Financial and Thornburg Mortgage, according to an examination of annual reports.

Those relationships put KPMG in a potentially vulnerable spot as authorities increased their scrutiny of the subprime business. The Federal Bureau of Investigation has said it has 17 continuing investigations of possible corporate and accounting fraud related to subprime lending. That number, the F.B.I has said, is likely to increase.

Although federal prosecutors are examining the trading activities of New Century executives, KPMG is not a target of the inquiry, according to a person briefed on the matter who wasn’t authorized to speak publicly.

Moreover, the appetite for prosecuting accounting firms has diminished since Arthur Andersen was convicted of obstruction of justice as part of the Enron investigation, according to analysts. In 2005, the Supreme Court overturned that conviction, but it was too late to save the firm. With only four large accounting firms left, the government is unlikely to push any of them too hard, experts say.

“The Justice Department learned from its prosecution of Arthur Andersen that threatening entire firms jeopardizes our system of private auditing,” said Lawrence A. Cunningham, a professor at the George Washington University Law School. “What’s vital is that individuals be held responsible for wrongdoing.”

A MORE likely threat to auditing firms and mortgage companies could be civil, rather than criminal, lawsuits. Shareholders have already filed a raft of lawsuits against lenders that failed or whose stocks have dropped sharply. In some cases, shareholders are trying to add the auditors as defendants.

In January, New York City and New York State pension funds that are leading a class-action lawsuit against Countrywide added its auditors, KPMG and Grant Thornton, as defendants. KPMG declined to comment on the suit. A spokesman for Grant Thornton said the firm was confident it would be dropped from the suit because it had not audited Countrywide for four years.

Last week, liquidators of two hedge funds run by Bear Stearns sued the bank and its auditor, Deloitte & Touche. They contend that the firms hid the true financial risks and health of the funds, which invested in mortgage-linked securities. Bear Stearns declined to comment, and, in a statement, Deloitte said that the suit was without merit and that the firm intended to defend itself.

It is unclear whether the creditors in the New Century bankruptcy will try to recoup losses from KPMG. Even the court examiner, Mr. Missal, notes in his report that creditors of New Century could pursue negligence claims against KPMG but that such a case could be hard to win.

Even if KPMG is safe from large damages and a criminal prosecution, Lynn E. Turner, a former chief accountant at the S.E.C., said the findings were still troubling.

“The examiner cites different pieces of evidence that do raise concerns about whether or not you had an honest-to-goodness independent audit going on,” Mr. Turner said.

For its part, KPMG says that it faithfully carried out its professional duties.

“It is very easy — and totally unreasonable — to look at decisions made in 2005 or 2006 through a 2008 lens,” said Ms. Fitzgerald, the KPMG spokeswoman. “The full record shows that KPMG acted in accordance with professional standards. We will vigorously defend our audit work in the appropriate forum, which will allow for a complete hearing of the facts.”

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