|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