SEC KNEW ABOUT SUBPRIME ACCOUNTING FRAUD A DECADE AGO

by Elizabeth MacDonald FoxBusiness

The Securities and Exchange  Commission is missing a bigger fraud while it chases the banks. Even though it knew about this massive, plain old fashioned accounting fraud back in 1998.
Instead, the market cops are probing simpler disclosure cases that could charge bank and Wall Street with not telling investors about their conflicts of interest in selling securities they knew were damaged while making bets against those same securities behind the scenes, via credit default swaps.
Those probes have gotten headlines, but there aren’t too many signs that this will lead to anything close to massive settlements or fines.

For instance, the SEC doesn’t appear to be investigating how banks frontloaded their profits via channel stuffing — securitizing loans and shoving paper securitizations onto investors, while booking those revenues immediately, even though the mortgage payments underlying those paper daisy chains were coming in the door years, even decades, later. Those moves helped lead to $2.4 trillion in writedowns worldwide.
The agency said it  believed banks were committing subprime securitization accounting frauds back in 1998 and claimed to be ‘probing’ them.
I had written about these SEC probes into potential frauds while covering corporate accounting abuses at The Wall Street Journal. The rules essentially let banks frontload into their revenue the sale of subprime mortgages or other loans that they then packaged and sold off as securities, even though the payments on those underlying loans were coming in the door over the next seven, 10, 20, or 30 years.
Estimating those revenues based on the value of future mortgage payments involved plenty of guesswork.

Securitization: Free Market Became a Free For All
The total amount of overall mortgage-backed securities generated by Wall Street virtually tripled between 1996 and 2007, to $7.3 trillion. Subprime mortgage securitizations increased from 54% in 2001, to 75% in 2006. Back in 1998, the SEC had warned a dozen top accounting firms that they must do a  better job policing how subprime lenders book profits from loans that are repackaged as securities and sold on the secondary market. The SEC “is becoming increasingly concerned” over the way lenders use what are called “gain on sale” accounting rules when they securitize these loans, Jane B. Adams, the SEC’s deputy chief accountant, said in a letter sent to the Financial Accounting Standards Board, the nation’s chief accounting rule makers.
At that time, subprime lenders had come under fire from consumer groups and Congress, who said banks were using aggressive accounting to frontload profits from securitizing subprime loans. Subprime auto lender Mercury Finance collapsed after a spectacular accounting fraud and shareholder suits, New Century Financial was tanking as well for the same reason.

SEC Knew About Subprime Fraud More than a Decade Ago
The SEC more than a decade ago believed that subprime lenders were abusing the accounting rules.
When lenders repackage consumer loans as asset-backed securities, they must book the fair value of profits or losses from the deals. But regulators said lenders were overvaluing the loan assets they kept on their books in order to inflate current profits. Others delayed booking assets in order to increase future earnings. Lenders were also using poor default and prepayment rate assumptions to overestimate the fair value of their securitizations.
Counting future revenue was perfectly legal under too lax rules.
But without it many lenders that are in an objective sense doing quite well would look as if they were headed for bankruptcy.
At that time, the SEC’s eyebrows were raised when Dan Phillips, chief executive officer of FirstPlus Financial Group, a Dallas subprime home equity lenders, had said the poor accounting actually levitated profits at lenders.
“The reality is that companies like us wouldn’t be here without gain on sale,” he said, adding, “a lot of people abuse it.”
But this much larger accounting trick, one that has exacerbated the ties that blind between company and auditor, is more difficult to nail down because it involves wading through a lot of math, a calculus that Wall Street stretched it until it snapped.

Impenetrably Absurd Accounting
These were the most idiotic accounting rules known to man, rules manufactured by a quiescent Financial Accounting Standards Board [FASB] that let bank executives make up profits out of thin air.
It resulted in a folie à deux between Wall Street and complicit accounting firms that swallowed whole guesstimates pulled out of the atmosphere.
Their accounting gamesmanship set alight the most massive off-balance sheet bubble of all, a rule that helped tear the stock market off its moorings.
The rules helped five Wall Street firms – Bear Stearns, Lehman Bros., Morgan Stanley, Goldman Sachs and Merrill Lynch – earn an estimated $312 billion based on fictitious profits during the bubble years.

Who Used the Rule?
Banks and investment firms including Citigroup, Bank of America and Merrill all used this “legit” rule.
Countrywide Financial made widespread use of this accounting chicanery (see below). So did Washington Mutual. So did IndyMac Bancorp. So did FirstPlus Financial Group, and as noted Mercury Finance Co. and New Century Financial Corp.
Brought to the cliff’s edge, these banks were either bailed out, taken over or went through bankruptcies.
Many banks sold those securitized loans to Enron-style off-balance sheet trusts, otherwise called “structured investment vehicles” (SIVs), again booking profits immediately (Citigroup invented the SIV in 1988).
So, presto-change-o, banks got to dump loans off their books, making their leverage ratios look a whole lot nicer, so in turn they could borrow more.
At the same time, the banks got to record immediate profits, even though those no-income, no-doc loans supporting those paper securities and paper gains were bellyflopping right and left.
The writedowns were then buried in obscure line items called “impairment charges,” and were then masked by new profits from issuing new loans or by refinancings.

Rulemakers Fight Back
The FASB has been fighting to restrict this and other types of accounting games, but the banks have been battling back with an army of lobbyists.
The FASB, which sets the rules for publicly traded companies, is still trying to hang tough and is trying to force all sorts of off-balance sheet borrowings back onto bank balance sheets.
But these “gain on sale” rules, along with the “fair value” or what are called “marked to market” rules, have either been watered down or have enough loopholes in them, escape hatches that were written into the rules by the accountants themselves, so that auditors can make a clean get away.
As the market turned down, banks got the FASB to back down on mark-to-market accounting, which had forced them to more immediately value these assets and take quarterly profit hits if those assets soured – even though they were booking immediate profits from this “gain on sale” rule on the way up.
Also, the FASB has clung fast to the Puritanism of their rulemaking by arguing a sale is a sale is a sale, so companies can immediately book the entire value of a sale of a loan turned into a bond, even though the cash from the underlying mortgage has yet to come in the door.

Old-Fashioned ‘Channel Stuffing’
This sanctioned “gain on sale” accounting is really old-fashioned “channel stuffing.”
The move lets companies pad their revenue and profit numbers by stuffing lots of goods and inventory (mortgages and subprime securities) into the system without actually getting the money in the door, and booking those channel-stuffed goods as actual sales in order to cook ever higher their earnings.
Sort of like what Sunbeam did with its barbecue grills in the ’90s.

Intergalactic Bank Justice League
Cleaning up the accounting rules is an easier fix instead of a new, belabored, top-heavy “Systemic Risk Council” of the heads of federal financial regulatory agencies, as Sen. Chris Dodd (D-Conn) envisions in financial regulatory reform.
An intergalactic Marvel Justice League of bank regulators can do nothing in the face of chicanery allowed in the rules.

Planes on a Tarmac
What happened was, banks and investment firms like Citigroup and Merrill Lynch who couldn’t sell these subprime bonds, or “collateralized debt obligations,” as well as other loan assets into these SIVs got caught out when the markets turned, stuck with this junk on their balance sheets like planes on a tarmac in a blizzard.
Bank of America saw its fourth-quarter 2007 profits plunge 95% largely due to SIV investments. SunTrust Banks’ earnings were nearly wiped out, a 98% drop in the same quarter, because of its SIVs.
Great Britain’s Northern Rock ran into huge problems in 2007 stemming from SIVs, and was later nationalized by the British government in February 2008.
Even the mortgage lending arm of tax preparer H&R Block used the move. Block sold its loans to off-balance-sheet vehicles so it could book gains about a month earlier than it otherwise would. Weee!
The company had $75 million of these items on its books at the end of its fiscal 2003 year. All totally within the rules.

Leverage Culture
The rampant fakery helped fuel a leverage culture that got a lot of homes put in hock.
Banks, for instance, started advertising home equity loans as “equity access,” or ways to “Live Richly” or as Fleet Bank once touted, “The smartest place to borrow? Your place.”
In fact, Washington Mutual and IndyMac got so excited by the gain on sale rules, they went so far as to count in profits futuristic gains even if they had only an “interest rate” commitment from a borrower, and not a final mortgage loan.
Talk about counting chickens before they hatch.

Closer Look at Wamu
Look at Wamu’s profits in just one year during the runup to the bubble. Such gains more than tripled in 2001 at Wamu, to just shy of $1 billion, or 22% of its pretax earnings before extraordinary items, up from $262 million, or 9%, in 2000.
But in 2001, Washington Mutual took $1.7 billion in charges, $1.1 billion of it in the final, fourth quarter, to reflect bleaker prospects for the revenue stream of all those servicing rights.
It papered over the hit with a nearly identical $1.8 billion gain on securitizations and portfolio sales.

Closer Look at Countrywide
The accounting fakery let Countrywide Financial Corp., the mortgage issuer now owned by Bank of America, triple its profit in 2003 to $2.4 billion on $8.5 billion in revenue.
At the height of the bubble, Countrywide booked $6.1 billion in gains from the sale of loans and securities. But this wasn’t cold, hard cash. No, this was potential future profits from servicing mortgage portfolios, meaning collecting monthly payments and late penalties.

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Bank Investigations Cheat Sheet: ProPublica

by Marian Wang, ProPublica – May 13, 2010

Here’s our attempt to lay out exactly what’s known about which banks are being investigated by whom and for what. We’re going to keep updating this page, so please send usstories or details we’ve missed. Related: Covering the Bank Investigations: A Cautionary Tale

  What has been reported What the bank has said
 
Citigroup
Citing “a person familiar with the matter,” The Wall Street Journal has reported that Citigroup is under “early-stage criminal scrutiny” by the Department of Justice. Also citing unnamed sources, Fox Business reported on May 12 that the SEC has an active civil investigation into Citigroup and has subpoenaed the firm, but has not issued any Wells notices. A report on May 12th by the Journal cited unnamed sources saying that the Department of Justice is scrutinizing a few CDO deals that Morgan Stanley bet against–but which were underwritten by Citigroup and UBS. Neither the SEC nor the Justice Department have confirmed these reports.

Citing two anonymous sources, The New York Times has reported that New York Attorney General Andrew Cuomo is investigating eight banks to determine whether they misled rating agencies in order to get higher ratings for their mortgage-related products; Citigroup has been named as one of the banks. Subpoenas were issued on May 12, according to the Times and the Dow Jones Newswires, both of which relied on anonymous sourcing for their reports.

Citigroup has declined to comment to us and other outlets.

Credit Agricole
Credit Agricole has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating separately. Credit Agricole did not immediately respond to the Times’ request for comment and has not yet responded to ours.

Credit Suisse
Credit Suisse has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating. Credit Suisse declined to comment to the Times about the New York attorney general’s investigation.

Deutsche Bank
Citing “a person familiar with the matter,” The Wall Street Journal has reported that Deutsche Bank is under “early-stage criminal scrutiny” by the Department of Justice. Also citing unnamed sources, Fox Business reported on May 12 that the SEC has an active civil investigation into Deutsche and has subpoenaed the firm, but has not issued any Wells notices. Neither agency has confirmed these reports.

Deutsche Bank has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating separately.

Deutsche Bank declined to comment to Fox, the Journal, and the Times about possible investigations.

Goldman Sachs
The SEC has brought a civil fraud lawsuit against Goldman, alleging that the investment bank made “materially misleading statements and omissions” when it allowed a hedge fund to help create and bet against a CDO, called Abacus, without disclosing the hedge fund’s role to investors.

The Wall Street Journal, citing “people familiar with the probe,” reported in April that the Justice Department has been conducting a criminal investigation into Goldman’s CDO dealings following a referral from the SEC. Neither agency has confirmed this, but the AP, citing another unnamed source, has reported the same thing. Since then, many news organizations–including the The New York TimesABC News and the Washington Post–have also reported on the criminal probe, citing unnamed sources. No charges have been brought.

Goldman Sachs has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating separately.

Goldman called the SEC’s accusations “unfounded in law and fact.

After the reports of a criminal investigation, a Goldman Sachs spokesman declined to confirm that the bank had been contacted by the DOJ but also told several news outlets that “given the recent focus on the firm, we’re not surprised by the report of an inquiry. We would cooperate fully with any request for information.”

The bank has declined to comment to us on the New York attorney general’s investigation.

 
JP Morgan Chase
Citing “a person familiar with the matter,” The Wall Street Journal has also reported that JPMorgan Chase has received civil subpoenas from the SEC and is under “early-stage criminal scrutiny” by the Department of Justice. Neither the SEC nor the Justice Department has confirmed these reports. A JPMorgan spokesman told the Journal that the bank “hasn’t been contacted” by federal prosecutors and isn’t aware of a criminal investigation.

Merrill Lynch (now part of Bank of America)
Merrill has not been named in any SEC investigations. But as we pointed out, a lawsuit brought by a Dutch bank asserts that Merrill Lynch did a CDO deal that was “precisely” like Goldman’s. The SEC has declined to comment on whether it is investigating the deal.

Merrill Lynch has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating.

Merrill has said its CDO deal was not like Goldman’s, calling Goldman’s Abacus deal an “entirely different transaction.”

The bank did not immediately return the Times’ request for comment about the investigation by Coumo, but when we called and asked, a spokesman from Bank of America, which merged with Merrill, said, “We are cooperating with the attorney general’s office on this matter.”


Morgan Stanley
Citing “people familiar with the matter,” The Wall Street Journal reported on May 12 that the Justice Department has been conducting a criminal investigation into Morgan Stanley’s CDO dealings, including its role in helping design and betting against two sets of CDOs from 2006 known as Jackson and Buchanan. The Justice Department declined to comment. No charges have been brought, and according to the Journal, the probe is “at a preliminary stage.” A Morgan Stanley spokeswoman said the bank had “no knowledge of a Justice Department investigation into these transactions.” The Journal reported that the SEC has subpoenaed Morgan Stanley on several occasions, but the bank says it has received no Wells notices, which would indicate pending SEC charges.

Morgan Stanley has also been named as one of the banks that New York Attorney General Andrew Cuomo is investigating.

A Morgan Stanley spokeswoman said on May 12that the firm has “not been contacted by the Justice Department about the transactions being raised by The Wall Street Journal, and we have no knowledge of a Justice Department investigation into these transactions.”

The investment bank declined to comment to the Times about the Coumo’s investigation.


UBS
Citing “a person familiar with the matter,” The Wall Street Journal reported that UBS has received civil subpoenas from the SEC and is under “early-stage criminal scrutiny” by the Department of Justice. In a report on May 12, the Journal reported that the Justice Department is scrutinizing a few CDO deals that Morgan Stanley helped design and bet against–but which were marketed by Citigroup and UBS. Neither the SEC nor the Justice Department has confirmed these reports. The firm has not disclosed that it has gotten any Wells notices.

UBS has also been named as one of the banks New York Attorney General Andrew Cuomo is investigating.

A UBS spokesman has declined to comment on any of the investigations.

Moooove Over SLACKERS!! NY AG CUOMO probing 8 banks over securities

AP Source: NY AG probing 8 banks over securities

NEW YORK — The New York attorney general has launched an investigation into eight banks to determine whether they misled ratings agencies about mortgage securities, according to a person familiar with the investigation.

finance-20100513-US.Wall.Street.InvestigationAttorney General Andrew Cuomo is trying to figure out if banks provided the agencies with false information in order to get better ratings on the risky securities, said the person, who spoke on condition of anonymity because the investigation has not been made public.

Cuomo’s office is investigating Goldman Sachs Group Inc., Morgan Stanley, UBS AG, Citigroup Inc., Credit Suisse, Deutsche Bank, Credit Agricole and Merrill Lynch, which is now part of Bank of America Corp.

Representatives from Goldman Sachs, Citigroup and Credit Agricole declined to comment. Others were not immediately available comment.

During the housing boom, Wall Street banks often packaged pools of risky subprime mortgages together. The securities were then typically given top-notch ratings and investors purchased them, in part, because of their high ratings.

The ratings, given out by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, are used as a guide for investors to judge how risky an investment might be.

As the housing market collapsed and more customers fell behind on repaying their mortgages, the securities began to fail.

The securities have been widely blamed for exacerbating the credit crisis and costing investors and the banks themselves billions of dollars in losses. The ratings agencies have come under fire for having given such high ratings to securities that soured.

The attorney general’s probe comes as federal regulators are investigating whether some of the banks misled investors when marketing and selling the securities and other investments that were tied to mortgages.

The Securities and Exchange Commission charged Goldman Sachs with fraud over its packaging of mortgage securities. Goldman is facing a separate criminal investigation into the same securities. Goldman has denied the charges and plans to defend itself.

Earlier this week it was reported that federal prosecutors are investigating whether Morgan Stanley misled investors about its role in a pair of $200 million derivatives whose performance was tied to mortgage-backed securities.

The increased scrutiny over how banks managed, packaged and portrayed mortgage securities and derivatives comes as Congress discusses a major overhaul of financial regulations. Politicians have said an overhaul would add more transparency to investments and trading.

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

The cautionary tale of Aegis Mortgage’s bankruptcy – Aug. 17, 2007

Not Much Has Changed! What could we have learned?

The darker side of buyout firms

The case of Aegis Mortgage shows that when private equity loses a high-risk bet, ordinary employees are the ones who suffer, reports Fortune’s Katie Benner.

By Katie Benner, Fortune reporter
August 20 2007: 1:24 PM EDT

 

NEW YORK (Fortune) — Buyout firms like to present themselves as a can’t-fail combination of operational genius and financial support that can heal sick businesses and create thriving companies. But sometimes, as in the case of Aegis Mortgage, genius fails and bankruptcy is declared. The private investment firm Cerberus bought a controlling stake in the Houston-based mortgage lender in 1998, but despite an infusion of cash and talent, Aegis ceased operations on Monday, August 6. Now hundreds of employees have been laid off – all without health insurance. It’s a reminder that risky turnarounds can mean real pain for more than just investors raising questions about how Cerberus will treat other ailing companies it has purchased, notably Chrysler.

Aegis, which was founded in 1993, closed its mortgage production operations on August 6. Two days later, employees were warned that there would be layoffs within 60 days and that benefits would be terminated effective midnight August 10, according to Aegis employees. They were also told that earned paid-time off would not be paid out and that there would be no severance. When the layoffs came on Monday, August 13, 782 people out of 1,302 employees were fired. Those let go were shocked to find that they were not eligible for COBRA. While Federal law requires businesses with more than 20 employees to offer departing workers the chance to buy an extra 18 months of health insurance, it is only required for companies with an active benefit plan, and Aegis had terminated its plan days before. Moreover, Aegis admitted in its bankruptcy filing that it didn’t have the money to pay employee benefits anyway.

Those actions have some up in arms. Richard Thompson, who co-founded Aegis in 1993, is asking Cerberus and Aegis to take care of its employees. “As a founder of Aegis, one of our stated corporate values was to always do the right thing,” says Thompson, who was CEO until October 2006, when Cerberus ousted him. “The right thing is to reinstate the company’s health insurance policy for the thousands of families affected by their actions last week.”

Thompson, of course, has reason to dislike Cerberus. Not only was he fired, he is suing Cerberus for mismanaging the company and destroying its chance to go public. Other observers note that many companies that go bankrupt leave their employees stranded. John Challenger, head of executive outplacement firm Challenger Gray Christmas, says: “Creditors will line up, so the company is taking these harsh actions to save what they can. You’re going to see lots of fighting over the company assets.” In its bankruptcy filing, Aegis said it had $625 million in debt and owed banks including Goldman Sachs, Deutsche Bank, Merrill Lynch and Morgan Stanley. Madeleine LLP, a subsidiary of Cerberus, is also in line for money.

Cerberus declined to comment; an Aegis spokesman said that the company is doing what it can to help its remaining 500 or so employees, including providing health care and job training.

What happened to Aegis? The company managed to survive the mortgage meltdown and S&L problems of the ’90s, but it had been wounded. Plans in 1997 to hold an IPO for its REIT business were scrapped when the REIT sector began to exhibit problems. The conditions were perfect for a company like Cerberus, which regularly scoops up distressed businesses it believes will be winners in the future. The mortgage business was suffering in the late 1990s, but the industry is cyclical and Cerberus was betting on returns during the upswing. (Indeed, even as the subprime business began to melt down this spring, Cerberus agreed to buy sub-prime lender Option One Mortgage from H&R Block this April.)

So in 1998, Cerberus agreed to buy a controlling stake in Aegis, which had $2.5 million in equity. Following a familiar pattern, Cerberus immediately injected a huge amount of money into the company ($47 million), placed its own people on the board and kept the management team, including Thompson, in place. It rolled pieces of other dying lenders into Aegis and built a thriving mortgage lending operation.

In late 2006, the company had grown its capital in reserves to $361 million, and like all other lenders it couldn’t issue mortgages fast enough for the Wall Street machine that used them to create high-risk, very profitable bonds. At the height of the mortgage origination boom, Aegis employed about 3,500 people, mostly in the Houston area. But Aegis lost it all in just nine months when the market for mortgage loans tanked.

The failure calls into question the management and health of Cerberus’s other loan plays. Cerberus owns a majority stake in GMAC and its mortgage subsidiary ResCap. Thanks to the credit crunch, the ratings agencies have downgraded ResCap, thus making it more expensive for the company to operate. The rising cost of capital may hurt Chrysler Financial, too, the healthy operation within Chrysler that should have been able to help fund the ailing automaker’s turnaround. At a minimum, Cerberus will take a financial hit because of Aegis and the bankruptcy is an embarrassment amid the firm’s recent spate of high-profile acquisitions.

“Cerberus has become a major player in the global economy. Its many constituents rightly will expect a higher standard of behavior than was exhibited last week with Aegis,” says Thompson. It’s a sober reminder that even the vaunted geniuses of private equity can’t save every company, and that employees – more than investors – are the real victims when they go under.