Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

In yesterday’s Part 1 on whether auditors in the subprime mess, in addition to the rating agencies, are culpable for bad information prepared by their clients the subprime loan originators, we looked at this New York Times article about unlucky auditor KMPG and its now-bankrupt client New Century: 
 

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 explosive 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.

 

We deserve this untapped wealth

 

When you’re growing beyond all imagining, you tend to believe it’s due to your incredible wisdom, insight, or hard work – that is, you deserve your remarkable success.  You become impatient with the bean-counters who want you to shift scarce corporate resources from growth to management.

 

The only control I care about is the speedometer

 

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.

 

Fast-growing organizations are allergic to policies.  They take time to compile and they inhibit our entrepreneurial spirit.  There’ll be time for policies when we’ve reached our mature state.

 

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.

 

Freddie Mac and Fannie Mae had the world’s most sophisticated tools, and look what happened to them.

 

We pointed precisely at the wrong target

 

Sometimes a fancy tool is more of a dazzle device than something simpler.

 

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.

 

Is one of them, “don’t book revenue you haven’t earned”?

 

It’s not just the auditors who should be watching; the independent directors have a duty – many would say the principal­ duty – to keep on top of these issues.

 

You’re supposed to keep an eye on the pilot

 

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.

 

I’ll decline to speculate about Mr. Zona’s motivations both for his resignation drafts and for his decision not to send them, as these will be the subject of hours of deposition and trial testimony.

 

Yes, your Honor, this is what I wear to a deposition

 

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.

 

Asking the right questions, at any rate!

 

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.

 

For what it’s worth, I called the top in this market in December, 2005, with words that seem more prophetic each time I quote myself:

 

“Do I quote myself? 
Very well, then, I quote myself
I am large, I contain multitudes.”
[Lines 1324-1326]

 

Forecasting is notoriously difficult.  Prices are extremely complex, interdependent, multi-variant, and phase-delayed (with larger and smaller economic forces having both leading and trailing effects).  They are seasonal, regional, tragical, comical, lyrical, pastoral …

 

Neither a subprime borrower nor a CDO investor be 

 

Out of all that apparent chaos, how does one prospectively determine major trends?  (Anybody can determine them retrospectively, but that’s very cold consolation.)

 

Enter the miner’s canary — the sensitive universal leading indicator.  And mine has just started wobbling, as this article from the Washington Post reveals:

 

Mortgage delinquencies among homeowners with high-cost loans will rise by 10% to 15% in 2006, as borrowers struggle with higher interest rates, high debt levels and higher energy costs amid flattening home prices, a new report from investment analyst Fitch Ratings predicts.

 

Why is subprime lending a leading indicator?  Because by definition, subprime borrowers are at the edge of the bankable frontier — people who are trying their hardest to stretch their limited dollars into a purchase.  When the yield curve is positive — which is the normal state of things — the lowest interest rate is to be had if it is variable.  So the same feature that drives someone to a subprime lender also motivates that borrower to choose a variable rate loan when she arrives. 

 

About 19% of home loans nationwide are subprime, up from about 5% a decade ago, as homeowners take on heavy debt burdens.

 

The much higher percentage of loans being subprime means more folks closer to the economic edge have elected to buy homes.  Observant herds can turn into stampedes and in so doing can drive prices up above ‘normal’ (whatever that is).

 

I have a normal brain – how about you?

 

Note the obvious: subprime delinquency rates lead normal market rates.  You might think that subprime borrowers, having managed to leap onto the rising economic ladder of homeownership, could rapidly pull themselves up.  Economic reality is more cruel; while many do, quite a few don’t:

 

Most borrowers find ways to catch up on their payments, refinance or sell their homes before they go into foreclosure.

 

Up to now [December, 2005 – Ed.], I’ve read innumerable frothy insubstantial Chicken-Little-market top articles, and found all of them utterly unpersuasive.  But this modest story — the newspaper equivalent of a green salad! — is different; this feels like a leading indicator. 

 

“I don’t like my role in this ecosystem“

 

So here it is, folks.  I’m calling the market top. 

 

Calling market tops since 2005

 

To return to our story, recognize that we had already called the market top, on precisely this evidence:

 

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.

 

Under its typical selling arrangements, New Century would place a security that was collateralized by a basket of loans.  The security’s buyers would have the right periodically to swap out non-performing loans and make New Century swap in performing ones.

 

You can have that one back

 

A spike in loan swaps is a huge leading indicator of trouble afoot.

 

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.

 

After repo requests, and before

 

I like Mr. Cloyd – a man who uses clear metaphors is a man trying to tell the truth.  Meanwhile, I don’t like Mr. Morrice, the CEO:

 

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.

 

I’m trying to report only good news, get it?

 

Yet the very next day, New Century issued a press release about its August lending levels, which it said had climbed 9% 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.”

 

Modesty is in the eye of the beholder.

 

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.

 

With all the litigation out there, nobody’s going to say a word beyond what’s already on the record.

 

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.

 

To put that in context, that’s $1 in reserves for every $3,000 in loans.  Does that sound like enough?

 

 

[Concluded tomorrow in Part 3.]

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