Nothing to see here: Part 3, churning CFOs
[Continued from the previous Part 2 and Part 1.]
So far, in exploring how failure to report leads to reporting failure, we’ve used this New York Times article about now-bankrupt New Century, its unlucky auditor, and its troubled but unmoving directors. By the end of 2006, when new CFO Tajvinder S. Bindra was quizzing his new firm’s controller and auditor, New Century was reserving only $1 for every $3,000 of outstanding balance.
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.
Was it enough? Now the story gets gruesome:
But you can’t look away, can you?
To begin with, we have to convert two numbers that aren’t directly comparable. Reserves should equal expected losses, which are normally expressed in the Absolutely Basic Loss Formula:
Were their default rates 1%, and their losses given default 3%?
Those filings were not audited by KPMG, but they were reviewed by the firm.
And KPMG was preparing to sign the 2006 audit … but it did not. So we do not know whether KPMG agreed with the loss reserves, or disagreed, and whether the disagreement was a material factor in KPMG’s refusal to finalize.
The reserve was woefully inadequate, according to the examiner’s report.
We know that now; could KPMG have known it then?
That’s the litigators coming up on your tail
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% of that troubled pool of loans.
All right, that’s a 3.5% default rate. Did New Century think it would be able to recover a portfolio-wide average of 99% of post-default 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.
Dear, dear – ignorance of your own financials is not only no excuse, it’s worse than no excuse.
“It’s not my fault! I had no idea trouble was coming!”
At about this point, were I a New Century shareholder, I would be getting quite angry with everybody.
I was not angry ere I came to New Century until this instant!
The examiner asserted that New Century had made two glaring errors in how it calculated its repurchase reserves:
Make too many errors and you’re cooked
[1]. 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.”
Yes, since it’s 13 times as large as the reserve.
But Ms. Fitzgerald [KPMG spokesperson – Ed.] 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.”
[2]. 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.
As you read this damning indictment, see it as just that – an indictment, conclusions by a party whose predisposition is to find indictable actions.
We were looking for indictable actions
“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.”
Go ahead – serve my writs
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.
Zach Gast of RiskMetrics said better accounting at New Century would have raised flags sooner, perhaps tempering the subprime fiasco.
Credit Mr. Gast for going on the record.
The reports created a stir at New Century, and the accounting department prepared a rebuttal.
Which looks pretty silly in hindsight, with New Century filing bankruptcy barely three months later.
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,
In the post-Sarbox world, another miner’s canary is the churning CFO; if they keep being replaced, the financial reporting air is almost certainly bad.
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.
Why did I give that interview?
While I’m no fan of the anonymous source, it’s entirely understandable here. If you had worked at New Century, and you weren’t part of the financial reporting circle but you were close enough to see who met with whom, would you want to bring yourself into litigation that will cost you money, challenge if not ruin your reputation, and give you the kind of Google-search you absolutely do not want?
Until late January, according to the report, Mr. Kenneally [New Century’s controller — Ed.] defended the company’s reserve calculations. After that, the report said, Mr. Donovan [from KPMG – Ed.] told him that a further accounting review showed that New Century had made a mistake.
At that word ‘mistake,’ the blood probably drained from Mr. Kenneally’s face.
The demon auditor of Fleet Street?
By under-reserving, 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.
“Okay, so reality doesn’t fit the narrative.”
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.
That’s not the issue; the issue is when, and with what damage.
“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.
Did it? I’ve never heard the case made in those terms.
“The economic model here is what is at fault. It’s the cause of what happened, not anything that KPMG did.”
Perhaps Mr. Weil will be among the experts KPMG will call at its trial.
It all went down the drain right about here
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.
That won’t stop people from trying.
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.
Losing billions is troubling. Going bankrupt is troubling. It’s all 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.
No, really, I’m independent
You pay me. You supply me with all the information I examine. You review my draft work product. You question my findings. You know more about the business than I do. Yet when the time comes, I have to sign my firm’s name to my own opinion, and it has to be my honest-to-goodness opinion. Mine.
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.
Alas for Ms. Fitzgerald, as she and her firm well know, it is precisely in through the lenses of hindsight that everything will be viewed.
A completely undistorted view
That’s why contemporaneous and consistent reporting is so crucial. People love to trumpet good news; they wish to bury or delay bad news. Every time I’ve had financial reporting get delayed or suspended, it’s been a leading indicator of financial trouble.
“You’re in a tough racket now”
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