[Continued from yesterday's Part 1.]

Yesterday, using as our text a New York Times article exploring Congress’s so-far-halfhearted attempts to reform rating agency regulation, we laid out the simple three-part fix for their inherent conflict of interest and flawed business model:

You sure that’s all there is to it?

[Our five-part rating-agency takedown from two years ago is here: Part 1, Part 2, Part 3, Part 4, Part 5.]

Simple, isn’t it?  Straightforward, right?  The kind of product the government factory should produce – no public expenditure, no disruption to the marketplace, uses principles forged in other arenas (e.g. SEC disclosure, certified public accounting).  Nothing to it.

Or is there?

So as Washington rewrites the rules of Wall Street, how is the overhaul of the Big Three coming? It isn’t, finance experts say.

“What you see in these bills are Botox shots,” says Joseph A. Grundfest, a professor of securities law at Stanford Law School. “For a little while, everyone is going to be frozen into a grin, and then the shots are going to wear off.”

Not frozen in a grin: Stanford’s Joe Grundfest

What explains the timidity of Congress’ proposals? This is not a case of lobbyists beating back ideas that might hurt their clients, say those close to the discussions.  Instead, Congress is worried that bold measures may backfire.

Lincoln used to say that he never allowed a committee of general to decide strategy, because they would always talk themselves into the most timid activity possible.  Leave it to Congress – a Congress where the House, Senate, and Administration are all aligned, the ultimate laminar political environment, the ideal time for bipartisan and long-sighted legislation – to out-timid itself:

“It’s fair to say we knew we were taking on a problem with no silver bullet,” said Representative Paul Kanjorski of Pennsylvania, the chairman of the Financial Services subcommittee that has led reform efforts in the House. “I’m convinced that we’re getting more control over the rating agencies than ever before but not at all sure we’ve developed the perfect system.”

 “I’m convinced that we’re getting more control over the rating agencies than ever before but not at all sure we’ve developed the perfect system.” Paul Kanjorski, representative from Pennsylvania.

Mr. Kanjorski, you’ve confused control with accountability.  Proscribe what rating agencies cannot do, and make them accountable in the courts for what they can do, and between the two the marketplace will take care of the problem for you.

“Moody’s shares the committees’ goal of increased transparency for the ratings process,” said Michael Adler, a Moody’s spokesman.

Oh, how nice.  Act meek and conciliatory and let the anger dissipate as the committee of generals talks itself into believing that merely by talking it will have solved the problem.

S&P is equally sanguine. “We support globally consistent, nondiscriminatory regulation that will help restore investor confidence and bring more transparency to the capital markets,” said Catherine J. Mathis, a spokeswoman for Standard & Poor’s. A spokesman for Fitch declined to comment.

What total goo.  Like drowning in a tub of warm Karo.

No really, it’s blood, not syrup

Nor is anyone on Capitol Hill suggesting a rewrite of all those rules that put rating agencies in the middle of so much Wall Street action.  

Why not?

Instead of cajoling the Big Three into producing more accurate ratings –

Cajole?  Who needs to cajole them?  Turn them over to the marketplace

Are you not reformed?  Are you not satisfied?

– why not take away the special status of those ratings and make them less important?

Point 1 of our simple proposal – open the field to competition.

“There are a lot of complicated issues that nobody knows how to deal with, like water shortages in different parts of the world,” says Jonathan Macey, a deputy dean at Yale Law School and a member of a bipartisan task force that has conferred with lawmakers about rating agency reform.  “But this isn’t one of them.”

Dean Macey’s got to work on his press quotes, but his point is clear enough.

“We could solve this one pretty easily with a modicum of political will. It’s just mortifying.”

That it is.

Meantime, to the consternation of detractors, the companies are now earning fees from a new source: re-Remics, an acronym for resecuritization of real estate mortgage investment conduits.

These are transactions that take downgraded mortgage securities and separate the riskiest assets from the strongest, making the strongest easier to sell.

As I posted in Remixing REMICS, or shake your booty, it may be right or it may be too risky:

Put simply, if value is added through the remixing, there are three possibilities:

1. The restructuring changed the risk profile. 

2. The old assessment was too pessimistic.

3. The new assessment is too optimistic.

Of these three, Theory 1 is positive change, Theory 2 has positive impact, and Theory 3 will only make things worse.  So we’d really like Theory 3 to be false, but as we saw some months back, it’s all too easy for people to believe what they desperately hope should be true.

Hope is not good enough – we need expertise and integrity.  Where will we seek it?  Why, the supposedly independent rating agencies. 

I can be disinterested if you pay me enough

And as Frank Zappa would have put it, the rating agencies are only in it for the money.

The companies do not break out re-Remic revenue in financial reports, but to some, it seems to be a way for rating agencies to profit from a mess they helped make.

Ye-es.

At minimum, much of what is in the House and Senate bills sounds familiar.

Both bills enhance the power of the S.E.C. to supervise the rating agencies and both require the companies to bulk up their compliance teams. The Senate bill allows individuals to sue a rating agency for a “knowing or reckless failure to investigate or to obtain analysis from an independent source.”

Mr. Kanjorski and Senator Jack Reed of Rhode Island, who led the Senate’s look at rating agencies, said in interviews that they thought their bills went as far as possible to change the system in a judicious manner.

I don’t mean to offend

Is that milquetoast soft enough for you?

Could you make it less scary,  please?

Academics and former rating agency employees who have been warning lawmakers about the Big Three for years say Congress is tiptoeing when it ought to be charging ahead.

Tiptoeing?  We’re positively skedaddling!

But for now, and for the foreseeable future, the market for ratings is sure to look uncannily similar to the one that helped usher in the crisis: three rivals, all of them paid by issuers, bestriding the market.

It is a picture of the future so rosy and so rife with the potential for profits that some investors see a buy sign.

“I’ve had a few hedge funds call and ask me what I think of the rating agencies as investments,” said Frank Partnoy, a professor of law and finance at the University of San Diego school of law, who has written extensively on the rating agencies. “If the dysfunctional regulatory structure stays put, the rating agencies soon will be back to business as usual, which will mean a continuing monopoly and sky-high operating margins approaching fifty percent.”

Partnoy’s complaint: so rotten it’s gotta be profitable

Translation: they’ll wriggle out of any meaningful punishment or restrictions.

One senior Senate aide, who requested anonymity because the aide was not authorized to speak, said that the bill that would reach President Obama’s desk early next year would merely be a beginning.

“Look at what happened in the 1930s,” this aide said, “they passed bill after bill after bill. Now, we’re not going to do that, but credit rating agencies are so tied into the way business is conducted, so tied into rules, it’s going to be incredibly complicated to unwind, and we’re not going to fix it all in one bill.”

Why not?  How hard are the three principles I listed above?

 “I think these bills are misguided and wrongheaded because they will have the ironic effect of making the incumbents even more important,” said Lawrence J. White, an economics professor at the Stern School of Business at New York University. “They’re going to encrust the procedures already in place and discourage new business models.”

But somehow, what looked like the low-hanging fruit of financial reform is still dangling, right where it hung at the start of this calamity

Can nothing be done?  Look to unlikely heroes:

While Congress may be happy with cosmetic surgery, law enforcement officials are getting more aggressive. Dozens of lawsuits have been filed against the rating agencies, including a case filed on Nov. 20 by the Ohio attorney general on behalf of public pension funds. The Ohio suit, as well as the earlier suits, seeks billions of dollars in damages from the rating agencies and accuses the firms of negligence and fraud.

Though it’s hard to believe, I’m rooting for the tort lawyers.

Here’s for the tort lawyers!

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“Just wait ’til your father gets home, young man, and then you’ll really be in trouble!” 

Mother, I’m trying to look intimidated by you

After hearing that threat, how often were you able to wriggle out of your deserved punishment?

That’s the current don’t-you-dare-smirk posture of Congress toward the Big Three rating agencies, who by putting their heads down and making industrious noises appear on their way to a return to pre-crunch business levels and their pre-crunch business model.  At least according to the New York Times:

When the financial crisis began, few players on Wall Street looked more ripe for reform than the Big Three credit rating agencies.

It wasn’t just that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, played a crucial role in the epochal housing market collapse, affixing their most laudatory grades to billions of dollars worth of bonds that went bad in the subprime crisis.

Making this infuriating is that Congress’s paralysis is entirely of its own making, for the solution is at hand if only Congress or the Administration had the political backbone to enact it.

And we’re slow, too!

Two years ago, at the cusp of the subprime collapse [August, 2007 – Ed.], in a symbiote’s life is not a happy one [Full five-part post here: Part 1, Part 2, Part 3, Part 4, Part 5 – Ed.], I laid out the bones of a solution for rotten rating agencies, analogizing to the challenge facing a sports league whose referees’ integrity is questioned:

Whaddaya mean?  Best referee money can buy!

The NBA is suffering through a scandal of epic proportions: a referee who’s pled guilty to influencing the course of games – and possibly even the most recent NBA championship – by the way he called fouls to manipulate the over/ under line. 

Could one man bring down a league?

NBA referees are paid a tiny fraction of the money the athletes make, and an even smaller fraction of the money the NBA owners (their employers) make.  Placing that much responsibility in the same hands as that much temptation is a risky proposition.  Precisely the same scaling/ temptation dynamics apply to the agencies, the investment bankers they referee, and the capital markets who profit from their refereeing.

Sports leagues are closed networks of entities that collaborate on network health even as they compete with each other for prizes within the network.  If the network’s brand value drops, all the competitors suffer too.  The capital markets and structured-finance investment banking worlds are a league of professionals who compete on many levels but collaborate on others, including the health of the financial ecosystem and the free flow of ample liquidity. 

So it should be no surprise that when a league’s integrity is threatened, the league takes steps to restore its impartiality.  The NBA is now struggling to do that in the wake of Donaghy; 88 years ago, major league baseball did it after the Black Sox Scandal.

Players and their lawyers … first in a century-long trend

Back in 1919, the owners – a rogue’s club if ever there was one – searched out a person of unquestionable public integrity (Judge Kenesaw Mountain Landis) and appointed him Commissioner of Baseball, with sweeping powers.

I’m the commissioner, and I’m nobody’s friend

Landis’s reign – and the immense popularity of live-ball and Babe Ruth – gradually brought baseball back from its depths. 

Who then is the Commissioner of Rating Agencies?  Surprisingly, there is none.  [Snip]  If not – well, the world can function perfectly well with only two rating agencies instead of three.

Even as we flagellate the rating agencies, let’s acknowledge there’s plenty of culpability to go around.  (”All the other kids were doing it, Mom!”)  Yet culpability is absolute, not relative.  That others were culpable does not exculpate you.  (”If all the other boys ran off a cliff together, would you do it?”)

I don’t care what the other bloggers are doing!

It was the near universal agreement that potential conflicts were embedded in the ratings model.

They were.  They are.

For years, banks and other issuers have paid rating agencies to appraise securities — a bit like a restaurant paying a critic to review its food, and only if the verdict is highly favorable.

More like a restaurant paying a health inspector to certify the little pieces parts were edible, with no liability when the customers died of ptomaine poisoning.

Don’t enact anything, and one day you could be like them!

Without question, the credit rating system is one of the capitalism’s strangest hybrids: profit-making companies that perform what is essentially a regulatory role.

Not any stranger than certified public accountants, who audit financial statements for a fee, paid by the company being audited. 

The companies serve the public, which expect them to stamp their imprimatur on safe securities and safe securities alone. But they also serve their shareholders, who profit whenever that imprimatur shows up on a security, safe or not.

Again, no different from accountants, except that auditors can be sued and bankrupted – sayonara Arthur Andersen, hasta la vista Laventhol & Horwath.

En-what-ron?

Making this so exasperating is that the solution lies at hand, if only we had the wit to see it and gumption just to do it.  Capital markets are a large multi-player game with ever-changing participants.  Games have rules, and rules must be interpreted, adjudicated, and enforced by referees.  Referees, in turn, must be capable, disinterested, and accountable. 

The rating agencies could be the Referees of Risk Assessment, if their business model were circumscribed to make them capable, disinterested, and accountable.  Like this:

Simple, isn’t it?

It’s easier to remember that way, too

We do need rating agencies:

The Big Three, by allowing companies and public entities to raise money by issuing debt, are an essential engine in the country’s vast credit factory, and given the still-fragile condition of the equipment, lawmakers are reluctant to try anything but basic repairs, patches and a new alarm system.

Isn’t that always the claim? 

Mr. Kanjorski said he worried about remedies that undermined the Big Three because they were pretty much the whole system right now.

“We want to do as much correction as we can,” he said, “but we don’t want to kill the institutions because we have nothing to replace them with.”

If we have three of them, why not shoot one, pour encourager les autres?

Yet all is for the best in this,

The best of all regulatory systems

There is no talk about creating a fee-financed, independent credit rating agency, one modeled along the lines of the Public Company Accounting Oversight Board, which was established to oversee auditors after the Enron debacle — an idea floated by Christopher J. Dodd, the Senate Banking Committee chairman, as recently as August.

That approach would attack the conflict of interest problem head on.

Yes, it would.  Why isn’t it being done?

Senator Jack Reed of Rhode Island … has listened in recent months to lots of proposals that would have aimed at the issuer-pays system and promoted alternatives. He also looked at the idea of curtailing the importance of ratings by rewriting rules and laws that require mutual fund and money managers to stick to triple-A securities.

But he was concerned about the huge numbers of professional investors out there — like those working for small towns — who don’t have the resources to research every bond they buy.

Much though I like Senator Reed, he’s forgetting two things: (1) Small investors who don’t research every bond can buy only bonds they research.  (2) If the marketplace for ratings were robust, new entities would enter the field.

“We all understand the outrage, but our priority is to prevent this from happening again … ” — Jack Reed, senator from Rhode Island.

In addition, legislators say, there is little consensus about what a top-to-bottom renovation should look like.

That’s a copout, what with all the political oxygen being sucked up by siege warfare like the health-care reform debate.

Under bills that legislators are currently considering, the rating agencies will have to contend with greater oversight, stiffer rules about disclosure and a provision that would make it easier for plaintiffs to sue the firms.

Translation: “When he gets home, your father will know what to do with you.”

Wipe that grin off your face, and start looking scared.

But nothing in the laws tackles the critic-for-hire problem or threatens the 85% market share that Moody’s, S.& P. and Fitch now enjoy.

See Point 1 of our modest proposal – establish licensing standards and open the field to new entrants.  Specialists would emerge for each asset subclass.

To make matters more complicated, rating agencies are deeply entrenched in millions of transactions. Statutes and rules require that mutual fund and money managers of almost every stripe buy only those bonds that have been given high grades by a Nationally Recognized Statistical Rating Organization, as the agencies are officially known.

Then defrock one of them.  You don’t need three.

You’re branded for life

Up to now, the rating agencies have enjoyed the upside of their optimistic ratings – enormous fees and record profits – without the downside – litigation judgments.  Though some are trying …

When he filed his suit, Ohio’s attorney general, Richard Cordray, said that the “rating agencies’ total disregard for the life’s work of ordinary Ohioans caused the collapse of our housing and credit markets and is at the heart of what’s wrong with Wall Street today.”

Ratings agencies’ disregard is “at the heart of what’s wrong with Wall Street today.” — Richard Cordray, attorney general of Ohio.

After the suit was filed, Richard Blumenthal, Connecticut’s attorney general, said he planned to join the suit and thought that a “coalition of states” would also jump on the legal bandwagon — a potentially grim development for the rating agencies, which could find themselves contending with a phalanx of state officials like the one that aimed at big tobacco in the 1990s.

The Big Three object that the legislation proposed by Congress could make them more vulnerable to legal action.

Poor babies.

Even if there is no foolproof way to reform the rating agencies, the measures that Congress is now backing are strikingly weak, a number of critics say.

Why?  How hard this be?

It’s hard, dood

[Continued tomorrow in Part 2.]

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If no one wants your pile of booty, perhaps you should try shaking things up  At first blush, that appears to be the strategy behind the proposed remixing of Real Estate Mortgage Investment Conduits (REMICs), as presented in a recent Wall Street Journal article:

I’m gonna shake it up

Once upon a time, Wall Street invented a nifty means of centrifuging, separating, refining off, then packaging and selling the resulting slices.  It was called ‘securitization‘ and everyone everywhere lived happily ever after again.

I’ve invested all our money with Bernie Madoff, honey

Or something like that ….

Debacle, period

Certainly the Journal, which is always skeptical of money-making that doesn’t involve a smokestack industry producing manly products, brings appropriate skepticism to this one:

Some day, son, you too can read the Wall Street Journal.

Wall Street Wizardry Reworks Mortgages

Wizards, as we all know, are not manly men.

Oh no?  I can make your security that big

A new wave of financial alchemy is emerging on Wall Street as banks and insurers seek to make soured securities look better.

That’s full metal alchemy, you know

Regulators are pushing back, saying the transactions don’t have enough substance and stand to benefit bankers and ratings firms.

The popular deals are known as “re-remic,” which stands for resecuritization of real-estate mortgage investment conduits. The way it works is that insurers and banks that hold battered securities on their books have Wall Street firms separate the good from the bad. The good mortgages are bundled together and create a security designed to get a higher rating. The weaker securities get low ratings.

The Journal provides a handy graphic:

REMICs REMIX: How a bad bond is rebundled.

Doesn’t sound bad in the abstract; but we’ve seen this movie before, haven’t we? 

And the picture gets no better the second time

A hypothetical example cited in research by Barclays Capital said that a $100 million asset that required $2 million in capital at a triple-A rating may require $35 million if downgraded to double-B-minus. At triple-C, the capital requirement might rise to 100%, or $100 million.

Key to your understanding is that downgrades are not changes in the thing itself, but changes in the observation of the thing.  This is a Schrodinger’s Cat moment: the act of observing changes the thing’s value even if its essence remains unchanged. 

You observing me?  You think that changes me?

Though the essence is unchanged, the value is increased.

In a re-remic, three-fourths of the same asset may regain a triple-A rating, requiring just $1.5 million in capital, Barclays said. The remaining one-quarter may require 100% capital, but the total capital requirement would fall to $26.5 million.

Shake up your booty, and it becomes more tasty

The net result is financial firms’ books look better and they need to hold less capital against those assets, even though they are the same assets they held before the transaction.

Put simply, if value is added through the remixing, there are three possibilities:

1. The restructuring changed the risk profile. 

2. The old assessment was too pessimistic.

3. The new assessment is too optimistic.

Better when it’s green, isn’t it?

Of these three, Theory 1 is positive change, Theory 2 has positive impact, and Theory 3 will only make things worse.  So we’d really like Theory 3 to be false, but as we saw some months back, it’s all too easy for people to believe what they desperately hope should be true.

Hope is not good enough – we need expertise and integrity.  Where will we seek it?  Why, the supposedly independent rating agencies.  (I say supposedly because in a five-part series – Part 1, Part 2, Part 3, Part 4, and Part 5 – we saw the rating agencies cozily symbiotic with their ratees.) 

I can be disinterested if you pay me enough

Meanwhile, let’s examine the parol evidence:

American Equity Investment Life Holding Co. has told analysts that it is considering a re-remic. Recent downgrades of its mortgage bonds overstate their risk by a wide margin, its executives said.

That’s Theory 2 expressed in its quintessence.  And it might well be right – many folks, including me, have suggested that the capital markets’ liquidity shortage had led to a massive over-reserving on these assets. 

Some state insurance regulators worry that current ratings are flawed – perhaps even too harsh – for determining the capital that should back up residential-mortgage securities.

Arr, yer too low-rated, matey!

Another anonymous expression of Theory 2.

But they are chafing at the re-remic strategy. That’s partly because of the fees and partly because re-remics rely on ratings firms – faulted for failing early on to identify problems with mortgage-backed bonds – to rate the new securities.

We do know that a symbiote’s life is not a happy one.

At hearings Wednesday on Capitol Hill focused on the ratings firms, U.S. Rep. Dennis Kucinich (D-Ohio) raised concerns about the mounting number of re-remics, saying, “The credit-rating agencies could be setting us up for problems all over again.”

And I know about being set up for problems

Regulators would like “a lot fewer dollars” paid to Wall Street, as well as “less reliance on the ratings agencies,” said Kermitt Brooks, first deputy insurance superintendent in New York. The state is an important voice on financial matters at the National Association of Insurance Commissioners, or NAIC.

Fewer dollars paid is fine if the quality doesn’t suffer, and if you’re not going to rely on the discredited rating agencies, what not-yet-discredited referee are you going to rely on?

The alternative solution, proposed by trade group American Council of Life Insurers, calls for hiring an analytical firm with expertise in residential mortgage-backed securities to help regulators determine the value of deteriorated holdings on insurers’ books, bypassing the ratings providers.

There’s a place for experts who value complex interests.  What will make these postulated new ones any better than the current rating agencies?

It is unclear how big a concern this is for banking regulators. Alabama Deputy Banking Superintendent Trabo Reed said he has seen only a few examples of re-remics.

Is $11 billion ‘only a few examples’?

Wall Street bankers and analysts said a minority of re-remics, perhaps as little as 10% to 30%, are aimed at helping firms like insurers manage capital requirements. The general goal, as one banker put it, is to help “create buyers for orphan securities that otherwise would have languished.”

The issue isn’t why the booty’s being remixed; rather, the issue is whether the remixing is sound or unsound.

“There is $350 billion to $400 billion in market value of securities with no natural buyer due to their rating,” Barclays said in a June report. “The re-remic market provides a way out of this gridlock by creating new AAA securities, which are likely to be viewed as attractively priced.”

We’re only in it for the money

Remixing the booty has a valid regulatory purpose.  Institutions have capital requirements; low-rated securities consume very high capital reserves. 

And Protective Life Corp. said in August that its re-remics, totaling about $1.4 billion, improve the company’s capital standing “in the ballpark” of $75 million.

Getting the securities re-rated, or even re-rating a portion of the securities, adds meaningful value via Theory 1.

Insurance executives estimate that insurers pay 0.35% or so of a deal’s size in investment banking, ratings firm, legal and other costs.

Expressed as a percentage, that’s only 35 beeps.  Doesn’t sound like much, until you multiply it out and its $35 million in fees.

Thirty-five mil!

Pay $35 million, free up $75 million.  Worth it but not by a huge amount.

At an NAIC hearing last week, ratings firms described changes over the past year to improve their analytical, compliance and corporate-governance processes. But they also generally agreed that their ratings weren’t ideal as a sole basis for determining insurers’ capital levels.

In other words, discredited though the rating agencies be, nobody’s offered real competition.

The alternative is to go overseas and get your money from Sheik Yerbouti

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[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:

We could have 100% of our loans go into default, but if we eventually recover 100% of their value, our Expected Loss is zero.  Or we could have 1 in 100 of our loans go into default (1.0% default rate), and lose $1 in $30 from each one that does (3.3% loss on default, or 96.7% post-default collection rate), in which case our Expected Loss would be $1 in $3,000 – as New Century was reserving. 

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, David Kenneally, and the KPMG partner in charge of New Century’s audit, John Donovan,

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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[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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