KPMG: Stomped By The Elephant

Yesterday’s news that the trustee in bankruptcy for former subrime mortgage giant New Century (one of the first big subprime lenders to fail a couple of years ago) had sued KPMG and its international parent over the collapse of New Century didn‘t really come as a shock. When a company that big fails quickly and spectacularly, you know that its auditor has put its professional liability carrier on notice. You also know that the bankruptcy trustee is going to squeeze as much blood as he or she can out of the auditing turnip for the benefit of the unsecured creditors. However, today Francine McKenna at re: The Auditors, focused her keen eye on the matter and dug out some gems, including one near and dear to our hearts. That one was actually uncovered by Francine two years ago, the first time she wrote about New Century, and which she reiterated today. Discussing an SEC investigation, she notices some lapses in securities disclosure documents [emphasis Francine's]:

There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements….it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans. Did the ratios drop? Were they delivering their monthly compliance certificates to all the lenders? Were those accurate and truthful? Did the lenders have the right to call the loans unilaterally? It does say that if one called the loans it is likely that all would. Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened?… I find it very curious that no matter how much auditing and disclosing goes on, we continue to see “rapid, unexpected declines” in once high-flying companies that suddenly teeter on the edge of bankruptcy, even though the best and the brightest are supposedly “Keeping Watch” for us as their auditors.

As regular readers know, I’ve been yipping and yapping like an annoying little Shih Tzu about the primary danger of the “mortgage banking” business model for the little over five years this paltry blog has been in existence: the “Elephant in the Room,” investor-forced repurchases of loans. As Francine rightly points out, when you originate and sell a volume of loans many, many times the amount of your capital and liquid assets, you're facing tremendous potential risk if your underwriting is not, shall we say, “robust.” In seventeen pages of discussion of risk in a disclosure document, repurchase risk is never mentioned. That’s striking.

The Chairman of the Board of a small FDIC-insured financial institution once told me that his institution had outstanding loan sales of many thousands of times its capital. Yet, the specific federal regulator overseeing that institution consistently failed to ever ask the institution how it intended to cover that risk and, in fact, spent relatively little time evaluating origination and underwriting controls as opposed to the regulatory “flavor of the month,” such as Bank Security Act compliance, consumer protection law compliance, or other less critical areas. He wondered whether the regulators “got it.” I don’t know whether or not they ever “got it,” but you have to wonder if auditors failed to "get it," as well.

Francine makes other interesting points, among them:

• Suing the international parent of US accounting firms is a trend that we’ll continue to see.

• The emphasis of the complaint on a lack of “independence” might reflect a lack of sophistication by the plaintiff’s counsel as to the nuances between “independence” and simple negligence, although, to her, “[t]his one seems clear cut enough on the negligence and professional malpractice points alone.”

• “Rolling over and playing dead for the sake of the business is not an ‘independence’ violation, I’m sorry to say.” Lines like that keep me coming back to Francine.

• KPMG still audits Citibank and was the auditor of Countrywide. How much more fun can they stand? Moreover, “who’s next?”