Accounting Implications of the Subprime Meltdown

CPA Journal, The, Dec 2008 by VanDenburgh, William M, Harmelink, Philip J

The Peril of Forgetting the Fundamentals

During the late 1990s, it was common to hear that when it came to new Internet companies, earnings did not matter. The technology bust in the early 2000s should have put that claim to rest, but the succeeding housing boom of 2002 to 2007 was fueled by a similar kind of apathy-in this case, homeowners' earnings "didn't matter." For non-income verification home loans to become an acceptable industry standard requires a blatant disregard of basic accounting and auditing fundamentals. Some of the largest U.S. financial companies failed to recognize the risk of overlooking accounting fundamentals.

The subprime credit market fiasco nearly brought the $28 trillion credit cycle of the U.S. business economy to a complete standstill in August 2007. Major financial players, including Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, and AIG, have already been victim to the spreading financial crisis. Only unprecedented Federal Reserve and Treasury Department actions have kept credit markets from completely freezing up and have kept other major financial institutions afloat.

New Century

On February 29, 2008, the United States Bankruptcy Court for the District of Delaware released a mammoth court-commissioned report, authored by Bankruptcy Court Examiner Michael J. Missal, which detailed the failure of New Century Financial Corp., the second-largest originator of subprime loans. The court commissioned Missal to "investigate any and all accounting and financial statements irregularities, errors, or misstatements" in an expedited fashion. The resulting report was critical of New Century manage- ment, its audit committee, its internal audi- tors, and the KPMG audit engagement team. While the report contends that there were major auditing and accounting laps- es, others have countered that the New Century business model was destined for failure with the collapse of the U.S. housing market.

The court-commissioned report contended that New Century "turned a blind eye" to deteriorating loan standards and that the company's former chief credit officer even stated that New Century had "no standard for loan quality." The business environment fell to the point that the following conditions were alleged in the Missal report:

* Loans were made to borrowers whose income was not verified. These "stated income loans" became more aptly called "liar's loans" within the subprime business.

* Loans often had low "teaser" rates that would cause "sticker shock" when the rates were reset to market rates after a year or two.

* Appraisals were often deficient.

* Within New Century, its underwriting training program was internally referred to as "CloseMore University."

* Loan originations increased from $14 billion in 2002 to $60 billion in 2006. At the same time, there was an "alarming and steady increase in early payment defaults." There were increasing amounts of loan "kickouts" for a variety of reasons. Over $800 million in loans from 2004 and 2006 were rejected by investors simply because of missing documentation.

* The "tone at the top" did not advocate sound business procedures and there were inadequate technologies to monitor business transactions.

* New Century did not have adequate internal controls.

* Although the company had an audit committee, it did not focus on important issues of loan quality, risk, and internal control.

After reading the report, one must question why New Century's internal and external accountants were not more cognizant of common conditions that should have raised significant red flags. As the New Century report observed:

[E] ven if New Century's practices were not outside the norm of its industry, this would not absolve anyone from failing to follow applicable accounting rules, legal standards or prudent business practices.

New Century's management repeatedly exerted concerted and continued pressure on KPMG engagement teams. The New Century controller, a former KPMG manager, avoided producing requested documents by emailing the audit engagement partner a response which said that he was not a ''training center."

Troubling Audit Conditions

Of particular interest to the accounting profession is the discussion of external audit procedures and practices that were related to New Century's audits. Missal initially focused on accounting issues concerning loan repurchase reserves and the valuation of residual interest. In several court interviews in the second and third quarters of 2006, it was argued that the KPMG auditor recommended "improper changes to the repurchase reserve calculation." While KPMG denies these allegations, according to the report, it did document, evaluate, and approve these material changes. New Century's audit committee was not informed of these changes.

Missal contended that the auditor improperly agreed to New Century's use of "aggressive or stale assumptions in its residual interest valuation models" (e.g., inappropriate discount rates to compute present value). The net result of these and other accounting irregularities is that New Century understated its repurchase reserve by nearly 1,000% in the third quarter of 2006.