Video Credit: Dave Clark Five, appearing on Shindig, Circa 1965, via YouTube
I’d like to start this blog post out with a shared assumption—we do that in accounting all the time, so hopefully it’ll be familiar territory. In fact, assumptions are the very basis of accrual accounting. And with respect to this blog post, imagining a shared set of assumptions will help illustrate (hopefully quite simply) why the new financial regulations will most likely NOT prevent another subprime mortgage security crisis.
Our starting assumption for the post is this: Assume there was fraud imbedded in at least some of the bundled subprime mortgage securities extending far beyond liars’ loans and petty frauds at the homeowner/initial lender level. Additionally, assume these massive financial black holes (mortgage-backed securities) were intentionally created to steal billions of dollars out of the system.
Those of you who’ve read my financial thriller, Shell Games (available at Amazon.com), know it’s a rocking, sexy, fictional account about billion-dollar frauds embedded by a Wall Street firm called Lemon Brothers into many of the bundled subprime mortgages they issued. Similar to real life, when some of the plans go awry, the resulting fallout causes a global financial crisis.
As Robert Meixner of Port Saint Lucie, FL wrote in his review of Shell Games,
“Much of what passes for explanation of the current recession has to do
with the subprime mortgage business, and much of what is said about it doesn’t
make any sense to me. The numbers don’t add up. I need a better explanation, and
one that appeals to my logic as an accountant. A conspiracy theory that offers
just such an explanation has been advanced by author, Sara McIntosh in her novel
. . .”
This assumption of widespread fraud in our economy’s mortgage-backed assets is also well-founded in reality. For instance, Catherine Austin Fitts, former Assistant Secretary of Housing in the first Bush administration uncovered (in real life) a scheme she estimated meant frauds in up to 40% of the mortgage-backed securities. She says because no one wanted to address the situation, these frauds were never cleared out of the government’s asset portfolios. It took a native New Yorker and two generations of tracking to catch onto the frauds the crooks were perpetuating. Catherine outlines the whole incredible scam in her Voice of America radio interview with Jay Taylor—here’s the link.
Unfortunately, I doubt the new financial regulations are going to do much to dismantle (or even monitor) the conditions that make it so easy to bury fraud at every step of the process. You see, even though much of the “investing public” and government regulators don’t seem to recognize it—you get what you pay for when it comes to professional services, and not much more. And when it comes to regulators like the Securities and Exchange Commission, they aren’t paying the public accountants or credit rating agencies to do anything for them.
Right now, there’s not a client in the entire process willing to compensate the audit and credit rating service providers, or even provide them with access to relevant data, for either service provider to be able to catch intentional misrepresentations or outright frauds with these and other sophisticated, multi-tiered financial products in advance of another meltdown.
For example, let’s assume a fairly simple fraud right at the point of security issuance. Assume someone wanted to fraudulently represent that there were more mortgages backing a certain bundled mortgage security than there actually were, so that when the associated real mortgages were paid off, they could extract the excess cash without anyone missing it.
Would anyone catch them? Quite likely not.
Starting with the first step in hiding the fraud: The only outside party requirement before issuing the security is to obtain a credit agency rating for the security. The credit rating firms don’t actually audit the underlying mortgages to make sure there are no fraudulent ones. They ask the company to provide standard disclosures to them about things like default rates and such, and do their own analysis from thereon based on their own assumptions about how much they can rely on the information provided by the company. As non-auditors they are basically forced to rely on the representations of management (and their own knowledge of the company and its industry) to make their credit rating “forecasts.” No wonder they’re so worried about the new regulations causing them to assume liability related to the final accuracy of their credit rating “predictions.” (Note that as of the writing of this post, even this first third-party “review” step has been “temporarily” suspended by the SEC—see my blog post entitled “Time Kills All Deals.”) It was pretty easy to get the first rung of the fraud past them in our assumed post example.
Phase Two of getting further away from fraud discovery: As soon as the security is constructed and has received its credit rating it’s sold off. The issuer (who in my fictional example embedded the fraud) has received cash for their fraudulent transactions. There’s nothing really left to audit on the issuer’s balance sheet and the cash received is more than enough support to recognize the revenue. Assuming cash payments to settle the underlying mortgages (and clear the fraud out of the system) were also already transacted by the cutoff balance sheet date, there really is nothing to audit on the issuer’s books.
Third step completed and you’re golden! (Translation: the fraud will most likely never be discovered.) The first purchaser of the bundled mortgage security may or may not still be holding onto it when the relevant balance sheet period end arrives. However, no matter who is holding onto the financial hot potato (mortgage-backed security), it is highly unlikely the auditors reviewing the “asset” will actually try to tie the carrying value back to underlying mortgages. Instead they’ll calculate “lower of cost or market” book value in two main ways: valuing the asset at what the company paid for it (if they paid it, it must be worth it) and if possible getting a “market” valuation from a broker who sells similar securities.
So as you can see in this simple example, unless the details of the new financial rules actually address changing the way in which the value of these securities is tested/audited, we should expect whatever greed and lack of morality that caused the first financial crisis to be too tempting and cause another one down the line. Without real system-wide changes, these mortgage-backed securities are just too easy to manipulate for big bonuses and perpetuating massive fraud schemes, to end the fun and games.
Don’t even get me started on the difficulties auditing securities that aren’t even tied to real assets (e.g. indexed mortgage securities) or frauds that can be layered into the process every time these complex financial instruments trade from portfolio to portfolio. It’s taking me a series of fiction novels to showcase that!
In closing, I remind you, this is more than just fiction. The really scary thing is that right now trillions of dollars worth of these mortgage-backed securities make up a majority of our U.S. Treasury’s own balance sheet. What would happen if we had to take a massive 30% to 40% write-down due to as yet undiscovered frauds?
Ciao for Now,
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