Friday, August 13, 2010

Catch Us If You Can - GUEST POST by Sara McIntosh

NOTE: While I am on vacation, I invited some guest posts from popular bloggers. Following is a guest post from Sara McIntosh, author of the Sara McIntosh Blog, and of the recently released book, Shell Games.

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, 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,

Sara McIntosh

NOTE: If you have an established blog or publication and would like to submit a guest blog post for the FEI blog, please contact me at to discuss.

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Jonah Gibson said...

Even without the fraud supposition, which by the way I think you have made quite plausible, there are still huge write downs lurking in the creases of a lot of bank balance sheets. Meanwhile Fed and Treasury seem to be working overtime to make sure they aren't discovered until banks can cover them from other sources. This is sure to put the auditors in an even more untenable position when it comes to proposed adjustments--damned if the do and damned if they don't.

Ken Biddick said...

Unfortunately for auditors they were the one gatekeeper, given their charge to audit management's assertions, that could have nipped this early in the game. However, even as these transactions got bundled and further removed from the underlying individual mortgages, the auditor still had the same responsibility regarding management's assertions. The simple duty to verify existence (no different than if the mortgages were widgets) has been a failure of auditors for decades. Before you can consider valuation you need to determine that the stuff actually is real, pretty simple. And it really doesn't matter whose paying the auditor. An auditor's duty is to serve the public interest not their self-interest. Auditor's need to take personal responsibility and held personally accountable. Loosing ones license for life should be a penalty used more often since it seems that financial penalties borne by firms is a price they are all willing to risk.

Sara McIntosh said...

Hello Jonah,

I couldn't agree more about the auditors being damned if they do and damned if they don't. Especially the damned if they don't.

The auditors are selected, managed and paid for by the companies they are supposedly auditing. Their clients hire them to "sign off on their financial statements," not withhold an "alls-well" opinion.

Thanks as always for your insightful comments.

Ciao for Now,


Sara McIntosh said...

Dear Ken,

Thank you for taking the time to comment on this post. It is so difficult to find people who even care these days . . .

I find your comments to be very representative of what too many people incorrectly believe to be true:
1) That the auditors have a public responsibility above and beyond that of serving their clients' best interests, and
2) That the auditors have a "simple duty to verify existence" e.g. of actual mortgages supporting mortgage-backed securities.

Auditors only have a "perceived" public responsibility--not a real one.

With lawyers, we have States Attorneys and Judges who are paid by the public and have real, clearly defined public responsibilities. Same with IRS auditors being paid by the government, doing the job they do for taxpayers.

But with respect to the auditors, the public/government doesn't pay for anything. Why would we expect the auditors or anyone else to work for free?

And, more specifically, with respect to mortgage-backed securities and similar investments, even the PCAOB, (Public Company Accounting Oversight Board--the uber-regulators "overseeing" the Big Four and other public accountants, established as part of the Sarbanes-Oxley legislation meant to prevent future financial crises), in it's annual Inspection Reports of the Big Four, outlines standard audit procedures as being getting quotes from "outside parties" as to the "market valuation" of these investment securities--no actual review of underlying documentation, etc.

Please refer to my blog posts entitled "What On Earth Could Be Taking So Long, PCAOB" and "Handcuffed Without Consent" for a clearer picture of our abysmal accounting industry regulatory reality.

I thoroughly agree with you that auditors need to take personal responsibility and be held personally accountable for their actions. And I do not think license revocation is even a harsh enough consequence.

But the current flawed foundation (auditors selected, managed and paid for by the companies they are supposedly auditing) prevents, rather than fosters, responsibility and accountability.

Good for them. Bad for us.

Thanks again, Ken, for taking the time to comment. I hope to hear from you again in the future.

Ciao for Now,

Sara McIntosh