It's Not Just a Foreclosure Problem, It's an Accounting Problem

A recent decision by the Supreme Judicial Court of Massachusetts (U.S. Bank, NA v. Ibanez, Jan. 7, 2011) to block certain foreclosures has deeper implications than has generally been reported. The court ruled that two banks, trustees holding pools of securitized mortgages that tried to foreclose on two of the mortgages, hadn't submitted the documentation required to establish valid ownership of the mortgages. Thus, the banks couldn't prove they legally held the mortgages in question, and consequently couldn't foreclose. Nor could they obtain title to the mortgaged homes when they purported to buy them at the auction, so they couldn't resell them. Although the court didn't expressly say so, the homes would appear to be still owned by the original mortgage borrowers.

The court's decision implies that, for perhaps numerous securitized mortgages in Massachusetts, foreclosure may be difficult or near impossible. Such a legal conclusion, if applied nationwide, would gum up the recovery of the real estate markets. Even though halting foreclosures will hold homes off the market (because foreclosing banks can't resell what they don't legally own), prospective buyers will be cautious with the prices they pay for the remaining houses on the market. The foreclosure problems will eventually be resolved and foreclosed homes would then be dumped onto the market. This would push prices downward. Anyone who paid an optimistic price today could end up underwater in a year or two. The real estate markets will not stabilize until the foreclosure problems are dealt with. Delaying them, which will be the result of the Massachusetts decision and similar decisions by the lower courts of other states, will only postpone the day of reckoning. And the delay will add to the costs to the banks for having been so careless about documentation requirements.

What makes things worse is that there's more than a foreclosure problem here. If mortgages haven't been legally transferred to trustee banks, the principal process for financing home purchases--securitization--would have broken down. Mortgages being securitized are supposed to be pooled together and held by trustees for the benefit of investors. The big banks that underwrote the mortgage-backed securities would have breached their contracts to the investors by failing to deliver mortgages to the securitization pool. Investors could demand their money back. And refuse to accept losses the banks claim were sustained on defaulting mortgages, on the ground that those mortgages were never validly transferred to the securitization pool and the investors have no liability for losses from mortgages not held by the pool.

Moreover, depending on how the courts interpret the law, the banks might be liable for fraud, especially if bank officers were aware of the documentation deficiencies but sold mortgage-backed investments anyway. That could result in more liabilities, to investors and in SEC enforcement actions. In the worst case scenario, criminal charges could be filed. Since trillions of dollars of mortgages have supposedly been securitized, but now perhaps weren't, the potential liabilities could be very large.

Another problem would come up with mortgages that banks bought, either directly or as part of a securitization offering. If those mortgages have the same documentation problems the Supreme Judicial Court found deficient, the banks wouldn't really own the mortgages (or securitized interests in them), but would have reported phantom assets on their balance sheets. Again, depending on how widespread the documentation problems are, the quantity of improperly reported assets could be tens of billions, or even hundreds of billions.

Banks are now closing their books for 2010, and will be filing their financial statements at the end of March. The impact of the mortgage documentation problems will grow as a result of the Massachusetts ruling. The banks will have to account for these problems, and make a variety of disclosures. The banks' auditors will likely advocate caution; the New York Attorney General's recent case against Ernst & Young over Lehman Brothers' accounting for quarter end repo transactions will surely loom large in their minds. If the banks understate their problems, they (and their auditors) could buy more fraud suits from other classes of investors or government agencies. Stay tuned. This crisis could make our times even more interesting.

Banks Get Murkier

Just as an incipient credit crunch lurks in Europe's weeds, the financial condition of major banks is getting murkier. Spain's credit crisis is mostly a matter of banks being overleveraged (its government isn't in bad fiscal shape, compared to many Western nations). Some Spanish banks may not be marking their real estate assets to market. Spain's government is merging banks rather than liquidating them, which might obscure rather than illuminate the financial weaknesses of the banking sector (kind of like the way grocery stores mix good string beans in with the crappy ones to make lazy shoppers buy some, well, crap).

In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.

U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.

One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.

"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.

Financial Accounting Trainwrecks Coming

With the recession 18 months along and things still getting worse, it's as certain as the sun rising in the east that we'll see some corporate accounting and financial reporting failures. This would be in addition to the well-publicized mess on Wall Street. Even though the recession started because of Wall Street's recklessness and mismanagement, all of corporate America has been hit by falling sales, tightened (or turned off) credit, and difficulties raising capital. A lot of companies are in tight spots, and there surely is plenty of temptation to be overly optimistic in reporting financial results.

It was about at this point during the 2000-2002 stock market and economic downturn that WorldCom and Enron blew up. We'll probably soon see one or more similar trainwrecks. Accounting frauds have a life of their own. Once you cook the books, you usually have to keep cooking the books every subsequent quarter and year. That's because corporate books and records reflect a continuing process, where earlier profits or losses affect today's assets and liabilities. If the profits or losses were, say, freshened up the previous quarter, today's assets could be too large, today's liabilities could be too small, or both. Thus, the company has an ongoing problem that requires it to own up to fibbing (ha, ha, that would be funny if shareholders' money weren't involved), or bake today's financial reports so that there aren't segue problems with the preceding quarter. The longer the shenanigans continue, the greater the chances the fraud will fall apart and be exposed because it gets harder and harder to keep reheating the books. This far into the recession, some frauds could be nearing the breaking point.

Of course, there have been lots of public companies that have been reporting terrible results in the last year or so. Perhaps people are becoming more honest. Ha, ha, just another little joke. Moses lugged stone tablets down a mountain in part because people have long had a tendency to promise rose gardens.

Maybe the much criticized Sarbanes-Oxley Act is keeping more public companies in line. Ouch. A lot of corporate types and their lobbyists wouldn't like that thought. But Sarbox is probably an important reason why we haven't yet seen any large, brand name companies nabbed for accounting fraud.

However, with the economy doing so badly, it's surely just a matter of time before a big financial accounting scandal erupts. If we're lucky, it will involve high-maintenance mistresses, $5,000 umbrellas, $20,000 bidets, $5 million extreme executive office makeovers, senior executives sharing flights to posh destinations on the company jet with attractive younger subordinates for a corporate retreat (or something like that), and corporate coverage of all operating costs of the CEO's thoroughbred farm, along with enough additional cash to cover the CEO's income tax liabilities resulting from the company's purchases of hay, oats, and so forth. The real action in financial reporting frauds is in the manipulation of accounting reserves, overly generous interpretations of the definition of revenue, near mystical processes in the closing of the company's books where good numbers magically appear, so on and so forth. But that stuff is boring. And the thought of all the employees who lost their 401(k) accounts because their company stock proved worthless is depressing. The fun is finding out what all those hard charging, overbearing, disdainful executive types did with the moola after they picked the shareholders' pockets. After all, if you can't find a laugh in all this stuff, you might have to cry.