Making Sense Of The Subprime Debacle

Friday, February 1, 2008 - 01:00

Editor: The subprime and resulting credit-availability problems seem to be just the latest in a series of crises that have affected the capital markets. Can you draw any parallels between what is happening now and what happened during the financial statement problems at the start of this decade?

Girgenti: The issues we are seeing now in the subprime area have many parallels with other recent corporate crises, including the financial reporting and tech stock crises of the early 2000s and the savings and loan crises of the 1980s. Each involved a pattern in which there was financial exuberance on the part of investors and others in the financial sector. In the tech stock crisis, the exuberance was over the attempt to meet analysts' expectations about earnings. We saw a very vibrant stock market, especially in the dot.com area. The exuberance in the subprime crisis is over the increasing rise in the value of homes and the increasing opportunity to securitize mortgage instruments in order to take some of the risk away from the banks and financial institutions. In both instances, many red flags went unheeded.

Editor: Can you provide some perspective of how you believe we got into this current dilemma?

Girgenti:A s time goes on, we will gain a better understanding of what actually went wrong. During the past decade, Wall Street built a multi-trillion dollar market in securities, backed and supported by mortgages, which were sold not only in the U.S. but also globally. For the borrowers it was axiomatic that as long as the price of their homes rose, it was safe to borrow. Wall Street applied the same logic - the value of the home would never fall nationwide. It was assumed that the one payment that borrowers would always make would be their mortgage payment. Furthermore, there developed a tremendous desire as a matter of public policy to make homeownership more available to the American public. A securities business was built around this premise.

As we know, many new entrants became involved in the mortgage business. New types of mortgage instruments were introduced - adjustable rate and interest only loans - which were marketed very aggressively, sometimes to borrowers who had little or no credit.

Editor: What is your opinion on where all this is headed from a regulatory and prosecutorial point of view?

Girgenti: We shall see over the coming months. Not only litigation but also government investigations will unravel some of the causes of the crisis. Clearly, in the mortgage origination area there were extremely lax underwriting standards, at best, and, at worst, fraud and criminal behavior. There may also have been predatory lending practices. It has been reported that the FBI has opened more than 1,200 mortgage-fraud cases in fiscal year '07, nearly triple the number in 2003. Convictions in 2007 more than doubled from 2006. The U.S. Attorney's office in Miami recently filed charges alleging that a fraud ring of more than 30 brokers, sellers and appraisers who conspired to buy and sell homes at inflated prices. We may see that there were conflicts of interest and potential fraud in the appraisals of many of these homes in order to allow for additional equity, the basis for second mortgages, thus allowing owners to extract equity from their homes resulting in their use of funds to finance other assets. The practices of financial institutions in securitizing debts will be scrutinized closely. We already know that the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) are making inquiries to determine whether adequate disclosures were made about the bundling of subprime loans with less risky loans in order to obtain investment grade credit ratings. Inquiries are being made into what credit agencies knew and what they did to properly rate these securities. The crisis seems to have come to a head with those financial institutions that have now had to write-off the valuations of mortgage instruments. So far nearly $100 billion in losses has been written-off, and the consequences have been pretty severe for the CEOs of some of these organizations. With year-end filings there may be even greater write-offs. Much litigation has been generated owing to these early disclosures. The National Economic Research Associates (an organization of economists) recently released a report indicating that nearly 200 class actions were filed through December 15, 2007, 40 of which were securities class actions related to subprime mortgages. In 2006 there were no shareholder class actions related to subprime loans.In summary, we have seen a lot happen in a very short time but we still do not know the full extent of the problem.

Editor: Why not use the same criteria for mortgage brokers and bankers as that used for securities brokers - restrict sale of certain securities to only those investors who can withstand the risk?

Girgenti: The problem is that the regulatory scheme is disaggregated, existing on both federal and state levels. Many states that have tried to impose some regulation on who can borrow and what the borrowing practices can be have been restricted because of federal comity clauses.

Editor: Would low interest rates have contributed to the problem?

Girgenti: As long as the housing market was good there was no problem. But that did not last. In a sense the result was the perfect storm - a combination of a decline in the housing market and very risky loans being made to a risky group of people. We saw the highest rate of foreclosures in the history of the mortgage industry - approximately $6 trillion worth of housing wealth was wiped out. Generally, housing prices have decreased about 10 percent but as much as 30 percent in some areas.

Editor: Now that the regulators are beginning to look into the subprime crisis, and litigation is on the rise, where do you see the role of the forensic accountant?

Girgenti: The role of the forensic accountant is critical. Most of the team members that make up a forensic accounting group, such as the one we have at KPMG, come from a variety of backgrounds and have different expertise. Some have experience in providing litigation support, others in aiding investigations by examining books, records and documentation about lending, disclosures and how these instruments were ultimately valued. But among the team members are also many former regulators, former law enforcement officials from the various investigative agencies and the DOJ, and the FBI. This relevant expertise can assist client organizations in assessing what happened, in determining the facts, and in understanding both their potential litigation exposure and potential regulatory enforcement exposure. In order to assist financial institutions in putting together the records that are being subpoenaed or will be part of the discovery process, organizations facing these issues are turning to large firms such as KPMG to help them manage those litigation and investigation processes.

Editor: When you conduct your investigations you will be reviewing underwriting standards and whether or not real due diligence was applied. Are there any established benchmarks you can look to that would help you in measuring the controls that these organizations have in place?

Girgenti: There are many benchmarks. We would examine the origination of the loans, the lenders' responsibilities, the amount of due diligence that should have taken place, and whether the securities were properly evaluated and adequate disclosures of risks were made. The latter is one area that is going to be examined, particularly by the SEC.

Editor: How do you develop an accounting trail from the origination of the mortgages and the many derivatives that were used in their bundling into CMOs and CDOs and the cross-selling of securities to the final recipients?

Girgenti: I think what we are going to find in the first instance is that there probably will have to be a reconstruction of circumstances at the origination stage, since much of the record-keeping appears to have been inadequate. I would suspect mortgage applications were given to lenders who may have filled in some information without checking for accuracy. There will be little documentation. With more documentation, accountants can begin to develop the trail of record-keeping and how the money flowed. We will have to unravel the pieces of the package, and then trace them back to their origins to determine the level of risk at the time of the underwriting process. Once identified, we'll try to determine whether those risks were disclosed or if there was an attempt to conceal the level of risk.

Editor: And what accounting practices were used by the major investment houses now taking huge write-downs?

Girgenti: What happened essentially is that a year or more ago there was a market for the securities, and the investment houses were able to value those securities based upon what they could sell them for in the market, known as "marking to market." Beginning in the third quarter of 2007 there were fewer buyers and as a result the securities no longer could be valued at market rates. So, what most of the financial institutions did was create models to value these securities. One of the questions is: Were these models properly constructed? Were these models adequately validated, and did they truly reflect the value of the security? These models are very sensitive. Very slight variations in assumptions could cause huge changes in valuation. For example, if the valuation model was based on a default rate of 10 percent, you would get one level of valuation while if the default rate is 15 percent, it changed all of the results based on a single assumption, and there are many, many assumptions that go into these models. This is a major factor that is bringing about the write-downs.

Editor: The models are really artificial constructs in a sense?

Girgenti: They are artificial to the extent that one would prefer and normally mark a security to market pricing, but when you have no market for these securities, you have to find another means. That is where the models were used. To what extent did the financial institutions adequately build their models and validate them? I am not an expert on models, but what we do in these matters when we have an investigation is that we bring into the forensic team experts to help us understand the models better.

Editor: What future measures would you suggest for rectifying the absence of good controls on the part of the mortgage bankers and underwriters of CDOs, the outside firms or CDO managers, and the credit agencies?

Girgenti: I think two things will happen. There is currently a lot of fact finding going on - what happened, why it went wrong, who was responsible. I think we are in that stage right now. Once done, there will be a chance for the involved organizations - the lending institutions, securities companies and rating agencies to begin to look at what happened in their own risk management. Was it lax controls or an absence of adequate controls? Did individuals override controls?How much did the human element come into play? In examining the controls and processes, judgments will be made to determine whether they were effective enough, should they be changed or should new controls be created. If it was it a people issue, then firms need to take up issues of training and seeing that the right people are in the right positions. Very often in situations like this, as in the financial reporting crisis, I think we are going to find that people do not necessarily intend to do something fraudulent, but where you have strong incentives and pressures and where you can rationalize behavior based upon good objectives - "we want to make housing available to more people", etc. - sometimes you create a culture of rationalization that really blinds you to the potential risks and the red flags that on hindsight were perfectly obvious.

Editor: What role can forensic accountants play in helping to set up the controls for the future so that this does not happen?

Girgenti: What we have done in the past and what I imagine will happen here as well, is that as we conduct our investigations, we will also be evaluating those controls and making recommendations to management about what could be done to improve their processes in the future. So that will be a normal part of the work that we will be engaged in over the next few months as we look at more and more at these issues from both the litigation and investigation perspective.

Editor: And what else is needed to restore confidence in the financial markets?

Girgenti: We have to make sure that we have the right disclosures as to what happened. I think you will see a lot of legislation on both the state and federal level. I think you are going to see that since this has affected so many people on so many levels, it is going to be a situation where there will be a great effort to change and fix the regulatory environment. What were the agencies doing? Where they sufficiently vigilant? Did they have the right regulatory rules and regulations in place to be able to do their job effectively? Everyone - the regulators, the rating agencies and the financial institutions - will have to partake in a certain amount of Monday-morning quarterbacking in order to determine what more could have been done, just as was done after the tech stock and S&L crises.

Please email the interviewee at rgirgenti@kpmg.com with questions about the interview.