In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Tuesday, May 01, 2007

The New York Times Needs a Business Reporter

by Tanta on 5/01/2007 08:00:00 AM

I really don't think apologists for the sorry state of business reporting should start in on me today. Nobody, I'm sure, forced Lynnley Browning of the New York Times to write a story on mortgage gain on sale accounting.

Let's remember the ground rules of media criticism. The success or failure of a given piece of writing depends on what it is intended to do and for whom. If it is intended, oh, say, to explain a fairly advanced accounting issue to non-accountants, who might care about that, say, because they are or might become investors in REITs, then the article is successful only if, by the end, the non-accountant understands the accounting issue and can apply this knowledge reliably to his or her own investments. If the purpose of the article is to accuse someone of violating accounting rules, just for purposes of entertaining people who like to read about corporate nefarious conduct, then, given the seriousness of the charge here, the article is not successful unless it is quite accurate and clearly makes the case for a willful violation of accounting rules rather than, say, a bad forecast of the market and lax due diligence on its own loans. Right?

The article, "Accounting Said To Hide Lender Losses," purports to discuss the misuse of gain-on-sale accounting. We begin:

The technique promoted by Mr. Gotschall, who stepped down as chief financial officer in 2006 but continued as vice chairman of the board of directors, allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors.

The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through door, were then used to make more loans to risky home buyers.

Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors.

Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.

You tell me: doesn't it sound here as if the claim is that "gain on sale" was reported in a case where no sale settled in cash happened? Does it not sound as if this has something to do with securitizing mortgages? If you were a non-expert, what would you think here?

The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.

Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.

“The thing about gain on sale accounting is that you can create a machine that just manufactures earnings out of thin air,” said Richard Benson, an expert on securitization and president of the Specialty Finance Group, a financial broker.

Still with us? This gain on sale thing sounds pretty shady, doesn't it? It was an Enron thing? That's bad.

New Century, of Irvine, Calif., made money in two ways, and it used gain on sale for both.

In the first way, called “whole loan sales,” it sold pools of loans to big Wall Street investment banks. New Century made money by keeping the difference between the higher interest rates paid by subprime borrowers and the lower rates offered to the banks.

In the second way, New Century chopped up its other loans to home buyers, repackaged them into securities for sale to investors, a process called securitization. New Century then kept the pieces expected to earn money in the future, called residuals, for itself.

I suppose that if you know nothing about the business, you might think that a "whole loan" is always part of a pool, and that a securitized loan must be something other than "whole," so that must mean that the loan gets "chopped up" and therefore these securities are full of loan fragments. Someone who knows might have explained to this reporter that the term "whole loan" means the loan has not been securitized; the owner of that note owns all of it. As opposed to a securitized loan, wherein an investor owns a pro-rata share of a pool of loans, not individual whole loans. But I couldn't guarantee that this explanation would stick, in the present context, since this reporter seems dead-set on being confused about how loans get sold.

For both types of business, gain on sale allowed New Century to accelerate its profits. In 2005, the last year for which it has reported annual figures, New Century recorded income from gain on sale accounting of nearly $623 million out of a gross profit that year of $1.4 billion, according to its securities filings.

For the whole loan sales, New Century recorded up front the cash gains.

At the same time, New Century guaranteed to Wall Street investors that if the whole loans did not make as much money as it predicted — if home buyers were late with or defaulted on payments — New Century would buy back the impaired loans from the banks.

But through overly rosy forecasts, New Century underestimated how many impaired loans it would have to repurchase and how much it would need to have on hand to do that.

"If the whole loans did not make as much money as predicted"? Someone is so desperate to tie gain on sale to inflated earnings that she is wandering way far off the reservation when it comes to repurchase warranties. In any case, we have conceded here that New Century did actually record a gain "when cash came in the door." Could you forgive a reader who isn't already expert in accounting issues for being mildly confused here? Were we to introduce the concept of reserves for future liabilities (those potential repurchase warranties that all sellers of whole loans have), this might possibly clear up a little: there are cash proceeds from a sale, and there are reserves for future liabilities, and one tends to reduce the other on the books. It's the general accounting idea that no sale of an asset is "final" until there is no longer any residual liability; if there is such residual liability, that must be reflected in the gain/loss calculation.

In its second use of gain on sale, New Century booked future earnings based on its estimates of what it expected to earn from the pieces left over from the securitizations.

New Century’s problem, according to Zach Gast, an analyst with the Center for Financial Research and Analysis, was how it used gain on sale for its whole loan business. In the late 1990s, in the last downturn for subprime lenders, most abuses of gain on sale involved the securitization side.

I give up. Did New Century book gain on sale for a residual tranche of a security, or not? (Really, I'd like to know.) Are we talking whole loans here, or not? Is someone confused about the difference between mark to market and gain on sale, or not?

As the subprime market started to melt down last fall, New Century was forced to honor its guarantees to investment banks and other institutional investors and repurchase the impaired loans. It resold the loans at a loss.

But, Mr. Gast said, when New Century repurchased the loans, it recorded them at values that exceeded the fire-sale prices. In other words, New Century did not recognize upfront the losses in the impaired loans.

Mr. Gast said that New Century has “a huge number of repurchased loans that they haven’t taken losses on.” Under gain on sale accounting rules, “you should be recognizing the loss at the initial sale of the loan,” Mr. Gast said, adding that if you underestimate potential losses, you have to recognize those losses when you are forced to repurchase the loans — something New Century did not do.

At the initial sale of a loan, I should recognize the loss I would take 1) if I had to buy it back at par and 2) if I then had to resell it for less than par? I certainly always reserved for losses. If my losses were more than I reserved for, I certainly recognized that additional loss. On no planet did I ever take that additional loss on the original sale at the time of the original sale, since if I'd seen it coming, I'd have reserved for it. I guess I should be in jail with those Enron guys.

Ah, but in the last two paragraphs of the article, we get this breath of fresh clue:

Stephen Ryan, an accounting professor at New York University and an expert on securitization accounting, said that last year New Century had “underestimated the allowance for repurchase losses, which means that they overstated the gain on sale.”

“They had had a history of doing so well previously, so it’s a question of whether they didn’t expect this or of something more nefarious on the part of senior management,” Professor Ryan said.

I coulda got an A in Professor Ryan's class. What I don't understand is why I waded through this long ridiculous article to get to the point where we finally realized that we are talking about insufficient allowance for loan loss reserves. Toss out all these sinister references to Enron and chopped-up loans and subprime lending and gain on sale involving future income and it comes down to New Century having had way too much confidence in their loans and in future price fluctuations in the secondary market to have reserved sufficiently. Well, that certainly did cause them some problems. It is possible--indeed, it is likely, in my view--that New Century probably knew it should have upped its reserves but did not do so. That is bad, bad, business. I have yet to figure out why we are insisting that it's really an accounting problem.

But what did we learn about gain on sale accounting anywhere in this article except for the fortunate last-paragraph intervention of the good Dr. Ryan? Maybe we'll get lucky and Dr. Ryan will start writing for the Times. Until then, I guess the blogs will be the place where we try to remember that bad economic and business forecasts and a failure to control your loan pipeline to minimize your repurchase liability are not the same thing as cooking the books, and it matters that we understand this distinction.