According to the lawsuit, KPMG’s internal documents reveal that the firm knew there was a problem with New Century’s loan loss estimates because the number of loan repurchases had more than doubled from 2004 to 2005, rising to $332 million. Nonetheless, KPMG failed “to expand its procedures or testing of the company’s reserves,” the complaint alleges. New Century resold many of its loans to other financial institutions with a promise that it would repurchase them in the event of early defaults and some other conditions.
“KPMG signed off on models for the reserves that were just plain wrong,” said Steven Thomas, the lawyer who filed the case in the U.S. District Court in the Southern District of New York and Superior Court of California in Los Angeles County. “And instead of being a company that was making money, New Century was actually losing money.”
In February 2007, New Century said it needed to restate earnings for the first three quarters of 2006 because it had failed to properly estimate reserves it might need to cover obligation under its repurchase agreements. A month later a majority of its lenders declared New Century in default, accelerating its obligation to repurchase loans for a total of $8.4 billion. Without enough money to buy back the loans, New Century turned to bankruptcy.
During recent years, lending institutions across the nation failed to budget enough money to offset potential losses on bad loans, said Matthew Anderson, a banking analyst at Foresight Analytics, an Oakland, Calif., consulting firm.
“What you saw happening is the banks just didn’t have enough capital to take those losses, so they were stuck,” Anderson said, noting that nearly all the collapsed banks didn’t put aside enough money.
In the oversight board’s report on deficiencies, it cited a failure to perform proper checks to verify that a lender’s allowance for loan losses was reasonable. Auditors failed to understand the lender’s methodology, didn’t test the accuracy of underlying data, didn’t question key assumptions or relied on outdated appraisals. Some firms simply didn’t examine the loan loss estimates at all, according to the report.
If auditors had pushed bankers to shore up reserves when signs of the housing downturn emerged two years ago, lending institutions might have been reluctant to make so many subprime and alt-A loans to borrowers with more credit risk, experts say.
“Nonprime lending could not have existed with appropriate loss reserves,” said William Black, a professor of economics and law at the University of Missouri and a former senior banking regulator during the savings and loan crisis.
Nonprime loans often lose money or default and would have required much larger reserves, according to Black.
The oversight board’s inspectors also discovered numerous other auditing lapses. Problems ranged from a failure to investigate potential fraud to snafus in measuring cash flow. In one instance, Crowe Chizek and Company, a subsidiary of Crowe Group, “failed to appropriately respond to two indicators of fraud risk,” including a “financial relationship” between a senior executive at a lender and someone borrowing money from the lender, according to a 2005 inspection.
In another incident, Crowe auditors scrutinized a lender’s portfolio of auto loans. It turned out that auditors couldn’t locate 25 percent of the borrowers, suggesting something might be amiss. Still, the auditors “failed to identify this as a potential indicator of fraud” or conclusively prove that the loans were legitimate, the inspection report notes.
Crowe declined comment.
Rezaee, the University of Memphis professor, said faulting auditors only goes so far.
“You cannot blame the accounting profession for this financial crisis,” said Rezaee. “Should they have done a better job in seeing these problem areas and these warning signs and telling investors about them? Yes. They were not helping to detect these problems early on.”
Anderson studies national data and said there is more pain ahead for banks. The financial downturn has devastated the commercial real estate industry. Yet, compared with the recession of the early 1990s, banks have only set aside about half as much money for commercial mortgage loans that go bad.
“In my view that’s pretty thin,” he said. “The losses this time around are going to be far worse.”
ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest. ProPublica is led by Paul Steiger, the former managing editor of The Wall Street Journal. ProPublica's lead is provided by the Sandler Foundation and other philanthropies.
Jake Bernstein worked at The Texas Observer, an investigative biweekly, for six years, and as its executive editor since 2004. Earlier in his career, he was a staff writer for the Pasadena [Texas] Citizen and then for the Miami New Times. His work has received numerous state-level and national journalism awards, and The Texas Observer, under his leadership, was named Best Political Magazine of 2005 by Utne Reader. Bernstein is co-author of Vice: Dick Cheney and the Hijacking of the American Presidency (2006).