In Washington Mutual Inc. we have just witnessed the largest bank failure in U.S. history. If we consider the anatomy of a bank failure, a question emerges: What was the role of the outside independent auditors?
These are the professionals reviewing, auditing, and certifying on a year-round basis the soundness of the entity's financial statements. The outside auditors are required to bring a "healthy skepticism" to the representations of management. Yet in some cases they collect a large fee and provide little more than a clean bill of health to an unhealthy client.
In his speech explaining the financial crisis, President Bush cited Fannie Mae and Freddie Mac as a big source of the problem — they "fueled the market for questionable investments and put our financial system at risk." For nearly 30 years, however, Fannie Mae's auditors were KPMG LLP. Fannie Mae fired the firm in 2004 when the auditors failed to report "lapses" in accounting until after a government report warned of weaknesses and the Securities and Exchange Commission's chief accountant ordered the financials restated. Fannie sued its auditors in December 2006.
Lehman Brothers was audited by the New York office of Ernst & Young. On Jan. 28, 2008, the firm gave a clean bill of health to Lehman for the year to Nov. 30, 2007. The auditor's report says, "Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances."
Ernst & Young gave Lehman a clean bill of health in a July 10 report to the SEC for the quarter ended May 31. Despite the growing financial crisis, auditors expressed no reservations about the value of the company's derivatives or any scenarios under which the company might be unable to meet its obligations. Two months later, Lehman collapsed.
Likewise, the insolvency examiner's report on the collapse of New Century Financial Corp., once the second-largest U.S. subprime mortgage lender, concluded that its outside accounting firm "contributed to certain of these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitating the company's departure from applicable accounting standards." In particular, the report focused on concerns as to the adequacy of the loan buy-back reserve for securitized loans.
Some argue that large fees paid over extended periods pressure auditors to acquiesce in management decisions.
The calls for better internal controls and auditor independence were, of course, central themes in the 2002 passage of Sarbanes-Oxley, though certified public accountants have been reluctant to define "auditor independence." An early bank failure involving securitized loans was of NextBank, which led to an indictment of the auditor and a plea bargain for violations of Sarbanes-Oxley, as well as to shareholder suits. In its criminal complaint, the government stated that two Ernst & Young auditors altered the working papers and electronic records "that concerned Nextcard's allowance for loan losses and its securitization of receivables."
Both Sarbanes-Oxley and generally accepted auditing standards bring sharp focus to at least some of the recent institutional failures by highlighting standards — too often ignored — intended to avoid precisely these failures. A fertile area will no doubt be the inherent risks of nonbanks' owning banks because of the interplay between potential earnings management by a bank holding company and the adequacy of a bank's reserves.
Whereas safe and sound banking practice requires reserves that reflect losses inherent in a loan portfolio, higher reserves means lower reported earnings. A basic principle of financial accounting standards requires not only accurate financial statements but also the recording of loan losses.
So were the recent risks foreseeable? Should they have been reflected in the reserve methodology of the affected banks? Certainly the risks of nonpayment, especially of subprime loans, have long been well known. But so too are the risks of a downturn in the economy and the dangers of an overconcentrated investment in mortgage-backed securities.
The risks inherent in securitizations of debt were known to industry and auditors for years. Though seen as a way to remove loans from the originating bank's balance sheet, securitization programs in many cases also had the effect of masking true risk and creating a system in which loan quality became secondary to quantity. Reserves and reserve methodology were expected to reflect these risks.
In 1999, for example, the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. issued guidance on asset securitization that began: "Recent examinations have disclosed significant weaknesses in the asset securitization practices of some insured depository institutions" and specifically identified "inappropriate valuation and modeling methodologies."
A joint statement on loan-loss reserves issued by the SEC, the OCC, the FDIC, and the Office of Thrift Supervision in 1999 is one of many other admonitions: "The loan-loss allowance (ALLL) should take into consideration all available information existing as of the financial statement date, including environmental factors such as industry, geographical, economic, and political factors." The FDIC and OCC have consistently given detailed guidance, describing ALLL as "one of the most significant estimates in a financial institution's financial statements."
The independent auditors charged with certifying the accuracy of an institution's financial statements will no doubt point to management, as they did in the case of Fannie Mae, or argue that the most recent risks were unforeseeable. But were they?
If the independent auditors are held to the standards of competence, independence, and diligence set forth in the Financial Accounting Standards Board's rules, statutes, and case law, their role in this crisis will continue to unfold in the courts and future legislation.
