Deloitte Disappoints – A Case of Subprime Interruptus

It looks like Deloitte has borrowed a few tricks from PwC and left one of its clients feeling unsatisfied. They must have also learned a few lessons from their experience at American Home – Insist on protection or pull out!

(Link is from a site that goes behind the Times subscription wall.)

So This Subprime Lender Walks Into an Audit…
“The auditor got cold feet, and the company may die.

It would no doubt be interesting to hear a tape of conversations last week between the senior management of NovaStar Financial, a subprime mortgage lender, and its auditors at Deloitte & Touche.

NovaStar, like many of its competitors, has seen its business model blow up this year. But in mid-July it got a lifesaving $48 million infusion of capital from two institutional investors, with a promise of $101 million more to come.

Now Deloitte has effectively revoked its audit of NovaStar — evidently without claiming that any number in the report was wrong — and the investors do not have to put up the cash.

Deloitte seems to have invoked a little-known auditing standard that says an auditor cannot allow a previously audited financial report to be cited by a company if there are subsequent events “of such a nature that disclosure of them is required to keep the financial statements from being misleading.”

Deloitte won’t talk, but by NovaStar’s account, the auditors’ qualms did not surface until last week, when Deloitte said it thought that the 2006 annual report should have more disclosures on business problems and that there were questions about the company’s ability to continue as a going concern. But even with those changes, Delolitte was not prepared to quickly recertify the financial statements. …NovaStar holds a special place in the market not because of the problems it has encountered, which are similar to those of others in its business, but because of the long and bitter battle waged between investors who believed in the stock and those who did not. …It was NovaStar that Patrick Byrne, Overstock’s chief executive, pointed to when he began what he called his “jihad” against naked shorts. There is a suit pending by some NovaStar shareholders against major brokerage firms, charging that they aided naked shorting and thus cost the investors money…

In its prime, NovaStar appeared, to its fans anyway, to be a money machine…Critics asserted NovaStar used questionable accounting to produce those profits as well as other dubious business practices. One of its current problems is a $46 million judgment won by a competitor who said NovaStar conspired to drive it out of business. …NovaStar, like many other companies, sold mortgages on terms that left it with some of the risk. Just how much profit it reported depended on a series of assumptions about those risks.

“If our actual experience differs materially from the assumptions that we use,” NovaStar said in the annual report that Deloitte is no longer willing to certify, “our future cash flows, our financial condition and our results of operations could be negatively affected.”

That warning was prescient. With mortgage defaults rising, it appears NovaStar paid dividends from ephemeral profits.

The REIT status that helped make NovaStar attractive is now its albatross. … At current market prices, the entire company is worth far less than $100 million, so how can it give out preferred stock worth more than that?


The $48 million July investment in NovaStar, made by funds affiliated with the Jefferies Group and the MassMutual Corporation, seemed bold at the time. Now it seems foolish, providing for the purchase of preferred stock convertible to common at $28 a share…”