Settling For Silence: KPMG Closes The Books On New Century And Countrywide

And in the naked light I saw
Ten thousand people maybe more
People talking without speaking
People hearing without listening
People writing songs that voices never shared
No one dared
Disturb the sound of silence

It’s no coincidence that settlements were announced less than a week apart for both New Century and Countrywide.  As two of the earliest subprime failures, all parties were probably anxious to clear some clutter and make room for other matters.

Fortune, August 3, 2010: A federal judge signed off Monday on a settlement under which former shareholders of the troubled mortgage [originator] will get $624 million, the Los Angeles Times reported. The plaintiff lawyers called the sum the largest shareholder settlement since the mortgage meltdown started in 2007.

Bank of America (BAC), which acquired the mortgage lender two years ago and has since stopped using the Countrywide name, will pay $600 million and accounting firm KPMG will pay $24 million.

The Countrywide settlement comes just days after officers and directors in another big subprime class action agreed to pay $90 million to settle claims in that case. New Century co-founder Brad Morrice said then that he hoped the settlement “would make up for some of the losses suffered and provide closure to me and the shareholders.”

Closure isn’t coming any time soon for Countrywide. Bank of America’s annual report provides a list of legal cases tied to Countrywide that covers parts of three pages.

Nor is [Angelo] Mozilo [Countrywide former CEO] out of the woods. He and two other former Countrywide execs still face a Securities and Exchange Commission fraud suit that centers on familiar allegations, that the company duped shareholders by failing to disclose the growing risk of its subprime lending business.

Countrywide was not, strictly speaking, a failure.  Bank of America agreed to buy them in January of 2008, before the bigger “failures” of Lehman, AIG, and Bear Stearns changed the language describing our economic challenges from subprime crisis to full-blown, “is-it-a-second-coming-of-the-depression-well-at-least-it’s-a-serious-recession” financial crisis.

Reuters, January 11, 2008: “Regulators and politicians in Washington are very keen to see troubled lenders find solutions to their problems, experts said. Egan said the Federal Deposit Insurance Corp did not want to deal with the potential failure of Countrywide. And Bove said: “The people in Washington must be having fits about what would happen if a bank or a thrift with $55 billion in assets went under, so I think they pushed Countrywide hard in this direction.”

I started writing about the subprime crisis in early 2007.  Countrywide was already spinning out of control.

“Countrywide, the nation’s biggest mortgage lender in terms of loan volume, said it faces “unprecedented disruptions” in debt and mortgage-finance markets that could hurt earnings and the company’s financial condition. In its quarterly filing with the SEC, the bank said “the situation is rapidly evolving and the impact on the company is unknown.”

KPMG is their auditor and gave them a squeaky clean opinion in 2006.

By mid-2007, New Century was giving KPMG a migraine and Deloitte had its hands full with American Home. By November, Deloitte was also worried about Bear Stearns and Merrill Lynch.

Countrywide became a black hole for Bank of America.  The bank was still gushing red ink in March, while due diligence continued, before the deal closed.

This was unexpected, they said.

Countrywide’s Mortgage Woes Deepen

Countrywide Financial Corp.’s mortgage portfolio continues to deteriorate rapidly as defaults increase and home prices fall, a securities filing shows…The lender also said it took a big loss in the fourth quarter on home-equity lines of credit. 

Further losses may lie ahead…Countrywide was blindsided during the quarter by obligations on home-equity lines of credit that it had sold to investors in the form of securities…Countrywide said the likelihood of such a situation was “deemed remote” until late 2007. It blamed a “sudden deterioration” in the housing market. As a result, it recorded a $704 million loss to cover the estimated costs of its obligations on the lines of credit…A Countrywide computer model used to gauge risks on these securities didn’t take into account the possible effects of exceeding the loss levels that cut off reimbursements…

Much has been written about Countrywide and its failings. There was enough evidence, I suppose, in re Countrywide Financial Corp. Securities Litigation, 07-05295 that “former Countrywide Chief Executive Officer Angelo Mozilo and other executives hid the fact that the company was fueling its growth by letting underwriting standards deteriorate” to scare the defendants away from a trial.  Mozilo is still subject to SEC civil suits and potential criminal indictments for fraud. But Countrywide, its executives and its auditors, KPMG, were not subjected to a bankruptcy filing and a bankruptcy examiner’s report like New Century was.

The judge in the Countrywide case has agreed to accept KPMG’s acknowledgment of $24 million of the $624 million liability or about 4% culpability. Without a bankruptcy examiner’s report such as the New Century report or a trial, we will never know the full extent, if any, of KPMG’s knowledge, negligence, aiding or abetting of the alleged Countrywide fraud.

Michael Missal’s New Century bankruptcy examiner report was a tour de force, the complete anatomy of a pre-financial crisis fraud, including several smoking guns pointed at auditors KPMG. Let me remind you that pros like Mr. Missal, who cut his teeth on the World Com bankruptcy and Arthur Andersen, drew the map used by Anton Valukas and the Lehman bankruptcy examiner’s report. Missal set the standard for Valukas’ colorable claims against Ernst and Young for professional impotence and complacency when faced with Lehman’s Repo 105 activities.

Paul Barrett of Business Week reminded us, too, of the important role of the virtuoso bankruptcy examination when setting up Trustees’ litigation and criminal indictments:

“The unavoidable question is whether the SEC will hold someone responsible for what happened at Lehman,” says Michael J. Missal, a partner in Washington with the law firm K&L Gates. Missal, who makes a living defending companies faced with government investigations, is another of those attorneys capable, when asked by a court, of transforming himself into a public-spirited, if generously compensated, pit bull. He published an impressive bankruptcy examiner’s report of his own in 2008 in the case of New Century Financial, one of the subprime mortgage giants that, with Wall Street’s assistance, recklessly inflated the housing bubble.

I spoke to Michael Missal recently.  He told me that to have a successful bankruptcy examiner’s engagement, the examiner must be:

1) Thorough

2) Accurate

3) Fair

4) Objective

5) Timely

I think his New Century report, clocking in at 551 pages plus appendices, did a great job of explaining, for the first time, difficult issues we would see so many times in later subprime and financial crisis litigation.

The report also really nailed the auditors, KPMG.

Bloomberg, April 2, 2009: KPMG’s audits of New Century violated both professional standards promoted by its international body and regulatory requirements, according to the complaint. Dissenters within the auditing firm were silenced by senior partners to protect the firm’s business relationship with New Century and KPMG LLP’s fees from the company.

One KPMG specialist who complained about an incorrect accounting practice on the eve of the company’s 2005 annual report filing was told by a lead KPMG audit partner “as far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off,” the complaint said.

KPMG’s regulator, the PCAOB, has told us over and over that KPMG will fudge on behalf of their clients when it comes to auditing estimates of loan loss reserves. That claim was the smoking gun in the New Century litigation.

Steven Thomas, the attorney for the New Century Trustee, thought so much of this smoking gun he put a $1 billion price tag on the litigation by the Trustee against KPMG.

He said at the time:

Bloomberg, April 2, 2009: “Once an auditing firm lacks independence, then their audits aren’t worth the paper they’re written on,” Steven Thomas, an attorney for New Century Trustee Alan M. Jacobs, said yesterday in an interview. “KPMG had a duty directly to New Century and a duty directly to the public. It was acting as a gatekeeper for a company that was at the center of the housing boom.”

The SEC recently settled their litigation against the New Century defendants, and so did a group of shareholders who brought a class action against the same defendants, including KPMG.  KPMG agreed to pay $44.74 million of the $125 million settlement, or a much bigger percentage of the liability than in the Countrywide case.  That’s big bang for the buck on the bankruptcy examiner’s report when it comes to the auditor, assuming that the Trustee is expecting even more from their individual suit against KPMG. Both Mr. Thomas and the New Century Trustee have told me their case is also settled.

The truth about KPMG’s role, exhumed during Mr. Missal’s efforts, will be re-buried.

How many others of the financial crisis bankruptcies, bailouts, takeovers and nationalizations were subjected to a New Century/Refco/Lehman style bankruptcy examiner’s report, complete with details about the auditors’ role?

Bear Stearns: No

Merrill Lynch: No

Citigroup: No

Bank of America: No

AIG: No

Wachovia: No

GM: No

Ongoing litigation between the shareholders of Washington Mutual and their acquirer as a result of a bankruptcy and takeover by JP Morgan has forced the assignment of a bankruptcy examiner to that case.  Joshua Hochberg – of Refco bankruptcy examiner report fame – is the man who has to get it all done in just a couple of months.

Washington Mutual – like Bear Stearns, Merrill Lynch, American Home, and GM – was audited by Deloitte.  I will be very interested to see if Mr. Hochberg comes up with any colorable claims related to Deloitte.