Auditors Aren’t Forcing Full Repurchase Risk Exposure Disclosure

PwC And KPMG Are Overexposed

KPMG, and PwC, audit most of the banks being pushed the hardest to repurchase poorly or fraudulently documented loans they sold to the GSEs – Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

KPMG has settled claims as a result of their role as auditors for Countrywide and New Century. That allows them to concentrate on the next round of litigation surrounding repurchase risk. This phase will be centered, for KPMG, around Citigroup and Wells Fargo/Wachovia.

In March 2007 I warned you for the first time about repurchase risk. We were talking about New Century Financial.

Then I told you in September of 2009 about the risk to Wells Fargo/Wachovia.

Did Wells Fargo’s Auditors Miss Repurchase Risk?

How does the New Century situation and KPMG’s role in it remind me of Wells Fargo now?  Well, in both cases, there’s no disclosure of the quantity and quality of the repurchase risk to the organization…The lack of disclosure of this issue here mirrors the lack of disclosure in New Century and perhaps in other KPMG clients such at Citigroup, Countrywide (now inside Bank of America) and others.

How do I know there could be a pattern? Because the inspections of KPMG by the PCAOB, their regulator, tell us they have been cited for auditing deficiencies just like this.  Do we have to wait for another post-failure lawsuit to bring some sense, and some sunshine, to the system?

In January of 2010, the WSJ reported that JP Morgan and Bank of America – both audited by PwC  – were vulnerable to potentially material losses if forced to repurchase mortgages from Fannie Mae (audited by Deloitte) and Freddie Mac (audited by PwC).

The story has been building momentum slowly all year.

Most recently the Wall Street Journal printed a list of the banks with the largest repurchase risk exposure to the Federal Home Loan Banks.

Federal Home Loan Banks in Pittsburgh, Seattle and San Francisco have sued Wall Street banks, seeking to force them to buy back mortgage-backed bonds. In July, the Federal Housing Finance Agency issued 64 subpoenas to obtain information about loans underpinning securities sold to mortgage giants Fannie Mae and Freddie Mac.

The breakdown of the audit relationships for these banks:

BAC/PwC (Inherited Countrywide/KPMG and Merrill Lynch/Deloitte during crisis.)

JPM/PwC (Inherited WaMu/Deloitte and Bear Stearns/Deloitte during crisis.)

Deutsche/KPMG

Goldman Sachs/PwC

Royal Bank of Scotland/Deloitte

Credit Suisse/KPMG

UBS/EY

Morgan Stanley/Deloitte

Citigroup/KPMG

Barclays/PwC (Also inherited US portion of Lehman/EY)

HSBC/KPMG

The last line of the WSJ story also mentions AIG:

Separately, American International Group Inc. is analyzing mortgage deals it insured before it imploded in 2008. Chief Executive Robert Benmosche told investors in May that the company will take “appropriate action” if it finds it was harmed by the transactions.

Fitch, the ratings agency, says that exposure to claims from Fannie Mae and Freddie Mac are concentrated in four large banks – two audited by PwC, two audited by KPMG.

Government sponsored enterprises (GSEs) Freddie Macand Fannie Mae may exercise the right to force the big four banks, JP Morgan (JPM), Citigroup (C), Bank of America (BAC), andWells Fargo (WF), to repurchase up to $180bn delinquent mortgages, according to a report released by Fitch Ratings Wednesday.

As of June 30, the GSEs hold $354.5bn troubled mortgages, with 50% serviced by the big four banks. Fitch estimates the big four banks already received repurchase requests up to $19.1bn in the Q110 and Q210 — $10.7bn of which related to the GSEs.

Fannie and Freddie are “actively exercising their right to put back to the original lenders a considerable amount of the troubled mortgages in their portfolios,” write analysts Tom Abruzzo and Christopher Wolfe. The agencies have a right to require lenders to buyback delinquent mortgages, if it is determined the mortgage loan did not meet GSE investor underwriting or eligibility standards.

The Financial Times’ FT Alphaville Blog did a great job back in August in two posts, here and here, describing the banks’ most recent admissions in 2Q 10Qs. I hesitate to call them full disclosures. The posts describe the potential for additional losses and the level of reserves for repurchase risk at JPM Chase, Bank of America, and Wells Fargo. Lots of words like “uncertain”, “increasing”,  “evolving”,  “reducing” are used, says FT Alphaville.

I agree. Words but very few numbers.

I went back and looked at the JPM Chase and Bank of America (BAC) 2009 Annual Reports for more clues.

From JPMorgan Chase:

Page 241: At December 31, 2009 and 2008, the Firm had recorded repurchase liabilities of $1.7 billion and $1.1 billion, respectively. The repurchase liabilities are intended to reflect the likelihood that JPMorgan Chase will have to perform under these representations and warranties and is based on information available at the reporting date. The estimate incorporates both presented demands and probable future demands and is the product of an estimated cure rate, an estimated loss severity and an estimated recovery rate from third parties, where applicable. The liabilities have been reported net of probable recoveries from third-parties and predominately as a reduction of mortgage fees and related income.

2009 compared to 2008, page 66: Noninterest revenue was $12.2 billion, up by $2.8 billion, or 30%, driven by the impact of the Washington Mutual transaction, wider margins on mortgage originations and higher net mortgage servicing revenue, partially offset by $1.6 billion in estimated losses related to the repurchase of previously sold loans.

A reserve of $1.7 billion is much less than the $23.9 billion Compass Point Research and Trading estimated above in the Wall Street Journal as JPM’s potential liability to the Federal Home Loan Banks alone, not including claims by Fannie Mae and Freddie Mac.

From Bank of America:

The Corporation records its liability for representations and warranties, and corporate guarantees in accrued expenses and other liabilities and records the related expense in mortgage banking income. During 2009 and 2008, the Corporation recorded representations and warranties expense of $1.9 billion and $246 million. During 2009 and 2008, the Corporation repurchased $1.5 billion and $448 million of loans from first lien securitization trusts under the Corporation’s representations and warranties and corporate guarantees and paid $730 million and $77 million to indemnify the investors or insurers. In addition, during 2009, the Corporation repurchased $13.1 billion of loans from first lien securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls.

Bank of American admits “representations and warranties expense” as well as losses of $1.5 billion for repurchases of loans from first lien securitization trusts under their representations and warranties and corporate guarantees.  In addition, they’d already repurchased an additional $13.1 billion based on mods, delinquencies and other “clean-up”.

However, I can’t easily see anywhere in either bank what the actual reserves are for estimated future liabilities and how they come up with a number given the total loans sold by type and the current claims by various parties. I think it’s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

That should be easy, in particular, for JPM, BAC, Goldman Sachs, AIG, and Barclays for claims against them by the Federal Home Loan Banks (FHLB) and Freddie Mac.  That’s because PwC is on both sides of the equation, as auditor for all of these banks and AIG and as auditor of Freddie Mac and all twelve of the FHLB.

One of the most famous disputes of the financial crisis was beteeen AIG and Goldman Sachs over valuations of their super senior credit default swap portfolio, a product sold by AIG, purchased by Goldman Sachs.

In fact, Andrew Ross Sorkin told us in his book, Too Big To Fail, Goldman Sachs was still not satisfied in June of 2008 that PwC was pushing AIG hard enough to consider “market participants’ views” on pricing on a timely or suffiicient basis so Goldman could “obtain as much cash as possible from their collateral calls”:

…Sorkin describes a Goldman Sachs June 2008 board meeting where the issue of their collateral dispute with AIG boils over.

“In a videoconference presentation from New York, a PwC executive (PwC is Goldman Sach’s auditor, too) updates the board on its dispute with AIG over how it was valuing or in Wall Street parlance, “marking-to-market,” its portfolio. Goldman executives considered AIG was “marking to make-believe” as Blankfein told the board…the afternoon session proceeded with upbraiding PricewaterhouseCoopers:

“How does it work inside PwC if you as a firm represent two institutions where you’re looking at exactly the same collatteral and there’s a clear dispute in terms of valuation?”

How does it work, indeed.  Jon Winkelreid, Goldman’s co-president, may or may not have received an answer that day. Sorkin does not report one.  I have never heard one.

I still have not heard a specific explanation for how PwC could preside over a long running dispute between two of its most important global clients, a dispute that was material to at least one of them, obviously, that had the attention of its highest level partners, and not force a resolution based on consistent application of accounting standards sooner.

I mean… We are talking about valuation of the same assets!

And now we are talking about repurchase risk – disputes between several of PwC’s clients over the value and efficacy of the same securities – and an associated liability must be quantified and reserved for the potential losses on these assets.  Three of  the Federal Home Loan Banks – San Francisco, Seattle, and Pittsburgh – have already sued the banks.  My sources tell me that there are special projects to review these portfolios at other FHLBs and more suits are likely.  So, not only do the FHLBs have a number in mind but they’re putting a legal contingency on their books.

Do PwC’s clients on the other side of these suits have the same numbers in mind?  Can PwC, in good faith, honestly sign off on financial statements on both sides of the disputes between the FHLBs and Freddie Mac and several PwC bank clients where completely different estimates of these liabilities are submitted?

I can understand judgment and leave some room for disagreement in a legal dispute as opposed to the valuation of an individual security. But, in the end, the quality of the documentation, the quality of the underwriting, the level of potential fraudulent documentation and the collectibility of the loan based on accuracy of the borrower ratings assigned at origination must all be relatively easy to ascertain on a comparable basis. These factors ultimately drive the value of the asset.

A loan doc is what it is. If it exists, that is.

The auditors have been helping the banks pull rabbits out of their hats for some time now.  But isn’t it about time we jump on the issue of audit firms behaving like Switzerland to protect their own self-interests? There are hundreds of millions of reasons in New York alone for PwC to stay neutral and to allow balance sheet “window dressing” via manipulation of reserves. But what does that say about the integrity of the financial information published by these banks?

Shareholders and other stakeholders will suffer greatly when the the banks eventually “surprise” us with the huge losses.

Postscript:

Annual total audit and other fees earned by PwC, per 2010 proxy statement data, from these banking and GSE clients:

FHLBs (New York) $13.05 million

Freddie Mac (Washington DC) $47.2 million

Barclays (London and New York) $~82 million

JPMorgan Chase (New York) $95.8 million

Goldman Sachs (New York) $106.9 million

Bank of America (Charlotte and New York) $128 million

AIG (New York) $205.2 million

Main page image source TaiShimizu.com Times Square Overexposed