Inquiry Assails Accounting Firm in Lender’s Fall
By Vikas Bajaj
The New York Times
Thursday, March 27, 2008

A sweeping five-month investigation into the collapse of one of the nation’s largest subprime lenders points a finger at a possible new culprit in the mortgage mess: the accountants.

New Century Financial, whose failure just a year ago came at the start of the credit crisis, engaged in “significant improper and imprudent practices” that were condoned and enabled by auditors at the accounting firm KPMG, according to an independent report commissioned by the Justice Department.

In its scope and detail, the 580-page report is the most comprehensive document yet made public about the failings of a mortgage business.  Some of its accusations echo charges that surfaced about the accounting firm Arthur Andersen after the collapse of Enron in 2001.

E-mail messages uncovered in the investigation showed that some KPMG auditors raised red flags about the accounting practices at New Century, but that the KPMG partners overseeing the audits rejected those concerns because they feared losing a client.

From its headquarters in Irvine, Calif., New Century ruled as one of the nation’s leading subprime lenders.  But its dominance ended when it was forced into bankruptcy last April because of a surge in defaults and a loss of confidence among its lenders.

The report lays bare the aggressive business practices at the heart of the mortgage crisis.

“I would call it incredibly thorough analysis,” said Zach Gast, an analyst at RiskMetrics who raised concerns about accounting practices at New Century and other lenders in December 2006.  “This is certainly the most in-depth review we have seen of one of the mortgage lenders that we have seen go bust.”

A spokeswoman for KPMG, Kathleen Fitzgerald, took strong exception to the report’s allegations.  “We strongly disagree with the report’s conclusions concerning KPMG,” she said.  “We believe an objective review of the facts and circumstances will affirm our position.”

The report zeros in on how New Century accounted for losses on troubled loans that it was forced to buy back from investors like Wall Street banks and hedge funds.  Had it not changed its accounting, the company would have reported a loss rather than a profit in the second half of 2006.

The report said that investigators “did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation, although its accounting irregularities almost always resulted in increased earnings.”

Even so, the profits were the basis for significant executive bonuses and helped persuade Wall Street that the company was in fine health when in fact its business was coming apart, the report contends.

In bankruptcy court, creditors of New Century say they are owed $35 billion.  The company’s stock peaked at nearly $65.95 in late 2004;  it was trading at a penny on Wednesday.

A spokesman for New Century, which is being managed by a restructuring firm under the supervision of the bankruptcy court, said the company was pleased that the report had been published.

The investigation was led by Michael J. Missal, a lawyer and former investigator in the enforcement division of the Securities and Exchange Commission who was hired by the United States trustee overseeing the case in United States Bankruptcy Court in Delaware.

Mr. Missal, who also worked on an investigation of WorldCom’s accounting misstatements, concluded that KPMG and some former New Century executives could be legally liable for millions of dollars in damages because of their conduct.

In the aftermath of the collapse of Enron, Arthur Andersen was indicted and convicted on obstruction of justices charges.  The conviction was overturned by the Supreme Court in 2005, long after the company had ceased doing business.

Mr. Missal drew an analogy to Enron and said there was evidence that KPMG auditors had deferred excessively to New Century.

“I saw e-mails from the engaged partner saying we are at the risk of being replaced,” Mr. Missal said in a telephone interview about a KPMG partner working on the audit of New Century.  “They acquiesced overly to the client, which in the post-Enron era seems mind-boggling.”

Ms. Fitzgerald of KPMG countered, “There is absolutely no evidence to support that contention.”

In one exchange in the report, a KPMG partner who was leading the New Century audit responded testily to John Klinge, a specialist at the accounting firm who was pressing him on a contentious accounting practice used by the company.

“I am very disappointed we are still discussing this,” the partner, John Donovan, wrote in the spring of 2006.  “And as far as I am concerned we are done.  The client thinks we are done.”

KPMG said Wednesday that a national standards committee had approved the practice in question.

The accounting irregularities became apparent when a new chief financial officer, Taj S. Bindra, started asking New Century’s accounting department and KPMG to justify their approach, beginning in November 2006.

Most of the mortgage company’s executives from that period have resigned or been laid off.  A spokesman for two of the company’s three founders, Edward F. Gotschall and Robert K. Cole, said both had cooperated with the investigation but had not yet reviewed the report.  A lawyer for Bradley A. Morrice, the third founder who was president and chief executive in 2006 and part of 2007, did not return a call.

The three founders together made more than $40.5 million in profits from selling shares in the company from 2004 to 2006, according to an analysis by Thomson Financial.

The company and its executives are the subjects of a federal investigation by the Justice Department.  Investors have filed numerous civil lawsuits against the company.

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