Guest Post: Subprime Auditing – The Fox In The Chicken Coop

By • Sep 3rd, 2010 • Category: Food for Thought, Pure Content

Aubrey M. Farb has been a Texas CPA since 1947.  Next month he will be 88 years old. He is a survivor of the Battle for Iwo Jima, having served as a Japanese Language Officer in the 3rd Marine Division. He was elected to Phi Beta Kappa based on his first three years at Rice University when he was 18 and graduated with a BA degree in May 1942.  Both before and after military service he attended the Columbia University Graduate school of Business and received a Master of Science in Accounting degree in August 1946.  He was elected to Beta Gamma Sigma and received an award from the NY State Society of CPAs for being the outstanding accounting student in his class.

Mr. Farb taught elementary accounting at Brooklyn College in the spring of 1946. He was employed by Price Waterhouse in their NY City office from September 1946 to June 1947. In July 1947 he joined the faculty of the University of Houston where he taught the advanced accounting and auditing courses. During the 1960s he taught auditing for the AICPA at their staff training program at the University of Texas. From 1962 to 1970 he was a Visiting Professor of Accounting at Rice University.

Mr. Farb was a partner in a local accounting firm until December 1967 when they merged with Alexander Grant and Mr. Farb became the managing partner of its Houston office.  He took early retirement in early 1972 because he says he disagreed with the firm’s ethical standards. Mr. Farb told me he still feels like “Diogenes in a green eyeshade.”

He is a former member of the AICPA Auditing Standards Committee and a former member of the AICPA Audit Task Force appointed to assist President Nixon’s Blue Ribbon Committee to Restructure the Defense Department.

A guest post by Aubrey Farb

We all remember the story of The Three Little Pigs. This story is about the 4 Big Pigs, more commonly referred to as the Big 4. These are the four gigantic international accounting firms that have a virtual monopoly of the auditing industry – PricewaterhouseCoopers, KPMG, Deloitte, and Ernst & Young. They rule the roost and conduct themselves in a manner that ignores their responsibility to the citizens of our great country.

We are all familiar with the subprime loans scandal. It almost wrecked our nation’s banking system and even had dire effects on banks in other countries, such as the Royal Bank of Scotland (RBS).  RBS had unfortunately bought a piece of ABN AMRO bank, a Dutch company. It turned out that ABN AMRO had a large block of these bundled up mortgages on its balance sheet – the mortgages that Wall Street so judiciously marketed to as many suckers as it could find.

And how did the 4 Fat Pigs respond to the making of all these sub-prime loans?

Surprise! They invented Subprime Auditing Standards.

Let me explain. Our benevolent Congress decided that it would be in the best interest of the nation’s economy if more lower middle class and poor people could become homeowners. So, they relaxed the standards for lending by Fannie Mae and Freddie Mac who then sent the good news to its mortgage makers, the loan sharks, the shady saving and loans, and the voracious banks. This was their chance to earn a little easy money.

So off they went to broadcast the good news to the home builders, who obliged them by constructing lots and lots of overpriced dwellings which they proceeded to market to buyers whose appetite for a bigger new home was bigger than their financial stomach. And, of course, the shyster loan brokers saw their opportunity to make a bundle. They recruited buyers with insufficient incomes and little financial acumen to purchase these overpriced and oversize homes. To add insult to injury they charged huge brokerage fees for bringing their poor little sheep to the slaughterhouse.

It was all so simple. They manufactured the information about the finances of the buyers, got them loans that they could not meet the payments for, and pocketed their brokerage which was paid out of the loan proceeds. Everybody was happy. The buyer had his mansion, the builder sold his house at a stiff profit, the broker got his slice of the pie and the makers of the loans got what they wanted – a large volume of mortgages that were guaranteed by the FHA and other mortgage insurers.

All seemed well until many of the buyers either stopped making their monthly mortgage payments or never paid any payments at all. Who were some of these lenders?

They include Countrywide – the largest in the USA and now owned by Bank of America – WaMu (Washington Mutual) now owned by JP Morgan, Mercury, New Century, and Golden Gate. All of these were public companies. All of them were audited by the Fat 4.

None of the auditors qualified any audit reports that barely disclosed the disastrous conditions of these subprime loans on a timely basis nor issued “going concern” opinions when things became really precarious. That’s because the auditors used SUBPRIME AUDITING AND REPORTING STANDARDS. They literally ignored the sorry state of affairs and just kept on collecting their ungodly huge fees and danced the night away.

What should have been done? If the Fat 4 had conducted their audits in accordance with generally accepted auditing procedures (GAAS) and reported on their findings in the manner stipulated by the American Institute of CPAs, the whole sorry state of affairs would have been revealed at an early date and the nation would not have had to go through this horrible depression – not a recession.

I know a Depression when I see one!

The first thing the auditors were required to do was to study the mortgage makers’ systems of internal financial and management controls with a view to determining whether they were strong enough to prevent loans from being made to unqualified borrowers and to limit fraudulent accounting.

Second, the auditors would have examined the loan files for a reasonable scientific sampling of the mortgages. What should a loan file include? An appraisal of the property, a survey of the property, proof of the buyers income (preferably copies of three years of tax returns), at least two credit reports, a detailed application, and the notes from a personal interview of the prospective borrower. But that takes too long – both from the mortgage originators’ perspective and the auditors’.

Third, the auditor should have sent out positive confirmation letters to a scientific sample of the borrowers.

Now let’s look at what really happened. Even though the auditors could not satisfy themselves that the internal financial and management controls were sound, the auditors certified in their reports that the controls were strong enough to prevent loans from being made to persons who did not qualify.

Next, after so many loans went bad it was discovered that the vast majority of these loans had NO loan files. Many just had scraps of paper saying how much the applicant earned.  With no verification!

And lastly, it was found that many of these borrowers could not be found.  If positive confirmations had been sent, many would have been returned marked “Addressee Unknown. Unable to Forward.”

There, boys and girls, you have the whole story. It sounds like a fairy tale.  I wish it were. How long are we going to stand for the Fat 4 aggrandizing themselves at the expense of the nation’s taxpayers?

I rest my case.

Photo is Diogenes of Sinope (Greek: Διογένης ὁ Σινωπεύς Diogenes ho Sinopeus). He was a Greek philosopher and one of the founders of Cynic philosophy. Also known as Diogenes the Cynic, he was born in Sinope (modern-day Sinop, Turkey) in 412 or 404 BCE and died at Corinth in 323 BCE.

Diogenes was one of the few men to ever publicly mock Alexander the Great and live. He intellectually humiliated Plato and was the only pupil ever accepted by Antisthenes, whom he saw as the true heir of Socrates. Diogenes taught his philosophy of Cynicism to Crates who taught it to Zeno of Citium who fashioned it into the school of Stoicism, one of the most enduring branches of Greek philosophy. He believed that virtue was better revealed in action than in theory. His life was a relentless campaign to debunk the social values and institutions of what he saw as a corrupt society. None of his many writings have survived, but details of his life come in the form of anecdotes (chreia), especially from Diogenes Laërtius, in his book Lives and Opinions of Eminent Philosophers.

is
Email this author | All posts by

8 Responses »

  1. Outstanding post, Mr. Farb. Thank you, Francine, for sponsoring this dead-on guest editorial at your industry-leading blog site.

    I especially like Mr. Farb’s “Subprime Auditing Standards” term–the Big Four truly are accountable to no one. They’ve all even moved their corporate headquarters out of the U.S. to friendlier countries where the regulators don’t annoy them as much.

    And it’s because of all the fraud, blatant financial statement manipulation supported by audit “negotiations,” and repeated failures to perform adequate audit work, I’ve seen over the course of my 30+ years in the accounting and finance industries, that I wrote my financial thriller, Shell Games (available at Amazon.com).

    Shell Games demonstrates just how easy it is for Wall Street’s financial institutions to continue with their subprime mortgage shell games due to their adept use of the Big Four as blindfolds for the regulators and investors who may try to uncover their games. Shell Games is a fun, sexy, suspenseful fictional account of these issues, aiming to spread the word of need for massive change in the auditing industry to those who are being victimized–the general public.
    We need the masses (America’s dwindling middle class) to understand exactly how they are being financially raped, if we ever want change to occur. Unfortunately, most industry insiders are financially in bed with the Big Four one way or another to ever speak up (like you just did and Francine does every day) or change the status quo.

    Bravo on your outstanding life and post, Mr. Farb! Thanks again for caring enough to speak out.

    Ciao for now,

    Sara McIntosh

  2. Thank you Mr. Farb for the post and thank you, Francine, for running with it.

    I’ve seen the best and the worst of the Big-4 during my career and I share Mr. Farb’s concern with respect to “audit failures”.

    With respect to the mortgage industry in particular, given the Federal government’s growing underwriting of the industry through quasi-governmental entities — are we prepared to face the truth that the Federal government will sooner or later default on those guarantees?

    Do we then blame the “Big-4″ for having failed to qualify their opinions based on the growing financial uncertainty concerning the US government?

    I agree with Sara that we do, indeed, need to wake up to what is happening in the US, but Wall Street is far from the only “Shell Game” being played!

    Thanks,

    Ron Ratliff

  3. I share your concerns; however, if the auditors had done their job, the volume of these lousy loans would have been curtailed. It is too bad that the auditing profession does not seem to recognize that what they do or fail to do has a ripple effect on our entire economy.

    When WorldCom failed, it was not just the creditors and shareholders who lost. WorldCom was located in Clinton, Miss. A large number of residents lost their jobs. This created a virtual depression in the small town. There was vast unemployment, not just the ex WorldCom people. There were foreclosures, loss of ad valorem tax revenue, loss of sales tax revenue. The shareholders lost almost 2 biilion dollars. That too had a ripple effect. Even the government lost money due to the use of the tax losses or the failure to be able to tax the gains that people had before the crash.

  4. In some ways, subprime loans were a form of a Ponzi scheme in that the payback of the loan wasn’t really coming from the borrower. Rather, the payback was coming from another loan or from another homebuyer. And, it is likely that the likelihood of loan payback was determined based on the expectation that the mortgages could be refinanced, i.e., more investors, or the house could be sold at a profit. The fact that the likelihood of a loan payback was determined largely on expectations of increases in real estate prices should have at least raised somebody’s suspicions.

  5. There is no question that the great rise in the value of homes contributed to the building boom. Nevertheless, had the auditors used standard auditing procedures and AICPA reporting standards, the sub prime mortgage fiasco would have been revealwed at any early date. The importance of this failure on the part of the various auditing firm almost wriecked the US economy and had widespread effectson every citizen of this country.

  6. As I understand it, Mr. Farb is saying that from Year 1, the auditors should not have signed off on the statement because of internal control problems such as the missing documentation in the loan files. I hadn’t thought that way but that’s probably a reasonable position. However, I haven’t seen any evidence of lawsuits taking that position. (It’s possible that there are so many other defiiciencies in the audits that are easier to spot.) You’d wonder why the bank examiners wouldn’t have taken that position at some point. Because in the S&L crisis, it’s my recollection that regardless of how bad the CPA firms were, the bank examiners weren’t so quick to be fooled.

    I think the boom that was fed by the subprime crisis actually made even honest auditors reluctant to act. As long as the price of real estate kept going up, the banks could get away with the lax loan policies. If Mr. Farb had his way, the real estate boom would never have happenned. That’s not a bad thing although it may have seemed a bad thing at the time.

    If Mr. Farb thinks that the CPAs could have had a role in preventing the crisis, I would encourage him if he hasn’t done so to provide the Financial Crisis Inquiry Commission (FCIC) with his position with respect to what the CPAs firm could have and should have done on the audits. (http://www.fcic.gov)

  7. My position is that each of the major financial institutions was audited each and every year. Regardless of the loosening on the loan parameters the audit and reporting procedures should not have been altered. The results of the audits would have shown that financial and management internal controls at the makers of these loans were so weak that high level management was not aware (?) of of the poor qualifications of many of its borrowers. Furthermore, had the auditors properly examined the loans files they would have found them either highly deficient or not in existence. This would have led to qualifications of the auditors’ reports and as a result the financial community would have been put on notice that all was not well in LaLa Land. Thus the number and size of these sub-prime mortagages would have been substantially curtailed, if not eliminated.

    The bottom line is the catastrophic fianancial debacle of 2008 and 2009 would not have occurred.

    It is imperative that the entire nation understand the ramification of the failure of auditor to recognize that the word “public” in the title Certified PUBLIC Accountant has a special meaning in that their responsibility to the PUBLIC is a sacred obligation and that it is the paramount reason that CPAs are placed in their almost monopolistic position.

  8. “It is imperative that the entire nation understand the ramification of the failure of auditor to recognize that the word “public” in the title Certified PUBLIC Accountant has a special meaning in that their responsibility to the PUBLIC is a sacred obligation and that it is the paramount reason that CPAs are placed in their almost monopolistic position.”

    And it’s still amazing to this day that some CPAs think that public accounting firms are ran just like “any other business”. Kinda sad actually. Probably one of the main reasons why the big 4 model needs revamping.

Leave a Reply