Making the non-obvious connections between the audit firms and their clients, between the clients and each other, and between the firms and each other is like shooting fish in a barrel. As each new story comes out, especially about the banks, the web of connections and the repeated attempts by desperate executives to move the same deck chairs around on the financial system Titanic are becoming easier to spot.

Sometimes I don’t even have to close my eyes to see the last story where the same guy or the same assets or the same scam is mentioned.

Yesterday it was news of the sale of servicing rights to a gazillion dollars of almost worthless mortgages by Bank of America to Fannie Mae.  Why Fannie Mae?  Because they are so good at using their marketing skills to “conduit” bad paper from the very needy to the less needy.  But is the next guy really a sucker or do they know something we don’t?  When was the last time Fannie Mae assisted the system in this way?  And how do we know it was rotten paper crossing from one bad actor to perhaps another on a government-sponsored bridge built of the taxpayers’ aching backs?

And who is standing on the sidelines watching it all with a wink, a nudge, and a “say no more”?

For the answers to these and other questions, you’ll have to read, “Fool Me Twice: Bank of America Plays Hide and Seek Using Fannie Mae.”

Here’s a teaser:

The last time Fannie Mae got involved in shape-shifting servicing rights to hide fraudulent activity was Taylor Bean Whitaker. That‘s the mortgage originator, audited by Deloitte, that used Fannie Mae’s silence and their influence, according to Bloomberg, to market servicing rights on bad loans to GMAC.

How do we know the most recent $73 billion portfolio might be full of loser loans made via potentially fraudulent means? Fannie Mae told us so when they sued Countrywide, the mortgage originator and source of significant woe Bank of America bought in 2008.

To his credit, Judge Kaplan does leave one important allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure.

Now they’ve got a public airing of some dirty laundry by the PCAOB.

From Compliance Week:

The Public Company Accounting Oversight Board has barred the now-former E&Y partner, Peter O’Toole, from associating with a PCAOB-registered firm for three years and fined him $50,000. The board barred the now former senior manager, Darrin G. Estella, from associating with a PCAOB-registered firm for two years. Both auditors can petition the board for reinstatement at the end of their penalty periods. In December, the PCOAB issued an earlier action against Jacqueline Higgins, an E&Y manager, in connection with the same incident.

The PCAOB says the three auditors created, backdated, and added documentation to an audit file when they learned it would soon be inspected by the board. The disciplinary orders say O’Toole was the engagement partner for an audit of an unnamed public company with a Sept. 30, 2009, year-end. The firm gave the company a clean audit opinion on Nov. 23, 2009, then learned the audit would be inspected in April 2010, with inspectors planning to study “securities valuation.”

Ernst & Young spokesman Charlie Perkins tells The Financial Times, “no harm, no foul,” as far as the firm is concerned.

“Our firm’s policy explicitly prohibits persons from supplementing or changing audit workpapers in circumstances like those present here,” said Charles Perkins, a spokesman for Ernst & Young, in a statement.

“When we determined that firm policy had been violated, we subsequently separated the partner and senior manager from the firm. We have co-operated fully with the PCAOB throughout its investigation of this matter. The conduct described in the order had no impact on our audit conclusions or on the client’s financial statements.”

Unless there are sanctions, we won’t know if more of this kind of thing is happening at U.S. firms. That’s becasue that part of the PCAOB inspection report is private.

We do know it’s happening at Ernst & Young in the U.K. Repeatedly.

From my post at Forbes.com, “By Any Means Possible: Auditors Try To Meet Standards By Faking It”:

The latest inspection report for Ernst & Young in the U.K., the same global firm that the PCAOB recently disciplined, cited specific deficiencies: (The AIU inspected thirteen engagements of a total of 295 eligible.)

Signing and dating of audit reports:

On two audits the auditor’s report was signed prior to the completion or evidencing of all necessary review procedures.

Completion of audit disclosure checklists:

…On two of the files that we reviewed it was unclear from the audit file whether the team had re‐performed the completion of the financial statements disclosure checklist.

Audit finalisation:

We found weaknesses in connection with audit finalisation procedures on seven of the audits we reviewed. The majority of these weaknesses related to undetected clerical drafting errors in the accounts including, in one case, an error in the disclosed audit fee.

I was previously quoted in American Banker on bank balance sheet window-dressing.

My quote focused on disclosures and transparency – for the loans and the reserves for losses. It’s a subject I’ve written about extensively.

Has transparency improved?

Financial Accounting Standards Board rule updates that went into effect last December did require banks to disaggregate their data and to be more specific in their disclosures.

However, the FASB rule updates still leave banks with a lot of discretion as to how they break out their data on receivables such as second-lien loans.

“In general, we are seeing definitely better disclosure and more detailed disclosure,” said Francene McKenna, president of the consultancy McKenna Partners LLC. “However, it looks like they are still to some extent being somewhat a little optimistic on what the future is going to hold,” she said. “There are still missing pieces; you really wish for some kind of consistent disclosure.”

Unfortunately, I was unable to attend the AICPA National Conference on PCAOB and SEC Developments  in person.  As much as I would have loved to be there live, to ask questions and, perhaps, walk all over the wafflers with my Manolos, it’s not always possible.  In this case it may have been just as well.