The Securities and Exchange Commission missed a massive securities fraud while it chased the banks to be more transparent. Even though it knew about this massive, plain vanilla accounting fraud back in 1998.  

While it grabs at the low hanging fruit of disclosure cases, the SEC doesn’t appear to be investigating how banks frontloaded their profits via channel stuffing -- securitizing loans and shoving paper securitizations onto investors, while booking those revenues immediately, even though the mortgage payments underlying those paper daisy chains were coming in the door years, even decades, later. Those moves helped lead to an estimated $2.4 trillion in writedowns worldwide.

The agency said it  believed banks were committing subprimesecuritization accounting frauds back in 1998 and claimed to be 'probing' them.

I had written about these SEC probes into potential frauds while covering corporate accounting abuses at The Wall Street Journal. The rules essentially let banks frontload into their revenue the sale of subprime mortgages or other loans that they then packaged and sold off as securities, even though the payments on those underlying loans were coming in the door over the next seven, 10, 20, or 30 years.

Estimating those revenues based on the value of future mortgage payments involved plenty of guesswork.

Securitization: Free Market Became a Free For All

The total amount of overall mortgage-backed securities generated by Wall Streetvirtually tripled between 1996 and 2007, to $7.3 trillion. Subprime mortgagesecuritizations increased from 54% in 2001, to 75% in 2006. Back in 1998, the SEC had warned a dozen top accounting firms that they must do a  better job policing how subprime lenders book profits from loans that are repackaged as securities and sold on the secondary market. The SEC “is becoming increasingly concerned” over the way lenders use what are called “gain on sale” accounting rules when they securitize these loans, Jane B. Adams, the SEC’s deputy chief accountant, said in a letter sent to the Financial Accounting Standards Board, the nation’s chief accounting rule makers.

At that time, subprime lenders had come under fire from consumer groups and Congress, who said banks were using aggressive accounting to frontload profits from securitizing subprime loans. Subprime auto lender Mercury Finance collapsed after a spectacular accounting fraud and shareholder suits, New Century Financial was tanking as well for the same reason.

SEC Knew About Subprime Fraud More than a Decade Ago

The SEC more than a decade ago believed that subprime lenders were abusing the accounting rules.

When lenders repackage consumer loans as asset-backed securities, they must book the fair value of profits or losses from the deals. But regulators said lenders were overvaluing the loan assets they kept on their books in order to inflate current profits. Others delayed booking assets in order to increase future earnings. Lenders were also using poor default and prepayment rate assumptions to overestimate the fair value of their securitizations.

Counting future revenue was perfectly legal under too lax rules.

But without it many lenders that are in an objective sense doing quite well would look as if they were headed for bankruptcy.

At that time, the SEC’s eyebrows were raised when Dan Phillips, chief executive officer of FirstPlus Financial Group, a Dallas subprime home equity lenders, had said the poor accounting actually levitated profits at lenders.

“The reality is that companies like us wouldn’t be here without gain on sale,” he said, adding, “a lot of people abuse it.”

But this much larger accounting trick, one that has exacerbated the ties that blind between company and auditor, is more difficult to nail down because it involves wading through a lot of math, a calculus that Wall Street stretched it until it snapped.

Impenetrably Absurd Accounting

These were the most idiotic accounting rules known to man, rules manufactured by a quiescent Financial Accounting Standards Board [FASB] that let bank executives make up profits out of thin air.

It resulted in a folie à deux between Wall Street and complicit accounting firms that swallowed whole guesstimates pulled out of the atmosphere.

Their accounting gamesmanship set alight the most massive off-balance sheet bubble of all, a rule that helped tear the stock marketoff its moorings.

The rules helped five Wall Street firms - Bear Stearns, Lehman Bros., Morgan Stanley, Goldman Sachsand Merrill Lynch- earn an estimated $312 billion based on fictitious profits during the bubble years.

Who Used the Rule?

Banks and investment firms including Citigroup, Bank of Americaand Merrill all used this "legit" rule.

Countrywide Financialmade widespread use of this accounting chicanery (see below). So did Washington Mutual. So did IndyMac Bancorp. So did FirstPlus Financial Group, and as noted Mercury Finance Co. and New Century Financial Corp.

Brought to the cliff's edge, these banks were either bailed out, taken over or went through bankruptcies.

Many banks sold those securitized loans to Enron-style off-balance sheet trusts, otherwise called “structured investment vehicles” (SIVs), again booking profits immediately (Citigroup invented the SIV in 1988).

So, presto-change-o, banks got to dump loans off their books, making their leverage ratios look a whole lot nicer, so in turn they could borrow more.

At the same time, the banks got to record immediate profits, even though those no-income, no-doc loans supporting those paper securities and paper gains were bellyflopping right and left.

The writedowns were then buried in obscure line items called “impairment charges,” and were then masked by new profits from issuing new loans or by refinancings.

Rulemakers Fight Back

The FASB has been fighting to restrict this and other types of accounting games, but the banks have been battling back with an army of lobbyists.

The FASB, which sets the rules for publicly traded companies, is still trying to hang tough and is trying to force all sorts of off-balance sheet borrowings back onto bank balance sheets.

But these "gain on sale" rules, along with the “fair value” or what are called "marked to market" rules, have either been watered down or have enough loopholes in them, escape hatches that were written into the rules by the accountants themselves, so that auditors can make a clean get away.

As the market turned down, banks got the FASB to back down on mark-to-market accounting, which had forced them to more immediately value these assets and take quarterly profit hits if those assets soured - even though they were booking immediate profits from this "gain on sale" rule on the way up.

Also, the FASB has clung fast to the Puritanism of their rulemaking by arguing a sale is a sale is a sale, so companies can immediately book the entire value of a sale of a loan turned into a bond, even though the cash from the underlying mortgage has yet to come in the door.

Old-Fashioned 'Channel Stuffing'

This sanctioned "gain on sale" accounting is really old-fashioned “channel stuffing.”

The move lets companies pad their revenue and profit numbers by stuffing lots of goods and inventory (mortgages and subprime securities) into the system without actually getting the money in the door, and booking those channel-stuffed goods as actual sales in order to cook ever higher their earnings.

Sort of like what Sunbeam did with its barbecue grills in the '90s.

Intergalactic Bank Justice League

Cleaning up the accounting rules is an easier fix instead of a new, belabored, top-heavy “Systemic Risk Council” of the heads of federal financial regulatory agencies, as Sen. Chris Dodd(D-Conn) envisions in financial regulatory reform.

An intergalactic Marvel Justice League of bank regulators can do nothing in the face of chicanery allowed in the rules.

Planes on a Tarmac

What happened was, banks and investment firms like Citigroup and Merrill Lynchwho couldn’t sell these subprime bonds, or “collateralized debt obligations,” as well as other loan assets into these SIVs got caught out when the markets turned, stuck with this junk on their balance sheets like planes on a tarmac in a blizzard.

Bank of Americasaw its fourth-quarter 2007 profits plunge 95% largely due to SIV investments. SunTrust Banks' earnings were nearly wiped out, a 98% drop in the same quarter, because of its SIVs.

Great Britain’s Northern Rock ran into huge problems in 2007 stemming from SIVs, and was later nationalized by the British government in February 2008.

Even the mortgage lending arm of tax preparer H&R Block used the move. Block sold its loans to off-balance-sheet vehicles so it could book gains about a month earlier than it otherwise would. Weee!

The company had $75 million of these items on its books at the end of its fiscal 2003 year. All totally within the rules.

Leverage Culture

The rampant fakery helped fuel a leverage culture that got a lot of homes put in hock.

Banks, for instance, started advertising home equity loans as "equity access," or ways to "Live Richly" or as Fleet Bank once touted, "The smartest place to borrow? Your place." 

In fact, Washington Mutualand IndyMac got so excited by the gain on sale rules, they went so far as to count in profits futuristic gains even if they had only an “interest rate” commitment from a borrower, and not a final mortgage loan.

Talk about counting chickens before they hatch.

Closer Look at Wamu

Look at Wamu's profits in just one year during the runup to the bubble. Such gains more than tripled in 2001 at Wamu, to just shy of $1 billion, or 22% of its pretax earnings before extraordinary items, up from $262 million, or 9%, in 2000.

But in 2001, Washington Mutualtook $1.7 billion in charges, $1.1 billion of it in the final, fourth quarter, to reflect bleaker prospects for the revenue stream of all those servicing rights.

It papered over the hit with a nearly identical $1.8 billion gain on securitizations and portfolio sales. 

Closer Look at Countrywide

The accounting fakery let Countrywide Financial Corp., the mortgage issuer now owned by Bank of America, triple its profit in 2003 to $2.4 billion on $8.5 billion in revenue.

At the height of the bubble, Countrywide booked $6.1 billion in gains from the sale of loans and securities. But this wasn’t cold, hard cash. No, this was potential future profits from servicing mortgage portfolios, meaning collecting monthly payments and late penalties.