Did Auditors Contribute To The 2008 Financial Debacle


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Did Auditors Contribute To The 2008 Financial Debacle

  1. 1. Did Auditors Contribute to the 2008 Financial Debacle? Lavendar M. Watters What role did auditors play in the mortgage debacle? Although internal/external auditors do not have any legal authority over financial services firms; however, there are regulatory agencies that do have authority. These agencies employ examiners which are the equivalent of an auditor. Auditing does not prevent fraud from occurring; however, per the Professional Practices Framework 1210.A2, Internal Auditors are responsible for assisting companies prevent fraud by examining and evaluating the adequacy and effectiveness of their internal controls' system, commensurate with the extent of a potential exposure within the organization. In addition, the Statement on Auditing Standards No. 99 “Consideration of Fraud in a Financial Statement Audit,” provides guidance to auditors in detecting material fraud. Auditors should be professionally skeptical, discuss issues with management, apply audit tests unpredictably and follow up on management override of controls. Financial institutions bore most of the risk in the real-estate market for lenders loaned the entire purchase price of homes. Financial institutions loaded up on mortgage securities with no regard to the risks involved. In addition, debt agencies that rate debt issued by corporations and financial institutions issued high grades to many securities which diminished to almost nothing in value (Lehman, Merrill Lynch, Countrywide, etc.). Listed below are some of the some of the instruments and practices that contributed to the 2008 financial debacle: Interest-only mortgages  ARMs  Lax mortgage underwriting standards that put many buyers into dwellings that they  couldn't otherwise afford Conflict of Interest between the debt rating agencies and debt-issuing corporations  Mortgage Securities/Mortgage Types Overview To better understand the type of vehicles that were available to borrowers and types of securities that were issued to the investing public, a listing is provided below: Mortgage-Backed Securities – MBS are backed (secured) by mortgages. There are two types of mortgages: 30-year and 15-year. This type of asset-backed security is secured by a mortgage or collection of mortgages. These securities are grouped in one of the top two ratings as determined by an accredited credit rating agency (Moody’s; S&P), and usually pay periodic payments that are similar to coupon payments. The mortgage must have originated from a regulated and authorized financial institution. Collateralized Mortgage Obligations (CMO) -- A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus. Page 1
  2. 2. Option Adjustable Rate Mortgages -- A type of mortgage where the borrower has several options as to which type of payment is made to the lender. In addition to having the choice of making payments of interest and principal that amounts to those made in conventional mortgages, option ARMs also have alternative payment options where the mortgagor can make significantly smaller payments by making interest-only payments or minimum payments. Alt-A Mortgage – An Alt-A mortgage is a type of U.S. mortgage is considered riskier than prime and less risky than subprime, the riskiest category. Alt-A interest rates, which are determined by credit risk therefore tend to be between those of prime and subprime home loans. Subprime Mortgage -- A subprime mortgage is a type of loan granted to individuals with poor credit histories (often below 600), who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate (interest rate charged to credit worthy customers). Credit Default Swaps (Derivative) -- A swap designed to transfer the credit exposure of fixed income products between parties. The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. Securitization Process (Conduits) Mortgage originators can either (1) hold a new mortgage in their portfolio, (2) sell the mortgage to an investor or conduit, or (3) use the mortgage as collateral for the issuance of a security. When it is included as part of a pool of mortgages that is used for collateral for a certain security, the mortgage is securitized. Fannie Mae, Freddie Mac and several investment banks purchase these mortgages. These mortgages are pooled together and an undivided interest or share of the pool is sold to investors. Causes of Mortgage Meltdown Due to the demand for safe mortgage backed securities, mortgage qualification guidelines were modified: Stated income, verified assets (SIVA) loans – Borrowers didn't have to prove their income. They merely stated it and need to show that there was money in their bank account. No income, verified assets (NIVA) loans -- The lender was not interested in the borrower’s occupation. He/she needed to show some money in their bank account. No Income, No Assets (NINA) -- NINA loans are official loan products which lets a person borrow money without having to prove or state anything. The only required to obtain a mortgage was a credit score. Page 2
  3. 3. Banks did not care about an individual’s credit standard because they did not keep the mortgage on their books. These mortgages were sold to Wall Street and Wall Street repackaged them and sold them to investors as low risk investments. The banks that held the loans on their books believed that housing prices would continue to rise and that homeowners could either refinance before loans reset or, if the homeowner defaulted, the losses would minimal. At a minimum, an evaluation was required to determine if institutions had adequate controls for compliance risk, reputation risk and litigation risk. It is evident that institutions did not have adequate reserves on their books as it related to credit default swaps. Financial institutions took on large amounts of risk which led to their demise. Financial firms increasingly relied on investments in derivatives to produce profits, and therefore resulting in higher financial incentives. Banks wanted to generate higher volumes of mortgage loans by lending at higher loan-to-value (loan-to-value – The ratio of the fair market value of an asset to the value of the loan that will finance the purchase) ratios, with ultra-low teaser rates, to borrowers that were not creditworthy. Their income and their assets were not verified which invited fraud. Rating agencies were forced by top management to be more profit-oriented and friendly to issuers of debt. They issued letter grades to mark the safety of the investments - triple A is given to the safest ones. The firm’s objectivity was due to the fact that its revenue came from investors that bought their research (Moody’s, S&P, Fitch); however, the firms began working closely with the companies it rated and were being paid by them. This was clearly a conflict of interest. The relationship between the rating agencies and issuers of debt should have been evaluated by regulators and auditors. Compliance/Financial Controls Mortgage Documentation Federal regulations require that all mortgage loan information submitted by the applicant be validated and verified by the Loan Officer and Loan Processor. The Underwriter is responsible for reviewed the loan application and supporting documentation. Financial institutions that fund loans through brokers or other lenders are required to monitor loan documentation and appraisals. In addition, the borrowers’ ability to repay debt by final maturity requires evaluation. Risk Assessment Risk assessments should be performed by institutions annually. They should asses their enterprise business risks on a calendar year and review their risk assessments strategies on a quarterly basis as business processes, systems, strategies, etc, may also change during the course of the year. Derivatives (Swaps, etc.) Controls of Derivatives include setting board-approved guidelines derivatives, regularly updating the board on positions, ensuring that personnel are adequately experienced, ensuring that master agreements are properly formed, and monitoring counterparties for exposure (Counterparty -- In any financial contract, the persons or institutions entering the contract on the opposite sides of the transaction). Executive Compensation Page 3
  4. 4. Without appropriate monitoring mechanisms, corporate executives work to maximize their own welfare. Internal audits of executive compensation should promote transparency in executive compensation disclosures. These audits would enhance the credibility of the board and executives by creating a positive tone at the top that which would establish a culture of accountability within the entire organization. An executive compensation audit should focus on the following: Compensation committee philosophy and structure  Compensation consultants’ role and performance  Executive pay and perks  Executive compensation-related disclosure in proxy filings  It is apparent that there will be a new round of regulations for the financial institutions. We will need the right mix of regulation and oversight. Page 4