A kind commenter of my health care diary suggested that I comment as a fiscal conservative CPA on "the fiscal mess of the week(century?)."
The Big-X auditors were flat-footed wrong on their audits of many of these Wall Street firms, and they should have seen it coming. The profit from the high fees bought them off, however.
Three years ago I taught a dozen continuing education courses for CPAs (required in every state) and asked at each site, "What is the next big "unforeseen calamity" akin to the S&L screw-up (also an auditor problem)?" Universally, they said, "We no longer understand how to audit derivative contracts. They have intentionally become too complex to audit."
Yet KPMG, Ernst, Pricewatershouse, and the others signed off on the derivative contracts anyway. If you would depose these auditors, there is no way they could explain most of these new contracts that they approved.
The other screw-up was more basic – the old concept of "reserves." Traditionally, if you sell widgets on credit to a bunch of unknown customers, you set aside (reserve) a portion of your earnings to cover the high probability that several of these customers will not pay. This hurts income this year, but when the bad risks DO default, you are home clean, with no ill effect.
But let’s see what NovaStar did, approved by their auditor Deloite & Touche. Kansas City’s NovaStar was one of the first mortgage bundler casualties. The information is found in their 10-Ks for 2005 and 2006.
NovaStar bundled and sold $1.1 billion in subprime loans in 2005 "with recourse," which means that they guaranteed the mortgages were good, promising to buy back any bad ones. Yet, they reserved only 2 cents out of every THOUSAND dollars to cover the guarantee. It turns out that in 2006 the losses were TEN TIMES that, and it got worse from there, and they are now dead in the water.
If the auditors would have forced these companies to reserve commensurate with the risk, their profits would have been lower in the good times, and executive bonuses would have been lower, but when the loans did start to fail, they would have had the assets to cover their bad bets.
I worked for several years for a publicly-held company primarily controlled by one very rich man. He took the opposite tack. He liked to have us stash aside reserves for every risky transaction, which we hid deep in subsidiaries so the Wall Street analysts pushing for growth couldn’t easily find them. The analysts complained about his "sluggish" growth in good times. But when the dry times came, we wrote off the bad deals with no impact because we had the reserves. He died even richer.
Sue the auditors. They failed us.