SEC Chairman Christopher Cox signaled in June that the agency had opened roughly a dozen cases looking at the hedge funds and collateralized debt obligations, the complicated investment pools filled with mortgage-backed securities, that first ran into trouble. Now, the investigation has moved beyond those two groups to examine all the players involved--from the lenders that originated loans to the buyers of mortgage-backed securities and everyone in between. "Our team is focusing on whether any improper accounting, disclosure, or insider sales occurred," says Walter G. Ricciardi, deputy director of the enforcement division. "We will look for any potential fraud, by management, auditors, lawyers, credit-rating agencies, or others."
The biggest area of concern: whether the lenders and the big investors who hold the poorly performing loans are accurately marking down the value of those assets. With borrowers struggling to make payments and housing prices falling in many markets, the amount that mortgage holders, both those that own loans outright and those that invest in pools of loans, will ultimately collect is shrinking. And if the parties are under-reporting the potential losses, they may not be setting aside enough in reserves.
That could spell big trouble. Former SEC Chief Accountant Lynn Turner sees a dangerous parallel to the savings-and-loan crisis of the 1980s, which drove some 1,000 thrifts out of business and cost taxpayers roughly $125 billion. As home loans started to go south and prices sank, the S&Ls were unable to collect anything near face value on those assets. Yet they were very slow to write down the value of the loans and boost reserves. "As a result, S&Ls looked much more financially stable than they really were," says Turner, a bank auditor at the time. "The concern today is that once again institutions may be slow to record those losses on their loans."
Of course, much has changed since then. Banks and mortgage lenders no longer hold most of the loans they make. Instead, they are sliced and diced and packaged into complex securities that are held by hedge funds, investment banks, insurers, and other big investors. Today, about 56% of all mortgages are securitized, compared with just 10% in 1980. That complexity will make it much tougher for the SEC to determine if assets are being properly written down and where losses may lie, says Janet Tavakoli, president of Tavakoli Structured Finance Inc.: "Some of these bonds have such a hodgepodge of collateral."
But the basic problem remains. Once a home buyer falls behind on payments, the mortgage holder must determine if it's a temporary hiccup or something more permanent. If a loan is headed into foreclosure, then the owner generally has to mark down the value of the loan on its books to reflect the price it would get selling the home on the market.
Problem is, the standard accounting rules give mortgage holders a lot of wiggle room. They can delay reporting delinquent loans for at least a month, for example, and sometimes for several quarters. Real estate agents who specialize in foreclosures also say that many banks and Wall Street firms are asking unrealistic prices for homes they've taken over. And investors who hold large portfolios of mortgage-backed bonds use complex and widely varying internal valuation models. The assumptions in those models "can make a significant difference," says Fred Gill of the American Institute of Certified Public Accountants. "There's some concern that banks aren't basing their estimates on objective evidence." Much of that concern may be in the hallways of the SEC. By Dawn Kopecki, with Christopher Palmeri