Archive for the ‘fraud’ Category

As an accountant¬†— well, actually, someone with an accounting background — I have a keen interest in corporate accounting and the integrity of corporate financial statements. Unfortunately, sometimes those two things don’t comfortably co-exist (integrity and corporate financial statements).

While Generally Accepted Accounting Principles (GAAP), the set of standards that guides the presentation of corporate financial statements and supporting documents, may seem like a monolithic set of rules that are carved in stone with little or no room for interpretation, the bodies of financial statements that have been manipulated in the name of GAAP are piled high in a back room somewhere. There’s nothing like the pressure of analysts expectations for earnings or a large bonus on the line to get C-Suite executives to pressuring the CFO to fudge data just a bit…or a lot.

And when the watchdog is otherwise occupied, it would seem that the temptation would be even greater to bend or break the rules because there is that much less chance of being caught, when the odds were never that great in the first place.

So I was happy to see (it’s funny what can make me happy, but what can I tell you) that the new chair of the SEC, Mary Jo White, and her co-enforcement chiefs have decided to make accounting fraud a top priority of the SEC, according to the Wall Street Journal. Due to distractions from the financial crisis and budget cuts (my surmise), accounting fraud related enforcement actions have dropped by more than half from what they were in 2003 to 2005.

As corporations become more sophisticated and financial instruments more opaque, it is more necessary than ever before that the SEC stay vigilant and do its best to combat corporate accounting fraud. This is especially true given the fact that auditors have been shown again and again to side with management and allow egregious accounting practices to go unchallenged. Either that, or many are genuinely asleep at the wheel with what’s happened over the past few years.

Without the assurance that financial statements genuinely reflect the financial activity and results of corporations, shareholders are operating in the dark. And we deserve better than that.

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Charles Schwab has given up – at least for the moment – on forcing its customers to waive their right to a class action lawsuit in case of a dispute. While it’s hand was forced by the Financial Industry Regulatory Authority (FINRA), Schwab could have retained the class action ban in its securities agreements until its dispute with FINRA is fully resolved.

As reported by The Wall Street Journal, FINRA brought a compliant against Schwab early last year, alleging that the the class action ban was against FINRA rules. FINRA rules prohibit the use of class action waivers by brokerages and investment banking firms and requires firms to only require arbitration of individual claims.

In February, part of the FINRA complaint against Schwab was dismissed as the FINRA panel hearing the dispute said that it couldn’t stop Schwab from forcing its customers to waive those rights. FINRA has appealed that decision.

Then came the Schwab decision to modify its customer agreements to remove the class-action ban beginning May 15 and “in the foreseeable future.” Of course, if they ultimately win they are likely to reinstate the class action ban — a company spokesperson said, “We have chosen to voluntarily remove the waiver going forward until the issue is resolved by the appropriate regulatory and/or court decision.”

Regardless of the outcome of this dispute, it’s clear that the binding arbitration system in securities dispute needs to be throughly examined and eventually discarded by the federal Securities and Exchange Commission (SEC).

FINRA is the administrator and a major stakeholder in the current binding arbitration system, which requires customers of brokerage and investment banking firms to arbitrate disputes rather than take them to court. I’ve written about binding arbitration, which is biased against consumers, unfair and serves to abrogate the right of investors to access the U.S. justice system in a post entitled SEC should end mandatory arbitration clauses in brokerage contracts.

According to the consumer rights group Public Citizen, more than 7 million Schwab customers have been affected by the class action ban. In a letter urging new SEC Chairwoman Mary Jo White to take up the subject of either banning or modifying the use of arbitration in brokerage contracts, Public Citizen and 14 other organizations, including AARP, Consumer’s Union and the Consumer Federation of America, notes that “The 2008 financial crisis, the effects of which the country continues to wrestle with five years later, should be enough to motivate the Commission to restore investors’ legal rights.

“Brokerage firms were responsible for many fraudulent actions that led to or arose from the financial crisis. Indeed, the Commission identified Schwab as one of the firms that misled investors and ‘concealed the extent of risky mortgage-related and other investments in mutual funds and other financial products.’ Ensuring that investors can choose the forum in which to resolve disputes with broker-dealers and investment advisors is critical to both to remedying those past abuses and deterring future misconduct.”

Truth.

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Ever since Fannie Mae and Freddie Mac collapsed and were bailed out by the U.S. government in 2008, in one of the largest government bailouts in history, the future of the 30-year fixed mortgage has been in doubt. Both President Obama and the Republicans have expressed support for the idea of eliminating Fannie and Freddie and  privatizing the U.S. mortgage guarantee process.

But it hasn’t happened yet, and it’s been nearly 5 years. The reason why is that killing the 30 year mortgage, which an editorial in Bloomberg espoused yesterday, is extremely unpopular politically. Consumers love fixed-rate mortgages because they provide certainty in terms of the monthly payment, lessening risks that are posted by adjustable rate mortgages.

Interestingly enough, adjustable rate mortgages are the rule in Europe, where the government never developed the role in the mortgage process or the investment in the idea of homeownership that the U.S. government did. Here in the U.S., the government has for more than the past half century played a central role in the mortgage process, either outright owning or guaranteeing many fixed rate mortgages.

From a risk point of view, assuming the interest rate risk on a 15 or 30 year basis is something that few, if any, financial institutions are willing to take on given what happened in the financial crisis and what has happened with interest rates over the past few decades.

That’s because if interest rates increase — and they, will eventually — a financial institution would be stuck paying out higher interest rates on savings accounts, certificates of deposit and IRAs, while receiving a very small return on interest on fixed rate long term mortgage commitments made years ago. In contrast, an adjustable rate mortgage will eventually increase to market rates, which poses much less risk for banks and other lenders.

That leaves the U.S. government as the default lender of last resort for fixed rate mortgages. Today, the U.S. government owns or guarantees 90 percent of all new mortgages, which is a major increase from the 50 percent it owned or guaranteed in the mid-1990s. Given the boom and bust nature of U.S. real estate markets, that means it’s all too likely that at some point the U.S. government will be left holding the bag when the real estate market goes bust again and large numbers of homeowners default.

That’s not as likely with rates so low, because the underwriting environment is so conservative currently and payments are affordable. However, as underwriting standards loosen and rates go higher, the table will be set for another housing market disaster. After all, the most recent real estate market boom/bust wasn’t the first, just the latest in a long line of U.S. real estate market ups and downs.

So when the next bust happens, the U.S. government, as the guarantor of last resort will be on the hook for all those defaults, obligated to pay — wait for it — billions of dollars to banks for the homeowners who are unable to make those payments. And since the U.S. government is us, the taxpayers, we could be left footing the bill for another expensive bailout.

The solution, many say, is to abolish fixed rate mortgages altogether and leave adjustable rate loans as the only option for consumers. This would take the long-term interest rate risk out of the picture for both the government and financial institutions. Unfortunately, that leaves consumers holding the bag and assuming the vast majority of risk surrounding interest rates.

Well, that’s hardly fair. Why should consumers bear most of the risk from an unpredictable, speculative real estate market? We saw the impact of a variety of adjustable rate loans during the real estate bust. Lax underwriting standards, outright fraud on the part of some unscrupulous mortgage brokers and appraisers and exotic loans left homeowners at the mercy of sky high payments and many lost their homes or were stuck making unsustainable payment that they could barely afford.

The Bloomberg editorial mentions some creative solutions that could help fill the gap if the 30 and 15-year fix rate mortgage is abolished. These intriguing options include:

  • Pegging monthly mortgage and interest payments to neighborhood home values
  • Allowing borrowers to pay more up front for the ability to make lower payments later if home prices go down

If the 30-year mortgage is indeed toast, we need to see more innovative ideas like those above so that homeowners aren’t forced to bear all the risk from unpredictable real estate markets. It’s certainly not fair to expect the government or financial institutions to do so and there is no reason why consumers should have to either.