The excerpt presents a compelling case for why the FDR Framework needs to be embraced and fully implemented.
MARC COHODES had heard the stories. Heard how these guys would give a mortgage to anyone — even to a corpse, the joke went.
... So Mr. Cohodes, a money manager in Marin County, Calif., decided to bet against one of the big names of the subprime age: NovaStar Financial.
NovaStar was part of a crop of new lenders that had sprung up in the 1990s....
Like others in the subprime industry, NovaStar used aggressive accounting that obscured its increasingly precarious finances. As far back as the 1990s, it had to underwrite loads of new loans to offset losses on older mortgages.Under the FDR Framework, the damage to the financial system a NovaStar could cause would be minimized. This is a direct result of NovaStar having to disclose to market participants all the useful, relevant information in an appropriate, timely manner. In the case of NovaStar, this would have included its current loan-level performance data.
The disclosure of this data would allow market analysts to better understand the risk of NovaStar and its book of business. With this better understanding of the risk, market participants could do a better job of setting both the price of and amount of their exposure to NovaStar.
Hiding behind the opacity of current disclosure practices, NovaStar was able to obscure the true risk of its business. As a result, market participants under-estimated the risk and over-invested in the company and financial securities backed by loans originated by the company.
... Although NovaStar was not a household name in lending, in 2003 the company boasted 430 offices in 39 states. With headquarters on the third floor of an office building in Kansas City, Mo., it was fast becoming one of the top 20 home lenders in the country.
NovaStar was also becoming a Wall Street darling,..., Thanks to aggressive management, unscrupulous brokers, inert regulators and a crowd of Wall Street stock promoters, NovaStar’s stock market value would soon reach $1.6 billion.
... Mr. Cohodes knows every trick executives use to make their companies look better than they are. He prides himself on being able to spot trouble.... and he often shared his research with regulators at the Securities and Exchange Commission.
... So in February 2003, Mr. Cohodes started corresponding with the S.E.C. about NovaStar. He began “throwing things over the wall,” as he put it, to Amy Miller, a lawyer in the division of enforcement.
Among the questionable practices that are the easiest to find are those that appear in a company’s own financial statements.... “They made their numbers look however they wanted to,” he recalls. “Not even remotely realistic.”
One tactic gave the company lots of leeway in how it valued the loans held on its books. Another allowed it to record immediately all the income that a loan would generate over its life, even if that was decades. This accounting method ignored the possibility that some of the company’s loans might default. NovaStar assumed that losses on all of its loans would be nonexistent.Both of these tactics would be absurd in the face of having to disclose current loan-level performance data.
... NovaStar’s rosy assumption not only padded its profitability but also encouraged the company to make more mortgages, regardless of quality. The more loans it made, the more fees and income the company could record.With disclosure of current loan-level performance data, the market would have seen the deterioration in credit quality. The result would have been market discipline on management as investors charged more for the funds provided to NovaStar to be compensated for the risk.
... Mr. Cohodes and other NovaStar critics believed that they had found a company whose success was built on deceptive practices. What they did not recognize was that NovaStar was a microcosm of the nationwide home-lending assembly line that would lead directly to the credit crisis of 2008.
IN Atlanta, Patricia and Ricardo Jordan learned the hard way how NovaStar’s freewheeling lending practices imperiled unsuspecting borrowers.
The Jordans sued NovaStar in 2007. As part of the lawsuit, their lawyer found that their loan had been placed in a mortgage securitization trust assembled by NovaStar and sold to investors in November 2004. More than half of the loans in the pool were provided with no documentation or limited documentation of borrowers’ financial standing.
But the Jordans had given NovaStar bank statements and other documentation of their income. The lawsuit would show that NovaStar had inflated their monthly income by $500 to make the loan work. The lender had given the Jordans a loan that went against its own underwriting guidelines and that overrode federal lending standards.
The Jordans’ was just one loan. There were literally thousands more like it. (NovaStar settled with the Jordans in 2010. The terms were undisclosed.)Again, had there been current loan-level disclosure for the structured finance security, analysts could have seen what was occurring and the true riskiness of the underlying mortgages. If NovaStar could not access funds through securitization at an attractive or any price, it would have cut back on its lending and the associated deceptive practices.
... Although some of the S.E.C. people he spoke with seemed to recognize the problems in NovaStar’s operations, their investigation did not appear to be gaining traction.
The phone calls with the regulators went over the same material repeatedly, Mr. Cohodes recalls, leading him to conclude that Ms. Miller and her colleagues did not understand what was happening at NovaStar.
“Whenever they seemed to get it, they would either call up or make contact frantically saying, ‘Can you please go over this again?’ ” Mr. Cohodes said. “It was almost like someone was presenting a case to the higher-ups and they would say, ‘Are you sure? Go back and make sure.’ ”This sort of behavior by regulators is not limited to the SEC. In an earlier post, I discussed how bank examiners face the same issue. They might uncover a problem, but they have present a case to convince the higher-ups. In the meantime, the financial institution also got to present its case for why it was not a problem.
... But while NovaStar executives high-fived each other, a unit of Lehman Brothers, Wall Street’s largest packager of residential mortgage loans sold to investors, was discovering serious problems in a review of NovaStar mortgages. The findings were so troubling to the Lehman executives overseeing the firm’s purchases of NovaStar loans that they ended their relationship with NovaStar in 2004.
According to documents filed in a borrower lawsuit against NovaStar, Aurora Loan Services, a Lehman subsidiary, studied 16 NovaStar loans for quality-control purposes. What the analysis found: more than half of the loans — 56.25 percent, to be exact — raised red flags. “It is recommended that this broker be terminated,” the report concluded.
Among the problems turned up by the Aurora audit were misrepresentations of employment by the borrower, inflated property values, transactions among parties that were related but not disclosed, and unexplained payoffs to individuals when loans closed.
... S.E.C. rules require the disclosure by company management of information considered material to the company’s prospects or an investor’s analysis. In a 1999 S.E.C. bulletin, the commission defined materiality this way: “A matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.” Two Supreme Court cases use the same standard.
Surely, Aurora’s findings that more than half of the sampled NovaStar loans were questionable would have been an important consideration for the S.E.C.’s “reasonable person.”
Still, NovaStar failed to alert investors or the public at large to the Aurora analysis. Nor did NovaStar publicize the fact that Lehman Brothers had stopped buying its loans.The analysis done by Aurora is the type of analysis that disclosing current loan-level performance data would allow all market analysts to do. Without this type of disclosure, NovaStar was able to hide the Aurora analysis and resulting decision.
... To keep its money machine running, NovaStar regularly issued new shares to the public. Between 2004 and 2007, for instance, the company raised more than $400 million from investors. To those critical of NovaStar’s practices, this was money the company should never have been allowed to raise from investors who were kept in the dark by the company’s disclosure failings.
Mr. Cohodes reckons that over roughly four years, he conducted hundreds of phone calls with the S.E.C. about NovaStar. Each time, he would walk them through his points. Sometimes, a higher-up would get on the phone and contend that while NovaStar’s practices were indeed aggressive, the company did not appear to be breaking the law.
NovaStar’s selective disclosures — it was quick to report good news but failed to own up to problems on many occasions — seemed to be infractions that the S.E.C. should have dealt with. But its investigation went nowhere.
Fundamental to the FDR Framework is the principle that market participants have access to all useful, relevant information in an appropriate, timely manner. Had there been disclosure of current loan-level performance data, that would have been sufficient to limit the losses associated with NovaStar and the structured finance securities its mortgages were included in.
The story of NovaStar also highlights the role of regulators in ensuring access to all the useful, relevant information. This is the regulators' responsibility. A responsibility for which the regulators must error on the side of "too much" rather than "too little" disclosure.
Leading up to the credit crisis, decisions on disclosure were subject to a cost/benefit analysis. If the cost of disclosure exceeded the regulator's estimate of benefit, useful, relevant information was not disclose. With the hundreds of billions of dollars of losses taken by investors during the credit crisis as a result of inadequate disclosure, the cost/benefit analysis now permanently justifies providing disclosure.
Finally, the decision of what is useful, relevant information is driven by what market participants think is all the useful, relevant information and not what the disclosing party thinks is all the useful, relevant information. As NovaStar showed, the disclosing party may have an incentive to hide useful, relevant information.
... As is its custom, the S.E.C. declined to comment on the NovaStar inquiry or the agency’s discussions with short-sellers. But documents supplied by the S.E.C. under the Freedom of Information Act show the extensive communications between Mr. Cohodes and the agency. Ms. Miller, still at the S.E.C., declined to comment.
“It would be interesting to see who exactly dropped the ball, and why,” Mr. Cohodes said.
“It would be interesting why nothing was ever brought. The S.E.C. should have sent a plane for us to come to D.C. and say: ‘How do we make sure this doesn’t happen again?’ ”Fully implement the FDR Framework.
...At the end of 2009, NovaStar management concluded that the company’s financial reporting was “not effective.”
NovaStar had, in essence, confirmed what Mr. Cohodes had been telling the S.E.C. all along. The company’s financial reports just couldn’t be trusted.
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