May 1, 2007 Excerpt of the article "Accounting Said to Hide Lender Losses" By Lynnley Browning
In the spring of 1998, the chief financial officer of New Century Financial, a lender to home buyers with tarnished credit, wrote an unusual paper describing a then little-known accounting technique.
The executive, Edward F. Gotschall, marketed his white paper at industry seminars and conferences, and promoted it to Wall Street analysts as an insider's look at New Century, according to people who read the paper. New Century was at the time one of the nation's fastest-growing subprime lenders.
Now that technique, called gain on sale, may be coming back to haunt the company, while filed for bankruptcy protection on April 2 after disclosing a month earlier that federal prosecutors and securities regulators were investigating accounting mistakes and stock sales at the company. The company is expected to file restated results for most of 2006 as early as this month.
The technique promoted by Mr. Gotschall, who stepped down as chief financial officer in 2006 but continued as vice chairman of the board of directors, allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors.
The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through the door, were then used to make more loans to risky home buyers.
Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors.
Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.
But some financial analysts say that New Century appears to have also used gain on sale to hide losses as the subprime market began to falter late last year.
A New Century spokeswoman declined to comment on the company's use of gain on sale accounting, citing the bankruptcy proceedings.
The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.
Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.
"The thing about gain on sale accounting is that you can create a machine that just manufacturers earnings out of thin air", said Richard Benson, an expert on securitization and president of the Specialty Finance Group, a financial broker.
The deterioration in recent months of the estimated $1.3 trillion subprime housing market has been tied to rising loan delinquencies and the decision by Wall Street to cut off billion-dollar credit lines to companies like New Century, which last year was the largest independent player in the industry.
But Mr. Benson said that the stock prices of subprime home lenders like New Century Financial had "collapsed so fast because the income and balance sheet had been built on gain on sale, which turns out to be imaginary."
"The market woke up the fact that there's no there there," Mr. Benson said.