Nearly a year ago, there was a fairly wide SEC investigation going on in Puerto Rico: a group of major financial institutions appeared to be constructing a daisy-chain of transactions with each other. It wasn’t the sort of thing that was clear from the financial statements; the SEC must have spent a lot of time at ground level, because they announced yesterday that one of the firms involved, Doral Financial (NYSE:DRL), settled fraud charges for $25 million.
What did the Commission find? According to their complaint, they charge that Doral “overstated income by approximately $921 million or 100 percent on a pre-tax, cumulative basis between 2000 and 2004,” which enabled the firm “to report an apparent 28-quarter streak of “record earnings” and facilitated the placement of over $1 billion of debt and equity.”
In connection with the securitization of mortgage loans it had originated over the period, Doral had to estimate a fair value for interest-only [IO] strip securities it retained from the securitizations. The estimated values for these IOs were improperly calculated and resulted in the overstatement of the retained interests as well as the gains recorded on the sale of the loans. Worse: it was known within the company that the methodology used in calculating the estimated fair values was wrong - but they were used anyway.
In addition, Doral sold about $3.9 billion in mortgages to FirstBank Puerto Rico between 2000 and 2004, on which it improperly recognized gains on the sales - improperly recognized, because the sales inclueded “oral agreements or understandings between Doral Financial’s former treasurer and former director emeritus and FirstBank senior management providing recourse beyond the limited recourse established in the written contracts.” Doral, in effect, still had skin in the game for the mortgages “sold,” so they weren’t genuine sales.
What else? Doral “managed earnings through a series of contemporaneous purchase and sale transactions with other Puerto Rican financial institutions totaling approximately $846.9 million. These involved the generally contemporaneous purchase and sale of mortgage loans from and to local financial institutions where the amounts purchased and sold, and other terms of the transactions, were similar. Doral Financial entered into approximately $200.1 million worth of these transactions during the fourth quarter of 2004 with one Puerto Rican financial institution and approximately $646.8 million worth during 2000 and 2001 with other local financial institutions.” Another way of putting it: the company structured transactions with other institutions in order to present a specific amount of income in a certain accounting period, apparently with no real substance other than for making the earnings look good.
Interesting to note that the other financial institutions are not mentioned in the complaint, but it’s implied that their earnings are also “managed” by the same transactions. Maybe those firms are what the SEC is referring to in the last line of its litigation release: “The Commission’s investigation is continuing.”
There’s a bit of an unsettling coincidence in the timing of the Commission’s Doral release. Many of Doral’s transgresssions relate to its estimation of the fair value of the interests it retained in the securitizations of loans: their modeling was unrealistic, they knew it, and it provided them with an intended result. (As did their “contemporaneous purchases and sales.”) It’s an unpleasant reminder that fair value reporting, while useful, can be pushed and pulled and massaged into whatever management wants in the absence of visible market prices - and the absence of sturdy disclosures about derivations of fair values doesn’t help users. The coincidence: the Commission released this example of fair value problems the same week the FASB releases its new standard on fair value reporting, which should set the table for an expansion of fair value reporting in future accounting standards. Cue the theme from the Twilight Zone, please.