Corporate Governance

KPMG Forensic Accountant ?Makes Sense of the Subprime Debacle?

By Jim Hodgson

The current issue of The Metropolitan Corporate Counsel features an insight-filled interview with Rich Girgenti, National Practice Leader for Forensic Services at KPMG LLP.  Mr. Girgenti shares his views on the subprime mortgage debacle -- and, in particular, where the situation is headed from a regulatory and prosecutorial perspective.  (Readers may access the full interview here.)  Mr. Girgenti points out just how long (and, at times, convoluted) the trail is between mortgagor and investor -- and how the nature of mortgage securitization allows so many different parties the opportunity to engage in fraud.

For starters, Mr. Girgenti believes that only a combination of private litigation and governmental investigations is going to be able to ?unravel some of the causes of the crisis.?  According to Mr. Girgenti, the blame begins with ?extremely lax underwriting standards,? not to mention the ?fraud and criminal behavior? at the mortgage origination stage.  (This is the stage in which $665 billion had been loaned by the end of 2005 to poorly qualified homebuyers, according to the Center for Responsible Lending.)  No wonder, then, that the FBI commenced more than 1200 mortgage fraud cases in 2007 -- three times the number it opened only four years prior.  And convictions for these crimes in 2007 were twice those obtained just a year earlier.

Following the chain of fraud, Mr. Girgenti has identified substantial conflicts of interest among mortgage brokers and property appraisers during the early 2000s, resulting in inflated home appraisals for the purpose of generating false equity.  This ?increased? equity, in turn, formed the basis for so many unsound second mortgages.

The practices surrounding the securitization of mortgage debt by financial institutions should also face close scrutiny by investigators and litigants.  At issue at this stage is whether such financial institutions purposefully bundled subprime loans with stronger loans in order to achieve investment-grade credit ratings for their pooled and securitized mortgage instruments.

In addition, reviewing underwriting standards and determining whether adequate due diligence was undertaken is going to be a critical factor in bringing successful lawsuits against any number of parties responsible for marketing mortgage-backed securities.  And ?[t]here are many benchmarks,? according to Mr. Girgenti.  Specifically, he recommends close inspection of how investment banks evaluated the origin of the loans at issue; decided whether lenders had fulfilled their responsibilities to borrowers; conducted due diligence at the pooling stage; built and validated financial models; and disclosed (or failed to disclose) the risks associated with investments in securities backed by subprime mortgages.

Finally, credit rating agencies should expect intense examination in connection with what was known about these investment products and how that knowledge influenced published securities ratings.

In the midst of a crisis in which ?what happened, why it went wrong, and who was responsible? remains largely unsettled, perhaps only one thing emerges as a certainty:  investors were deceived by a complicated web of fraudsters -- leaving multiple parties the legitimate targets of litigation.  And perhaps the only way for investors and their attorneys to ?make sense of the subprime debacle? is to think as broadly as possible in relation to sources of potential recovery.  For the road leading to the marketing of mortgage-backed securities is a long and multifaceted one:  mortgages follow a complicated, and often hidden, path from borrower to broker to originator to arranger to investment banker to investor.  As such, recoveries could potentially come from any one of these middlemen -- or from all of them.

Full post as published by PomTalk on February 08, 2008 (boomark / email).