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In case some of you missed it, PwC and E&Y have been hired by the Treasury Department to help the government implement the $700 billion Wall Street bailout program. According to the story , PwC will act as the auditor for the program, under which Treasury will buy billions of dollars worth of preferred bank stock in a move to help recapitalize struggling banks, while E&Y will provide general accounting support. So basically these firms are being paid to help fix the problems they helped cause, and make no mistake, all of the Big 4 firms are complicit. Let's take a look though at the two "winners" shall we? PwC is the auditor of AIG and has been sued by AIG’s shareholders. PwC is also the auditor of Freddie Mac and now JP Morgan Chase and Bank of America, as well as Goldman Sachs and Northern Rock. Ernst & Young was the auditor of Lehman Brothers and IndyMac Bank, both bankrupt and now taken over. E&Y was also recently fined by the SEC for independence violations relating to paying hundreds of thousands of dollars to someone who sat on the Board of Directors of three of their audit clients, including on an audit committee responsible for retaining Ernst & Young. The cozy relationships that the Big 4 firms have with politicians and corporations is patently obvious, and there is no way to fix it, at least that I can see. To quote Queen Amidala in Star Wars: Episode I, "It is clear to me now that the Republic no longer functions as a democracy."
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1. Where to Begin?
Written by J.J. Thompson, on 10-28-2008 23:48
This is my first posting on here of any kind, not because I just found this site (I have been following Brandon's commentary for quite some time), but more as the commentary is usually spot on.
Following in the wake of the Wall St. Meltdowns responses (http://brightfly.com/content/view/592/2/#akocomment75) this was just simply too much.
I began to draft a very long response, and quickly realized that it would likely go over the top with too much detail. Hopefully, this short synopsis will suffice to bring some clarity to an important topic that is being oversimplified in this post to the point it muddies the water.
1) Do we all agree that someone should provide some semblance of independent third party oversight of our $700B? Who, would any of you propose, is better suited to do this than the Big 4?
2) I think it would be prudent to share how, exactly, the Big 4 "helped cause" these issues. Somehow, the Big 4 is responsible for greedy banks lending to individuals who shouldn't have been qualified for mortgages? Somehow, the accounting firms should have stopped acting as external auditors and instead should have been business consultants letting shareholders know that even though the financial statements were accurate based on accounting standards, they should warn everyone that collectively, our US markets are allowing people to make bad decisions? The comment that they "helped cause" this issue is ridiculous.
3) The main regulator for Freddie and Fannie (the two entities most closely linked to our economic failures, and cited regarding PWC above) is not the accounting firms, but OFHEO. Please review http://www.ofheo.gov/ to understand what OFHEO does. Then one can figure out the line between OFHEO and the Big 4 in roles and responsibilities and try to make their own determination about who is more responsible for this crisis.
Finally, I am surprised that this made it through the moderation process. I have referred numerous clients, business partners, and associates to Brightfly.com to have the latest and greatest unbiased, practical, real, and actionable intel on Compliance. There is a fine line between making bold comments and crossing the line where it can appear that someone is merely slinging mud to attract attention.
Guys, people are listening. People in our industry read these posts. People factor in the information as part of their decision making.
Individual contributors should be mindful of the audience and consider being a bit more cautious when making far fetched accusations unless they have a good response when asked "what do you propose as an alternative?".
Mark, I've heard nothing but great comments about you from those who know you and your Bio is very impressive. I'm a little surprised by the two posts referenced in this thread and welcome some follow-up from you.
As it is clear that you don't feel that the Big 4 (or PWC / EY) is not the answr, what do you propose as the alternative for fulfilling the objective of providing oversight and accountability regarding the $700B bailout?
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2. Further Explanation
Written by Mark Adams, on 10-31-2008 10:13
To begin with, my intention in posting my editorial comment was not to engage in “mudslinging”, nor was it to offer ideas on how to fix the oversight problem. All I wanted to do was ask the question that no one else seems to be asking, which is why the audit firms did not inform anyone that there were serious problems within these organizations. One of the purposes of Brightfly is to solicit commentary from a variety of viewpoints so that professionals can engage in healthy, and sometimes lively, discussions regarding issues of high importance to our industry. Good people can disagree, and that’s okay. What matters is that we get to see different opinions and decide for ourselves.
Moving right along, I agree with you on two things: 1) the OFHEO does indeed have primary responsibility for oversight of Fannie Mae and Freddie Mac, and 2) the problems we are seeing were caused by politicians (namely Democrats under the Clinton administration) legislating “affordable housing” requirements which forced mortgages to be sold to people who could not afford them. Regarding the role of the Big 4 in this mess, let’s separate Fannie and Freddie from the rest of the bunch for a moment.
As far as Freddie and Fannie are concerned, why didn’t their auditing firms raise any red flags as the OFHEO did in 2004? Granted, the Big 4 did not actually cause the problems, but they certainly didn’t alert anyone that there were problems. Why not? They are supposed to be the watchdogs for shareholders and investors. It’s possible that the audit firms, after seeing how the OFHEO was demonized in 2004 for trying to alert Congress as to the insolvency risk for Fannie and Freddie, decided to take the “safe” route and declare everything perfect. Looking at this from the shareholders’ point of view it’s easy to see why they would be angry. In fact, this is the kind of failure that in many cases leads to shareholder lawsuits against audit firms, like PwC being sued by AIG’s shareholders as I mentioned in my original post.
Regarding the financial firms, the Big 4 was similarly deficient as evidenced by the opinions they issued on Lehman Bros., Morgan Stanley, and so on. As an example, E&Y issued an unqualified opinion on Lehman Bros. for the 2007 fiscal year! We now know that this could not have truly been the case, so why the perfect score? Think for a moment what would have happened if E&Y had issued a going concern opinion for Lehman, or if Deloitte had issued one for Morgan. That would be like telling your girlfriend she has body odor -- all hell would have broken loose. Big 4 partners are extremely risk-averse and their sense of self-preservation probably kicked in. Still, should they be let off the hook for that? After all, they could have just walked away from the audit. Of course that would have meant losing all that audit revenue, so it appears they chose audit fees over professional ethics. I know that sounds harsh, but I think the question is worth asking. To clarify, I don’t know if that is indeed what happened, and I hope it wasn’t. However, I for one would like to know what did happen so we can make the necessary adjustments going forward.
It is also possible that the audit firms simply didn’t have enough knowledgeable staff on hand to do the work right. I used to see that all the time and I know it continues to be a problem to this day. If that was the case then fine, let’s address that somehow.
Lastly, you mention toward the end of your post that I do not feel that the Big 4 should be involved in overseeing the bailout and that I should provide an alternative idea. If you reread my original post you will notice that I do not really say that at all, I simply lament the current state of affairs. I also admit that I don’t know how to fix it. This is not a “Big 4” problem; rather it is the pervasive problem of incestuous relationships between government bureaucracies, corporate executives, and regulators. The Big 4 are well-represented within the government through lobbying, campaign contributions, and their presence on the boards and advisory committees of the very regulatory agencies that are supposed to keep them in check. So where does that leave us? Can we still trust the opinions that the audit firms issue? Should we trust them to oversee the bailout? Is so, why? Remember, I’m just calling it the way I see it, and I have no problem altering my opinion based on new information.
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3. I only play an auditor on TV...
Written by Brandon Dunlap, on 11-03-2008 08:34
First of all, thank you both, Mark and JJ for the commentary. Since you both have spent time inside the Big 4 watching the sausage get made, while I have been on the recieving end as a client, I'd like you to weigh in on how I see it.
With the insolvency issues in the firms taht Mark cited in his examples, it seems to me that at the very least the auditor's should have dropped a "Disclaimer of Opinion Report" and proceeded under SAS No. 59 guidance regarding the "going concern" question.
Many thnk that this sort of report is effectively a nail in the coffin of the entity under audit, and much research has been done to determine if this is the case. perhaps teh Big 4 were trying to avoid just such an event in the faceof impending financial devestation across multiple sectors and geographies.
Does that count as a lessor of two evils or does it further vilify them in the eyes of the public?
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4. Unfortunate Fallout From Real World Audi
Written by J.J. Thompson, on 11-03-2008 16:25
First of all, I appreciate that you both took the time to respond to my comment. I thoroughly enjoy the philosophical discussions on this topic and enjoy more converting them into reality. I didn't think that you were intending to "mudsling", but instead, I thought that perhaps you weren't aware of how many (of the right people) are reading what you write and perhaps had lost sight of how it could be perceived.
A few follow-up points… The rest I will package in some insights into the Bailout and Freddie as a stand alone article.
1) Red Flags Ignored…
You stated that "As far as Freddie and Fannie are concerned, why didn’t their auditing firms raise any red flags as the OFHEO did in 2004? Granted, the Big 4 did not actually cause the problems, but they certainly didn’t alert anyone that there were problems."
The objective of what you're saying would be that someone should have stood up. Someone should have shouted at the top of their lungs "HEY, EVERYONE LISTEN UP. THERES A HUGE PROBLEM HERE!!!!"
Well, someone did. It wasn't private. It was public. And no one really listened. Shame on all of us. Jump down to [REF 2] to read how the CEO notified everyone of the red flags in a few snippets from the annual report... that was no doubt part of the team effort with the Big 4, but clearly shows that even though major red flags were waved, no one heeded them. Its disappointing.
http://www.freddiemac.com/investors/ar/2007/03.htm
"Accordingly, some of the housing stock that is now or soon will be facing the threat of foreclosure will likely need to be converted, at least temporarily, into rental housing. So it makes sense to undertake efforts that would enable at least some of the families that briefly owned the properties to stay in them under certain circumstances, whether as ordinary renters, or on some kind of innovative shared-equity, rent-to-own or lease-to-buy basis. The specifics would have to be worked out as a matter of law and policy. But what’s already clear is that the right kinds of creative solutions would be better than foreclosure –– for lenders, families and neighborhoods alike."
[REF2: http://www.freddiemac.com/investors/ar/2006/03.htm]
One one of the first pages of the 2006 Annual Report, the CEO, Dick Syron, referenced the increasing risk in sub-prime mortgages. He referenced the internal control failures. He referenced the improvements being made (to resume quarterly reporting by mid 07).
He went on to say that "This February, in order to protect consumers and raise underwriting standards, Freddie Mac took the lead in announcing that after September 1, we will not buy subprime mortgages that pose an unacceptable risk of excessive payment shock and possible foreclosure. As a GSE, we feel a responsibility not only to help families buy their own homes, but to help them keep their homes, as well."
In risks, he stated: "We rely on third parties for certain functions that are critical to financial reporting, our Retained portfolio activity and mortgage loan underwriting. Any failures by those vendors could disrupt our business operations.
We outsource certain key functions to external parties, including but not limited to (a) processing functions for trade capture, market risk management analytics, and asset valuation, (b) custody and recordkeeping for our investments portfolios, and (c) processing functions for mortgage loan underwriting.
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We rely on internal models for financial accounting and reporting purposes, to make business decisions, and to manage risks, and our business could be adversely affected if those models fail to produce reliable results.
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We make significant use of business and financial models for financial accounting and reporting purposes and to manage risk. For example, we use models in determining the fair value of financial instruments for which independent price quotations are not available or reliable or to extrapolate third-party values to our portfolio. We also use models to measure and monitor our exposures to interest-rate and other market risks and credit risk. The information provided by these models is also used in making business decisions relating to strategies, initiatives, transactions and products. "
2) The answer to oversight of the bailout package is the collective EY / PWC team leveraging the team members and leadership from the Freddie and Fannie engagements. I know many of them personally, and there is no better team that will provide objective, insightful, risk averse, honest oversight than them.
More to follow in subsequent posts. This dialogue is great, by the way.
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5. Looking forward to your articles
Written by Brandon Dunlap, on 11-03-2008 16:53
JJ-
We look forward to hosting you as a Guest Researcher. Just let me know when you're ready to post. I'm sure Mark is looking forward to seeing it as well so we can continue the conversation.
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