You don’t hear much about it, but the March 2007
bankruptcy of a company called New Century Financial was arguably
one of the most important events leading up to the financial crisis
that nearly caused a second Great Depression.
It was the demise of New Century, then the nation’s second
largest mortgage lender, that triggered the collapse of the market
for collateralized debt obligations. And it was the collapse in the
value of collateralized debt obligations (a majority of which
contained New Century mortgages) that hobbled a number of big
financial firms. Once hobbled, the likes of Bear Stearns and Lehman
Brothers were ripe targets for unscrupulous hedge fund managers who
amplified their problems by spreading exaggerated rumors while
bombarding them with illegal naked short selling.
So we must ask: Why did New Century Financial go bankrupt? Did
the company die of natural causes, or did miscreants orchestrate
its destruction? And if miscreants destroyed New Century, did they
do so planning to profit from the broader economic calamities that
were certain to result from its collapse?
I do not yet have definitive answers to these questions. But
interviews with sources close to New Century and a review of
documents, including the oddly biased 500-page New Century bankruptcy
report, make it clear that at least two hedge fund managers
— David Einhorn of Greenlight Capital and Dan Loeb of Third
Point Capital — played a significant role in creating the
conditions that made New Century vulnerable to catastrophe. And
they did so while building massive short positions in Bear Stearns,
Lehman Brothers, MBIA and other companies that were likely to be
seriously damaged if New Century were to go bankrupt.
Einhorn was a major investor in New Century and took a
seat on the company’s board in early 2006. He has gone to
lengths to suggest that he lost a lot of money from his investment.
But given that his activities on the board were so contrary to New
Century’s best interests, and given that he was otherwise so
heavily invested in the collapse of the mortgage markets, it is
reasonable to ask if he was in fact short selling New
Century’s stock, or buying credit default swaps that would
pay out in the event of the company’s bankruptcy.
Moreover, some banks, most notably Goldman Sachs, created and
sold collateralized debt obligations containing New Century
mortgages while simultaneously betting that the CDOs would plummet
in value. Multiple media stories (such as
this one in “Investment News”) have speculated that
Goldman Sachs actually designed these CDOs in such a way that they
would be certain to implode, delivering large profits to Goldman
and preferred hedge fund clients. Those CDO could not have been
created without Einhorn and his allies inside New Century
delivering the mortgages that went into them. And there is no doubt
that Goldman Sachs delivered the knock-out punch that put New
Century out of business, ensuring that the CDOs would, in fact,
implode. This constellation of facts may be coincidental, of
course. Or not. This essay lays them out, and leaves it to the
reader to decide.
New Century’s problems began in December 2005, when board
member Richard Zona drafted a letter in which he threatened to
resign if senior executives did not agree to sell a greater
percentage of the mortgage loans on its books to various banks,
such as Goldman Sachs. In his letter, Zona explicitly stated that
he was making this demand in league with David Einhorn and Dan
Loeb.
Unfortunately, according to the bankruptcy report, New
Century’s executives never saw that letter. Zona stashed the
draft letter on his computer and instead submitted a letter making
a similar demand, but omitting all mention of Einhorn and Loeb. In
all likelihood, Zona changed his letter because he knew that New
Century’s executives had good reason to doubt whether Einhorn
and Loeb, who had recently reported large shareholdings in New
Century, were acting in the company’s best interests.
As Deep Capture has thoroughly
documented, Einhorn and Loeb are part of a network of hedge
fund managers and criminals who use a variety of dubious tactics to
destroy, seize, and/or loot public companies for profit. It is not
unusual for money managers in this network to appear as long
investors in the companies they are attacking, and sometimes they
seek to obtain a seat on a target company’s board in order to
be better placed to run the company into the ground for their own
private profit.
Essentially everyone in this network – including
Einhorn and Loeb — are connected in important ways to Michael
Milken, the infamous criminal who specialized in loading companies
with debt, looting them, and then profiting still more from their
inevitable bankruptcies.
Einhorn spent his early career working for Gary Siegler, who was
formerly the top partner in the investment firm run by Carl Icahn,
a corporate raider and ne’er-do-well who owes his fortune to
the junk bond finance that he received from Michael Milken in the
1980s. Icahn has various other seamy connections, and has employed
people with ties to the Mafia (see “The Story of
Dendreon” for details).
Prior to his attacks on Lehman Brothers and Bear Stearns,
Einhorn was best known for his eminently dishonest attempt to
demolish a financial company called Allied Capital. The attack on
Allied began in 2002 at a hedge fund luncheon. Halfway through that
luncheon, Einhorn stood up and declared that “Allied Capital
is going to zero!” Sitting next to Einhorn at that luncheon
was Carl Icahn.
Some weeks before the luncheon, Michael Milken had appeared in
the offices of a top Allied Capital executive. “You
know,” Milken told the executive, “I already am quite a
large shareholder of your stock – but my name will never show
up on any list you’ll see.” This may have been a
reference to a practice called “parking stock” (owning
stock but “parking” it in the accounts of friends with
whom one has made under-the-table arrangements), a practice that
figured in the high-count indictment that sent Milken to prison in
the 1980s. Milken appeared to the Allied executives to be
threatening Allied and fishing for information, paving the way for
Einhorn’s more public vitriol.
The Allied story is outside the remit of this article, but it is
enough to know that Einhorn proceeded to accuse the company of
massive fraud and of failing to account for its loans at
“fair value”. With some minor exceptions, none of
Einhorn’s allegations of fraud were ever proven to have
merit. And it was clear from the get-go that Einhorn’s notion
of “fair value” had nothing to do with
“fair” (as in “what the market was
paying”). Rather, “fair value” was an arbitrary
metric that could be taken to mean whatever Einhorn said the value
of the loans should be. This is important because Einhorn’s
outlandish “fair value” calculations featured
prominently in his attacks on Lehman Brothers and Bear Stearns. In
addition, as we will see, arbitrary and over-the-top “fair
value” assumptions about mortgage loans featured in the
bankruptcy of New Century.
As for Loeb, he is a long-time Einhorn accomplice who worked
side-by-side with many of Milken’s former traders at Jeffries
& Co. He got his first big break by obtaining preferential
access to certificates of beneficiary interest that had been issued
by Milken’s bankrupt operation at Drexel, Burnham, Lambert.
Loeb seems to take a certain pride in his bad boy image, and has
distinguished himself in all manner of chicanery, such as hiring a
cast of convicted criminals and scofflaws to spread false
information about public companies on the Internet. (Please search
Deep Capture’s archives; we have compiled substantial
evidence implicating Loeb in various misdeeds).
Given their backgrounds, there was every reason to doubt the
merits of the demand that Einhorn and Loeb had articulated through
New Century board member Richard Zona. Indeed, the majority of New
Century’s top managers (the company had three CEOs at the
time) were opposed to the Einhorn-Loeb demand to sell off all of
New Century’s mortgage loans, and for good reason. Selling
off all the loans would make the company entirely dependent on the
banks, such as Goldman Sachs, that bought the loans. If, for some
reason, the banks were to demand that New Century buy back its
loans, the company would go bankrupt.
Shortly before Zona submitted his letter demanding that New
Century sell off its loans, one of the company’s co-founders,
Patrick Flanagan, said by sources to be an ally of Einhorn and
Loeb, left the company. After a brief time, Flanagan went to work
for hedge fund Cerberus Capital. Cerberus Capital was run by Ezra
Merkin, famous for being one of the biggest feeders to the Bernard
Madoff fraud, and Stephen Feinberg, who was formerly a top employee
of Michael Milken. Cerberus is also the proud owner of an Austrian
bank called Bawag, which was at the center of a scandal that wiped
out Refco, once one of the most abusive naked short selling outfits
on Wall Street. (Refco’s former CEO, Phillip Bennett, and
executive Santo Maggio have been convicted and are serving prison
sentences, while one of its naked short selling clients, Thomas
Badian, is still living in Austria as a fugitive from US law)..
Sources tell Deep Capture that Cerberus made massive
profits from the demise of New Century, and if so, it is likely
that Flanagan had a hand in this. It is perhaps also no coincidence
that Cerberus now also employs Thomas Marano, the former head of
mortgage trading at Bear Stearns, and Brendan Garvey, the former
head of mortgage trading at Lehman Brothers. Marano and Garvey
helped sink their companies by buying New Century’s
repackaged loans from Goldman Sachs and a few other banks.
While still at Bear Stearns, Marano seemed almost eager to see
the bank collapse. At one point he called Roddy
Boyd, a reporter with close connections to the Einhorn-Milken
nexus of hedge funds, to leak an account of Bear
Stearns’ problems, though as we have documented, that leak
seems to have been exagerrated when Marano made it. One has
to wonder why he was leaking about his employer, and also wonder at
the coincidence of the fact that he was doing this while preparing
to go to work for a large hedge fund that was betting
against that employer.
After Flanagan left New Century, Zona organized a highly unusual
“off site” board meeting. The directors at this meeting
(which excluded all opposing viewpoints) decided to implement a
radical change to New Century’s management structure. Among
other changes, CEOs Ed Gotchall and Bob Cole were removed from
their posts, and the company was put under the sole leadership of
the third CEO, Brad Morrice.
Einhorn and Loeb orchestrated this change. Sources say the two
hedge fund managers had considerable input at the “off
site” board meeting even though Einhorn was not yet a
director. And Zona stated in the initial draft of his letter (the
one that stated that he was making his demands in alliance with
Einhorn and Loeb) that Gotschall was “immature and
disruptive,” while Cole was “not fully engaged”
– because they opposed the demand to sell off the loans.
In Morrice, Einhorn and Loeb had a CEO whom they could work
with. Prior to entering the mortgage business, Morrice had been the
founding partner, along with Richard Purtrich, of law firm King,
Purtrich & Morrice. In 2008, Purtrich was sentenced to prison
for funneling illegal kickback payments from a crooked law firm
called Milberg Weiss. Milberg’s top partners, Bill Lerach and
Melvyn Weiss, were also indicted in the scheme.
According to the
DOJ, the kickbacks were paid to plaintiffs who filed bogus
class action lawsuits against public companies “anticipating
that their stock prices would decline.” Deep Capture
has published extensive evidence showing that Milberg prepared
those bogus lawsuits in cahoots with hedge funds in David
Einhorn’s network. The hedge funds, of course, profited from
short selling the targeted companies, and it is indeed likely that
the bribed plaintiffs were “anticipating that the stock
prices would decline” because they knew that the hedge
funds were going to attack the companies via illegal naked short
selling and other tactics.
So it is fair to say that Morrice (whose former partner was
funneling kickbacks to plaintiffs who were conspiring with
Einhorn’s hedge fund network to attack public companies) was
intimately familiar with the tactics of Einhorn’s hedge fund
network.
In any case, soon after Morrice took the helm at New Century, he
quickly set about meeting Einhorn’s demand to sell off New
Century’s mortgage loans. Whole loan sales comprised less
than 70% of New Century’s secondary market transactions in
2005. By September of 2006, whole loan sales comprised a full 95%
of New Century’s mortgage lending. As a result, whereas in
all of 2005, New Century had sold a mere $256 million worth of
loans at a discount, during the first nine months of 2006, New
Century sold $916 million worth of loans at a discount.
Much of the income from those loan sales was not used to build
New Century’s liquidity. Rather, at Einhorn’s
suggestion, it was used to buy back stock and pay out massive
dividends to shareholders like Einhorn. At the end of 2005, New
Century was paying $1.65 a share in dividends. In January 2007, two
months before New Century’s bankruptcy, the company was
paying dividends of $1.90 a share. If we accept the proposition
that Einhorn might have profited from New Century’s collapse,
it is clear that he planned first to profit from his long position.
This is similar to a classic “pump and dump” scam,
except that the strategy is to pump and destroy.
In March 2006, with the support of Morrice and Zona, Einhorn
obtained a seat on New Century’s board of directors. At this
point, according to one member of senior management, the
“activist investors” on the board did become extremely
“active,” agitating for more loan sales while pushing
for changes in New Century’s accounting. Many of these
changes were based on the premise that New Century was not
accurately recording the “fair value” of loans
that it had to repurchase from Goldman Sachs and other buyers.
Meanwhile, Einhorn convinced the board to create a finance
committee and presented himself as the man to run it. According to
the bankruptcy report, this committee met “unusually
often,” and according to sources, its principal activity was
to handle New Century’s relationships with Goldman Sachs and
the 13 other banks that were buying New Century’s mortgage
loans. In June 2006, at Einhorn’s behest, New Century hired a
woman named Lenice Johnson to serve as chief credit officer,
responsible for managing those same relationships.
As we shall see, two of those relationships – especially
the one with Goldman Sachs – would later mysteriously
deteriorate, leading to New Century’s demise. And soon after
New Century went bankrupt, Johnson went to work at the
above-mentioned Cerberus Capital (the Milken-crony hedge
fund). You may remember that Cerberus Capital was mentioned
above because Thomas Marano the head of Bear Stearns’
mortgage trading desk, sunk Bear Stearns by buying Goldman-packaged
new Century debt, then leaked information about Bear Stearns’
financial condition to New York Post reporter Roddy Boyd (Boyd is
Deep Capture All Star; his dishonesty has been fodder for
many of our stories), a few weeks before joining the hedge fund
– Cerberus Capital — that was betting against Bear
Stearns. In sum, then: Cerberus Capital bet that New Century would
face a credit crunch and bet against Bear Stearns for buying New
Century’s debt, then hired the New Century chief credit
officer and the head of the Bear Sterns desk that was making the
bad bets.
As Einhorn and Morrice eagerly sold off all of New
Century’s loans, other board members became alarmed. In
August 2006, board member Fred Forster wrote a letter to Einhorn
stating: “Whatever we do, we need to be very comfortable that
less capital/liquidity does not in any material way threaten the
very existence or viability of New Century.”
It needs to be stressed that at this point New Century was
seemingly in good health. Defaults on its mortgages had increased
only slightly, and in the third quarter of 2006, the company
recorded a profit of more than $200 million. The problem was that
nearly 100 percent of the mortgages it wrote were now being sold to
Goldman Sachs and 13 other banks. With no mortgages on its books,
the company depended entirely on the banks for income. If just one
of those banks were to pull the plug, the company would go
bankrupt. And as we know, one of those banks, Goldman Sachs, was
placing large short bets on CDO’s containing New Century
mortgages, meaning that Goldman had a motivation to see New Century
fail. In other words, New Century climbed into Goldman’s life
support chamber while Goldman kept its hand on the plug and bought
insurance that would pay out in the event of New Century’s
death.
Of course, as we know, Goldman was also selling CDOs that had
been stuffed with New Century’s subprime mortgages. No doubt,
Einhorn and his allies at New Century aided the proliferation of
these CDOs by selling Goldman ever-larger numbers of subprime
mortgages. Again, the problem was not that the subprime mortgages
had high default rates. The mortgages were always expected to have
high default rates. That’s why they were called
“subprime.” The problem was that Goldman (perhaps with
encouragement from their key client Einhorn) was selling the
subprime mortgages in essentially fraudulent CDOs that disguised
the subprime mortgages as AAA rated debt.
It was just a matter of time before the markets would discover
the true nature of these CDOs. That, no doubt, is one reason why
Goldman was simultaneously shorting them. All the better for
Goldman if New Century were to collapse before the CDO scam was
discovered. According to a McClatchy news report, when New Century
did collapse, Goldman was prepared with shell companies in the
Cayman Islands through which it could offload the last of its New
Century debt to unwitting foreign investors.
Supposing that miscreants did want New Century to go bankrupt,
all that was required was some precipitating event – an event
that would allow one of the 14 banks (say, Goldman Sachs) to force
New Century to repurchase its mortgage loans under the terms of its
contractual repurchase agreement.
As it happened, the foundations for that precipitating event
were laid in November 2006, when New Century demoted its chief
financial officer, Patti Dodge, and hired a man named Taj Bindra to
take her place. As Morrice, the New Century CEO, told the
bankruptcy examiner, Zona and Einhorn “had expressed doubts
about Dodge’s capabilities and competence to be the
company’s CFO,” and sources tell Deep Capture
that Bindra was hired at Einhorn’s behest.
Prior to joining New Century, Bindra had been the vice president
of mortgage banking at Washington Mutual. A lawsuit filed by a
consortium of respected insurance companies that were investors in
Washington Mutual alleges that JP Morgan conspired with
“investors” (read: “short sellers”) to
drive down Washington Mutual’s share price and manufacture
falsehoods about its financial health so that JP Morgan could take
the company over at a substantial discount. As part of this scheme,
the lawsuit alleges, JP Morgan “deceptively gained access to
Washington Mutual’s confidential financial records through
the use of ‘plants’ and ‘moles’ engaged in
corporate espionage.” The lawsuit alleges that one of the
“moles” was … Taj Bindra. It is this same Taj
Bindra who then went on to bigger things as CFO of New Century
Financial.
Whether or not you believe that Bindra was part of a conspiracy
to take down Washington Mutual, it is clear that his actions as CFO
of New Century Financial were strange. Understanding why, however,
requires delving into a bit of accounting arcara.
According to one source, Bindra had been CFO for “no more
than two days” before he began asking questions about New
Century’s accounting for mortgage loans that the company had
so far repurchased from Goldman Sachs and the 13 other buyers.
Specifically, Bindra asked why New Century did not include
so-called “income severity” (i.e. a mark down of the
value of repurchased loans to reflect their actual resale value) in
its reserve calculation.
Normally, one wants reserves in any financial company to
properly estimate the risks of certain events, and their potential
costs. However, Bindra’s question was somewhat esoteric
(especially for a CFO who had only been at New Century for
two days) because it referred specifically to an obscure change in
New Century’s accounting that had been made in the second
quarter of 2006. That change was as follows: instead of recording
the mark-down in its reserves, it recorded it in “loans held
for sale.” This does not mean that New Century
had stopped including income severity in its calculations, but
rather, had moved it to another (and equally or more visible)
part of its balance sheet. The books continued to balance
(that’s why they call it a “balance sheet”) and,
accounting experts tell Deep Capture, the change had
absolutely no effect on New Century’s bottom line, nor
was it any less transparent. Multiple New Century executives
explained this to Bindra. In addition, KPMG, New Century’s
accountants, confirmed to Bindra that the change did not affect
earnings.
But Bindra persisted. And, according to the bankruptcy report,
“such inquiries by Bindra led in relatively short order to
the discovery of material accounting errors.” Those
“material accounting errors” were none other than the
obscure change in accounting for income severity – i.e. the
change that had no effect on New Century’s earnings. By
remarkable coincidence, just as Bindra discovered this supposed
“error” in December 2006 (which was long before the
“error” was mentioned in any other public forum), the
Center for Financial Research and Analysis, an outfit known to
cater to short sellers, published a report that alluded to this
very same “error.”
When Bindra took this supposed “error” to the board,
there was much confusion among most of the directors. But Einhorn
and Zona insisted adamantly that New Century would have to restate
its earnings. This was strange not only because the change in how
the company recorded income severity had no material effect on
earnings, but also because Einhorn had eagerly signed off on the
change in the first place. In fact, the change had been one
of the board’s first initiatives after Einhorn took over the
finance committee. Given this, it certainly appears possible that
Einhorn initiated the accounting change so that his
hand-picked CFO would have some “irregularity” to point
to a few months later.
In any case, on February 7, 2007, New Century announced that it
had violated accounting rules and would have to restate earnings
for the previous year. Oddly, New Century never indicated by how
much it would have to restate earnings. It simply said that it
would restate. Given that the “violation” discovered by
Bindra had no effect on earnings, it makes sense that the company
would not provide a figure. That is to say, the figure could not be
provided because, as far as anyone at New Century knew at the time,
the figure was zero. But this “restatement”
announcement was nonetheless catastrophic for New Century, and the
beginning of the end for the stability of the American financial
system.
It was catastrophic because Goldman Sachs and the 13 other banks
that were buying New Century’s mortgage loans had small print
in their contracts that allowed them to cut off finance and force
New Century to buy back its loans if New Century were to restate
earnings. Indeed, a restatement was one of the only events that
would allow the banks to force New Century to repurchase all of its
loans.
Still, nobody actually expected any bank to act on this small
print. Presumably it would be mutually assured destruction,
with New Century going bankrupt and the banks losing a fortune in
the market for CDOs. Several weeks after the earnings restatement,
Citigroup made a large investment in New Century, obviously
reckoning that the fundamentals of the company were just fine.
But as we know, Goldman Sachs was impervious to mutually assured
destruction because it had been short selling the CDOs all along.
And sure enough, on March 7, 2007, Goldman, acting on that small
print in its contract, sent a non-public letter demanding that New
Century repurchase every single one of its Goldman-financed loans.
The next day, IXIS Real Estate Capital, then a subsidiary of the
French bank Natixis, sent New Century a similar letter. David
Einhorn had recently become a major investor in Natixis and had
been threatening to topple its management, but that is no doubt
another coincidence.
Certainly not a coincidence is the fact that a massive illegal
naked short selling attack on New Century began just before Goldman
Sachs sent its letter. SEC data shows that there were
“failures to deliver” of more than 4 million New
Century shares on March 8, 2007. Since failures to deliver occur
three days after the selling date, those 4 million phantom shares
must have been sold by March 6, one day before Goldman sent the
letter. It appears that somebody knew what Goldman had in store for
New Century.
An independent company that tracks the trading of hedge funds
reports that the biggest traders in New Century stock at this time
were SAC Capital, run by Steve Cohen, who was once investigated for
trading on inside information provided by Michael Milken’s
shop at Drexel Burnham, and none other than Dan Loeb, who was
Einhorn’s early ally in the ultimately successful effort to
force New Century to sell off all its loans. We do not know for
certain that those trades were short sales because the SEC does not
require hedge funds to report their short positions (on the grounds
that it might reveal their “proprietary trading
strategies” which are, in some cases, flagrantly
illegal), but it would be unlike Cohen and Loeb to invest in a
company that was about to be wrecked by Goldman Sachs.
In the days after Goldman and IXIS cut off credit, New
Century’s remaining bankers panicked. With Goldman pulling
out and naked short sellers on the rampage, it was clear that New
Century’s days were numbered. The other bankers pulled the
plug and within a matter of weeks, New Century, a company that had
reported a strong profit a few months before, declared bankruptcy.
The news of the bankruptcy immediately crashed the CDO market (the
market actually began to sink around the time Goldman sent New
Century its letter, but it went completely under on the news of the
bankruptcy). This set off shockwaves that ultimately collapsed the
American economy. Meanwhile, of course, Goldman made a handsome
profit, having bet that all this was going to happen – that
is, it bet that the instruments with which it was flooding the US
financfial system would turn toxic.
As we also know, Einhorn also earned a tidy sum — from his
short sales of MBIA, which insured the CDOs, and later from his
short selling of Bear Stearns and Lehman Brothers, which had bought
the CDOs. Did Einhorn or others in his network profit more directly
from the collapse and naked short selling of New Century? That is
for the SEC to decide.
But, of course, the SEC is unlikely to look into this. Instead,
it has charged New Century’s former CFO, Patti Dodge, and two
other New Century executives for violating accounting rules.
Yet to this date, no reputable independent body has provided
evidence that the change in accounting that Bindra
“discovered” in December 2006 actually affected
earnings. And it is that change that prompted the disastrous
announcement two months later that New Century was going to
restate. KPMG, New Century’s accounting firm, was never
consulted about the “restatement” and was fired before
it had a chance to object. The decision to announce this
restatement (and to not specify by how much the restatement would
affect earnings) seems to have been made entirely by Bindra, the
CFO, and one of Bindra’s minions, with the encouragement of
David Einhorn and his ally Richard Zona.
In prosecuting Dodge and her colleagues for accounting
violations, the SEC seems to have taken its cues from the
bankruptcy examiners’ report, which goes to lengths to paint
Dodge and other New Century executives (namely, those who were not
allied with David Einhorn) as criminals. But strangely, while the
bankruptcy examiner insists that there were all manner of misdeeds,
it nonetheless admits that it is possible that no actual accounting
rules were violated.
Indeed, the bankruptcy report is convoluted beyond belief,
and to this eye, biased beyond explanation. The examiner who
authored this report stated that he “found no persuasive
evidence” that New Century had deliberately inflated its
repurchase reserve calculation. He notes that the all-important
income severity component was indeed recorded in “loans held
for sale” (and therefore had no effect on earnings). But he
nonetheless suggests that earnings were inflated, noting that the
“elimination of Inventory Severity in the LOCOM valuation
account increased earnings by approximately 23.4 million” in
the second quarter.
This is a actually a neat trick. The examiner is not stating
here that income severity wasn’t recorded accurately. He is
saying that it wasn’t recorded in the “LOCOM
valuation” – i.e. at “fair value.” As I
have mentioned, notions of “fair value” are often
arbitrary. Indeed, from the report itself, it would appear that the
examiner pulled that $23.4 million figure out of thin air.
The tactic seems to be to point to a change in accounting (one that
had no effect on earnings) and suggest that this change did inflate
earnings by alluding to something altogether unrelated – i.e.
random assumptions about fair value.
That is, the argument (which, incidentally, is the same argument
that was heard from Einhorn at New Century board meetings) seems to
go like this:
Einhorn/bankruptcy examiner: “New Century
changed its accounting. It didn’t book income severity in
repurchase reserves. Therefore, New Century inflated
earnings.”
Innocent executive: “But we did record
income severity, in ‘loans held for sale.’ Earnings
aren’t affected by the change.”
Einhorn/bankruptcy examiner: “New Century
changed its accounting. Therefore, New Century must have inflated
earnings.”
Innocent executive: “But Einhorn signed
off on the change. In fact, it was his idea. And, again, it had no
effect on earnings.”
Einhorn/bankruptcy examiner: “Well, there
was a change. That must mean something is wrong.”
Innocent executive: “No”
Einhorn/bankruptcy examiner: “Look, the
problem is that income severity wasn’t recorded at
‘fair value.’”
Innocent executive: “What is ‘fair
value’?”
Einhorn/bankruptcy examiner:
“Here’s a number. I found it in my
underpants.”
Innocent executive: “That’s
completely arbitrary. We have a formula for marking to market that
has served us for years.”
Einhorn/bankruptcy examiner: “No, we
should use the number from my underpants. To prove my point, I will
note that New Century changed its accounting.
Innocent executive: “Changing the
accounting had no effect on the calculation of the
expense!”
Einhorn/bankruptcy examiner: “Right, but
you changed the accounting.”
Innocent executive: “I give up. This may
wreck the American economy, but I give up.”