Quelle Surprise! SEC Worked Hard to Ignore Warnings of Subprime Fraud

This from Yves Smith - "Naked Capitalism" -- please follow link to original
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Sunday, May 22, 2011
Quelle Surprise! SEC Worked Hard to Ignore Warnings of Subprime Fraud

Saying that regulators ignored danger signs in the run up to the financial crisis now verges on being a “dog bites man” account. But the New York Times excerpt from the new book Reckless Endangerment by Gretchen Morgenson and Josh Rosner show that the SEC was not merely asleep at the switch, but apparently peopled with higher ups who were looking hard for reasons not to pursue suspicious conduct.

The extract is about a particularly rancid case, that of subprime originator NovaStar, which was one of the twenty biggest. Not only did it issue the drecky mortgages in impressive volumes, but it engaged in obvious financial misreporting. While the frauds it foisted on borrowers fell largely between regulatory cracks, since NovaStar as a non-bank mortgage broker was regulated only at the state level, and those offices are chronically understaffed, misstatements in public reports reside squarely in the SEC’s beat.

Morgenson’s and Rosner’s account follows the efforts of short seller Marc Cohodes. Admittedly, the SEC has reason to take the claims of short-sellers with a grain of salt, but the evidence that Cohodes provided over time was extensive and troubling, including:

¶ Extremely aggressive accounting (no loan loss reserves, overvaluation of loans in inventory, acceleration of future income)

¶ Failure to report regulatory sanctions (cease and desist orders in Massachusetts and Nevada; a HUD inspector general report that determined that NovaStar branch system and use of contractors violated federal regulations)

¶ Failure to report loss of important business relationships, such as with its mortgage insurer, PMI, or one of its main loan buyers, Lehman

¶ Frequent deceptive and inaccurate statements in analyst conference calls

¶ Obvious false statements in SEC reports (for instance, phantom branches, with addresses that corresponded to unrelated businesses, like massage parlors)

The damage to investors wasn’t simply that NovaStar shares were overvalued in the secondary market (they went from over $30 at their peak to below $0.50). The company was able to do more damage via floating new shares during the time frame in which Cohodes was trying to get the SEC to take action.

The remarkable bit is not that the SEC ignored him. Lower level staff appeared to take his charges seriously. But it appears the more senior officials were more interested in finding excuses to do nothing than do their jobs and take the matter seriously. From the book:

Mr. Cohodes reckons that over roughly four years, he conducted hundreds of phone calls with the S.E.C. about NovaStar. Each time, he would walk them through his points. Sometimes, a higher-up would get on the phone and contend that while NovaStar’s practices were indeed aggressive, the company did not appear to be breaking the law. NovaStar’s selective disclosures — it was quick to report good news but failed to own up to problems on many occasions — seemed to be infractions that the S.E.C. should have dealt with. But its investigation went nowhere….

NovaStar’s shares collapsed, wiping out roughly $1 billion in market value from the peak of the stock price. Despite the implosion, between 2003 and 2008, [founders] Mr. [Scott] Anderson and Mr. [Lance] Hartman each made about $8 million in salary, bonuses and stock grants.

Neither man was ever sued by the S.E.C. or any other regulator. As is its custom, the S.E.C. declined to comment on the NovaStar inquiry or the agency’s discussions with short-sellers. But documents supplied by the S.E.C. under the Freedom of Information Act show the extensive communications between Mr. Cohodes and the agency. Ms. Miller, still at the S.E.C., declined to comment.

Even though the public has become accustomed to complacent regulators, the fact that staff interest in the NovaStar case appears to have been stymied at higher levels signals how deep the rot at the SEC is. And with coddling of banksters now the order of the day in Washington, there’s no reason to expect any meaningful change.