Did Wells Fargo's Auditors Miss Repurchase Risk?

On Friday, the Business Insider worried that Wells Fargo may be making the same fatal mistake AIG did – underestimating, or worse, naively ignoring Collateral Call Risk. 

The concern was focused on potential exposure from the credit default swaps portfolio they inherited from Wachovia. In WFC’s annual report the Buiness Insider saw limited discussion of this risk and no details of the reserves for it.

There are two possible ways to account for the lack of discussion of Collateral Call Risk.  Either Wachovia wrote its derivative contracts in ways that don’t permit buyers to demand more collateral or Wells Fargo is not disclosing this risk. (A third possibility—that they don’t even seem aware that they have this risk — seems remote after AIG.)

When I read that, I saw eerie parallels with New Century, all the more so because of the auditor connection – both Wells Fargo and Wachovia and New Century (now in Chapter 11) are audited by KPMG.  New Century was not too transparent either and, as a result, many people, including some very sophisticated investors were caught with their pants down. KPMG is accused in a $1 billion dollar lawsuit of not just being incompetent, but of aiding, abetting, and covering up New Century’s fraudulent loan loss reserve calculations just so they could keep their lucrative client happy and viable.

From the lawsuit:

KPMG’s audit and review failures concerning New Century’s reserves highlights KPMG’s gross negligence, and its calamitous effect — including the bankruptcy of New Century.  New Century engaged in admittedly high risk lending.  Its public filings contained pages of risk factors…New Century’s calculations for required reserves were wrong and violated GAAP. For example, if New Century sold a mortgage loan that did not meet certain conditions, New Century was required to repurchase that loan.  New Century’s loan repurchase reserve calculation assumed that all such repurchases occur within 90 days of when New Century sold the loan, when in fact that assumption was false.

In 2005 New Century informed KPMG that the total outstanding loan repurchase requests were $188 million.  If KPMG only considered the loans sold within the prior 90 days, the potential liability shrank to $70 million.  Despite the fact that KPMG knew the 90 day look-back period excluded over $100 million in repurchase requests, KPMG nonetheless still accepted the flawed $70 million measure used by New Century to calculate the repurchase reserve.  The obvious result was that New Century significantly under reserved for its risks.

How does the New Century situation and KPMG’s role in it remind me of Wells Fargo now?  Well, in both cases, there’s no disclosure of the quantity and quality of the repurchase risk to the organisation. Back in March of 2007, I wrote about the lack of disclosure of this repurchase risk in New Century’s 2005 annual report:

There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements….it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans. Did the lenders have the right to call the loans unilaterally? It does say that if one called the loans it is likely that all would. Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened.

Some have been writing since 2005 about the elephant in the room that is mortgage loan repurchase risk:

Even if a lender sells most of the loans it originates, and, theoretically, passes the risk of default on to the buyer of the loan, there remains an elephant lurking in the room: the risk posed to mortgage bankers from the representations and warranties made by them when they sell loans in the secondary market… in bad times, the holders of the loans have been known to require a second “scrubbing” of the loan files, looking for breaches of representations and warranties that will justify requiring the originator to repurchase the loan. …A “pure” mortgage banker, who holds and services few loans, may think he’s passed on the risk (absent outright fraud). Sophisticated originators know better…When the cycle turns (as it always does) and defaults rise, those originating lenders who sacrificed sound underwriting in return for fee income will find the grim reaper knocking at their door once again, whether or not they own the loan.

Clusterstock quoted Wells Fargo from page 127 of their 2008 Annual Report (emphasis added):

In certain loan sales or securitizations, we provide recourse to the buyer whereby we are required to repurchase loans at par value plus accrued interest on the occurrence of certain credit-related events within a certain period of time. The maximum risk of loss…In 2008 and in 2007, we did not repurchase a significant amount of loans associated with these agreements.

But earlier, on page 114, there is a footnote to a chart representing loans in their balance sheet that have been securitized–including residential mortgages and securitzations sold to FNMA and FHLMC–where servicing is their only form of continuing involvement. 

However, the delinquencies and charge off figures do not include sold loans. Wells Fargo tells us these numbers do not represent their potential obligations for repurchase if FNMA and FHLMC decide their underwriting standards were not up to par.

Delinquent loans and net charge-offs exclude loans sold to FNMA and FHLMC. We continue to service the loans and would only experience a loss if required to repurchasea delinquent loan due to a breach in original representations and warranties associated with our underwriting standards.

So where are those numbers?  Where is the number that correlates to the $8.4 billion dollar exposure that brought down New Century?  Wells Fargo saw an almost 300% increase from 2007 to 2008 in delinquencies and 200% increase in charge offs from commercial loans and a 300% increase in delinquencies and 350% increase in charge offs on residential loans they still hold. Can anyone say with certainty that we won’t see FNMA and FHLMC come back and force some repurchases on Wells Fargo for lax underwriting standards?

This is all we get from Wells Fargo in the 2008 Annual Report:  

During 2008, noninterest income was affected by changes in interest rates, widening credit spreads, and other credit and housing market conditions, including… 

  • ($847) million in write-downs of loans in the mortgage warehouse due to changes in liquidity and other spreads, and additions to the mortgage repurchase reserve…

The lack of disclosure of this issue here mirrors the lack of disclosure in New Century and perhaps in other KPMG clients such at Citigroup, Countrywide ( now inside Bank of America) and others.  How do I know there could be a pattern? Because the inspections of KPMG by the PCAOB, their regulator, tell us they have been called on auditing deficiencies just like this.  Do we have to wait for a post-failure lawsuit to bring some sense, and some sunshine, to the system?


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