An irreverent Wall Street Blog
by Bill Singer
by Bill Singer
Capital One And Two Former Execs Settle Loan Forecast Case With SEC
April 25, 2013
On April 24, 2013, the Securities and Exchange Commission ("SEC") charged Capital One Financial Corporation (Ticker: COF), former Chief Risk Officer Peter A. Schnall, and former Divisional Credit Officer David A. LaGassa with understating millions of dollars in auto loan losses incurred during the months leading into the financial crisis. In anticipation of the institution of proceedings, the three respondents submitted Offers of Settlement (the "Offers") which the SEC accepted. The settlements were undertaken without admitting or denying the findings. Respondents consented to the entry of cease-and-desist orders and civil monetary penalties of:
According to the SEC's Order instituting settled administrative proceedings, beginning in October 2006 and continuing through the third quarter of 2007, Capital One Auto Finance ("COAF") experienced significantly higher charge-offs and delinquencies for its auto loans than it had originally forecasted. The profitability of COAF's auto loan business was primarily derived from extending credit to subprime consumers; and as the Great Recession picked up steam, credit markets began to deteriorate. And all those black swans began to crap all over the much-vaunted computer models that were assuring companies that everything was under control and any blips were merely statistical anomalies within the accepted parameters of standard deviation. Yeah, right.
So how do big companies explain the divergence between what they publicly forecast as the likely level of profits versus what actually comes in? Quite often it starts with a C-Suite game of finger pointing, which often devolves into coming up with a clever way to blame everything outside of the business. At Capital One, it seems that the culprit was COAF's internal loss forecasting tool, which attributed the deviation from the forecast model to an "exogenous" factor outside of the business and apparently dependent upon macroeconomic conditions.
SIDE BAR: Frankly, when folks in accounting start blaming failed computer modeling on high fallutin' "exogenous" things, it's a fairly strong hint that there is probably something fundamentally wrong with the assumptions and algorithms upon which the programming is based. For an interesting riff on a variation of this theme about going to the numbers when everything you believed proves wrong, see Joshua Brown's 'I'm Right, The Market Is Wrong' As Josh notes in his article: "The fancier the math one uses to justify an entrenched investment opinion, the more obscure and arcane the indicators employed, the more desperate and wrong that person is. . ."
In any event, back to that exogenous factor and COAF's underestimated loss expense. The SEC alleged that in financial reporting for the second and third quarters of 2007, Capital One failed to properly account for losses in its auto finance business when they became higher than originally forecasted. As a result, Capital One understated its loan loss expense by approximately 18 percent in Q2 ($72 million) and 9 percent in Q3 ($51 million). As noted in Paragraph 20 of the Order:
Beginning no later than October 2006, Capital One started to face higher, unexplained loan charge-offs and delinquencies than it had forecast in virtually all of its consumer lines of business, including the credit card business, COAF, Global Financial Services and U.K. division. COAF continued to experience significant higher actual losses than forecast, referred to internally as adverse or negative variances, for the next four consecutive months. Moreover, COAF experienced negative variances across both dealer and direct lines of businesses and across both prime and subprime credit segments. Given the magnitude and broad scale of the losses, COAF was concerned that it was experiencing a credit turn, which was understood within the company to mean a phenomenon where there is a general worsening in the credit environment in a way that drives credit losses for consumer lending businesses.
In seeking out human beings to blame for the failed disclosure, the SEC's alleged that Schnall and LaGassa had deviated from established policies and procedures and failed to implement proper internal controls for determining the loan loss expense. In explaining the magnitude of the failed oversight, Paragraph 43 of the Order offers this assessment:
Had Capital One incorporated the full exogenous worsening in COAF, its consolidated third quarter provision for loan losses would have been $647 million, an increase of 9% over the $596 million that was actually reported. Further, consolidated net loss for the quarter would have been $115 million, a 41% increase over the reported net loss of $82 million. For COAF, the provision for loan losses would have been $296 million, which is 21% higher than COAF's $245 million reported loan loss expense for the quarter. COAF's $4 million reported net loss would have been more than nine times greater than reported, or approximately a net loss of $37 million.
Schnall was cited for having taken inadequate steps to document and communicate COAF's exogenous treatment and accounting requirements. LaGassa, who managed the COAF loss forecasting process, was found to have failed to document and to ensure that the proper exogenous levels were incorporated into the forecast.
Bill Singer's Comment
Compliments to the SEC on this investigation -- the Order sets forth the facts with exceptional clarity and presents a compelling case. Next up, perhaps the SEC will heed New York Times' reporter Gretchen Morgenson's warning of the ticking clock that is running down on the statute of limitations in the mortgage loan arena.
In "Note to New S.E.C. Chief: The Clock Is Ticking" (New York Times, "Fair Game" April 13, 2013), Morgenson raises questions about the impact of banks that misrepresented the potential risk attributable to aspects of their mortgage loan portfolio. Similar to the issues in the Capital One case, the ensuing losses from those portfolios blew off the internal forecast charts and seem so aberrational as to either call into question the integrity of the firm's computer models or the risk profile attributed to the underlying loans. As Morgenson stated in her article:
[T]he SunTrust whistle-blower complaint, which I reviewed, contends that company financial filings of recent years misrepresented the bank's exposure to risky no-documentation mortgages that it underwrote from 2006 to 2008. Many were sold to Fannie Mae and Freddie Mac, the taxpayer-backed mortgage finance giants.Shareholders have not been aware, the complaint says, that many mortgages SunTrust was selling to Fannie and Freddie in this period were so-called liar loans, with little to no documentation of borrowers' income or assets. The bank maintained that it had little exposure to low-documentation loans, the complaint says. . .