Finally! Nearly two years after one of the worst financial crashes in history—and nearly three years after the crisis broke out—the SEC has charged a major bank with accounting fraud.
On Wednesday, the SEC charged Regions Financial subsidiary Morgan Keegan with fraudulently overvaluing its holdings subprime mortgage securities. The company was running several big investment funds that were full of these assets, and when the subprime market took a dive, and mortgages started defaulting, they turned toxic. The SEC says Morgan Keegan arbitrarily bumped up the prices of these assets to avoid booking losses. The fund manager, James Kelsoe Jr., had his assistant make 262 of these “price adjustments” in the first half of 2007 alone.
If the SEC allegations are true, they means the company was manipulating the value of its investments multiple times a day, every day, and both their accounting department and their independent auditing firm let them get away with it.
One of the more amazing events to occur at the height of the financial crisis was a move by federal regulators to relax accounting rules and give banks much more leeway to say their toxic assets were worth more than they really were. It didn’t get a whole lot of press—hey, accounting is boring stuff right?—but it had tremendous implications for the banking industry, because banking just is accounting. Banks take in money in some form—an accounting entry—and lend it out—another accounting entry—or buy securities—another accounting entry. If you can manipulate the accounting, you can make a ton of money, no matter what these securities and loans might actually earn in the real world.
If you can say your assets are worth a lot of money, you get to say you made big profits, and you get to pay out big bonuses based on those profits. That’s basically the story of the savings and loan crisis—banks faked their accounting to pay huge compensation, and when the lousy accounting ultimately destroyed their bank, the executives walked away rich.
These subprime mortgage securities that Morgan Keegan was allegedly messing around with are complicated. They include thousands of different mortgages that have been sliced and diced and repackaged together, making it very difficult to actually figure out what they’re worth by analyzing the actual mortgages. So banks and regulators didn’t really rely on the mortgages to account for them. Instead, they relied on the trading value of the securities. Whatever amount the bank can sell the securities for is what the security is worth.
That changed in 2009. Regulators started allowing banks to use secret, internal valuation models to compute the “fair value” of these securities. That gave banks a lot of room to say their assets were worth more than they really were. And that allowed banks to avoid taking big losses.
But the SEC isn’t just charging Morgan Keegan with having improper or overly optimistic models. They’re charging the company with basically making stuff up. And astoundingly, it took three years for anybody to figure it out and do something about it.
Giant financial crashes like the one that took place in 2008 just don’t happen without rampant fraud and deception. If the SEC is really on the case, we’ll have many more of these charges filed in the future.