A Different Restatement: Countrywide Financial

 

Countrywide Financial filed an 8-K this morning for the purpose of informing investors not to rely on their 2004 interim financial statements. And thankfully (for those who are interested in these kinds of things), it had nothing to do with the lease treatment of crypto Custodian loan offices. This non-reliance notice revolved on Countrywide’s gains recognized in connection with securitizations.

Nothing terribly conspiratorial; nothing like bogus default rate assumed or silly prepayment assumptions. An excerpt here, with a little interpretation, might be helpful to explain what happened and why restatement was needed:

“Throughout 2004, Countrywide created certain mortgage-backed securities which were underwritten by the Company’s affiliate, Countrywide Securities Corporation (“CSC”). These securities contained embedded derivatives designed to protect rated security holders from extreme changes in short-term interest rates and/or to enhance the credit rating of the securities. At the end of each quarter in 2004, a small amount of these securities had not yet been sold by CSC. The securities held at each quarter end during the year ranged from 0.1 percent to 2.2 percent of the principal balance of the related loans securitized. In all cases, the remaining securities were sold shortly after quarter end.”

[Hang onto those italics; they’re important for what happened.]

“The Company believed that recording these transactions as sales fully complied with all applicable accounting principles. On February 18, 2005, Countrywide’s independent auditor, KPMG LLP, informed the Company that all securities that contained embedded derivatives needed to have been completely sold before any portion of the sale could be recognized. In light of this information, the Company revised its recognition of gain on sale accordingly. This revision is based on an interpretation of Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” which provides standards for gain on sale accounting.”

The thinking of the auditors, in their interpretation, probably went along these lines: if the company sold a batch of securities, all covered by the same embedded derivative/agreement to make holders whole in the event of those “extreme changes,” then the firm (CSC) still has an ongoing relationship to the items sold if it’s still retaining an interest in the securities. That may be the way the contract between CSC and the securitization trust was structured. Therefore, a genuine sale hasn’t occurred – there’s still an umbilical cord between CSC and the securities. Only when all of the securities are sold, is the cord completely cut.

“This revision will result in the reporting of a material weakness in internal controls over financial reporting in the Company’s Form 10-K for the period ended December 31, 2004. The Company has modified its securities distribution practices so that it will not retain any securities that contain embedded derivatives at each quarter end. In addition, at each future period end, the Company will review its inventory of securities to confirm that no such securities remain in inventory. The cost of this remediation is insignificant.”

So there’s a financial reporting internal control issue too: if a certain kind of transaction doesn’t qualify as a sale, financial statements aren’t supposed to go out the door including them as sales. And I’d agree with the company: the cost of the remediation probably is insignificant.

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