VideoWhen BankBoston announced last January 18 that it was buying a stake in Mercury Finance Co., the bank thought it was getting a great deal in return for all the shares of its own auto lender, Fidelity Acceptance Corp. After all, BankBoston's investment banker, Merrill Lynch & Co., was pitching Mercury as a terrific investment, rating agencies had blessed its credit as investment grade, and KPMG Peat Marwick LLP had signed off on its financials.
At the time the deal was an-nounced, Mercury's stock was trading at around $14--roughly 22 times Mercury's most recently audited earnings. And no wonder. The company was touted far and wide as the best of a new breed of specialty finance companies racking up big profits in the booming business of auto lending (albeit to borrowers with poor credit histories). Mercury was said to be preparing to return to the capital markets for the first time since it went public in 1989.
Then the party came to a crashing halt. Barely three weeks after the announcement, Mercury disclosed that it had overstated earnings. BankBoston, the nation's 15th largest, with $62 billion in assets, was caught completely off guard. At last count, the auto finance company had apparently overstated its earnings for 1996 and the previous three years by more than 100 percent, up to about $125 million. The stock is now almost all the way down to $2, as the company struggles to stay solvent.
What did the Boston bankers miss? An audit of the company's 1996 results by Arthur Andersen LLP, which Mercury hired after firing KPMG, still isn't complete; nor are the investigations reportedly under way by federal authorities. But at this point, the discrepancy appears to be based on inadequate loan loss reserves.
Granted, bankers say loan portfolios are especially difficult to examine because it's impractical to determine the status of every account in the time frame required to complete a deal. But if anyone should be positioned to discover that a lender was playing accounting games with its loan losses, it would be another lender, especially one with the conservative credentials of BankBoston.
The irony is that BankBoston might not have needed much more information than was already available from Mercury to have detected trouble. One clear indication of Mercury's woes, in fact, was in full public view several months before BankBoston announced its engagement. This took the form of a footnote to the consolidated financial statements in Mercury's report to shareholders for the second quarter of 1996. In this footnote, Mercury admitted that it would have to restate its financial results for 1995 because of a mistake made during the fourth quarter of that year.
The problem: Reserves for losses in its life insurance business had been counted twice, once for that business and again as reserves for loan losses, which meant that Mercury had set aside less than it claimed it had. And the likely effect on the bottom line, Mercury said, was that its net income for 1995 would be about $12 million less than it had reported, or about 11 percent.
Some analysts contend it was understandable that BankBoston missed such an admission. "No one reads the footnotes," says Howard Schilit, the president of the Center for Financial Research & Analysis Inc., a Rockville, Maryland, research firm for institutional investors.
Still, the report was a second, amended statement for the June quarter. A restatement is required by the Securities and Exchange Commission "immediately" after a company detects a problem with an earlier statement, explains John Heine, a commission spokesperson.
"If you see an amended 10-Q," says Thomas Butler, a partner at Price Waterhouse LLP, "your eyes get wide." Of course, restatements are required even for minor problems. But Butler notes that an amended 10- Q pointing to a problem involving more than 10 percent of net income could hardly be considered insignificant.
Actually, BankBoston was well aware of the restatement, but insists that it had nothing to do with the problems that KPMG discovered last January. "We thought the change in accounting was an improvement over what they'd done before," says an insider familiar with the deal. So what does that say about Mercury's previous practices? BankBoston seems to believe Mercury's auditor should have done a better job detecting problems. KPMG won't comment.
In any case, there were other, earlier signs that Mercury's story was being oversold. Behind the Numbers, an investment advisory service based in Dallas, noted on May 3, 1996, that rising industry competition was hurting the finance company's profit margins. And Westergaard Online, an investment research and strategic analysis firm in New York City, warned investors against Mercury as far back as early 1995.
"Two things were screwy," John Westergaard, president of the service, recalled in a newsletter dated January 31, 1997, that reminded subscribers of its prescience. First, Westergaard noted, the company was paying out more than 40 percent of its earnings in dividends, although it was heavily leveraged and purportedly earning more than 30 percent on equity. "Why pay it out when you're making that kind of a return?" he asked.
Second, at a point when Mercury's stock was at its highest, selling for 40 times earnings, the company failed to pursue equity financing even though it could have raised a lot for a pittance. "Maybe they were afraid back then of undergoing the scrutiny of due diligence," Westergaard offered. Given the lack of scrutiny Mercury got from everyone from Merrill Lynch to BankBoston, the auto lender may have had less to fear from the process than it thought.
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