Risk Management

Subprime Suspects

Just about everyone, it seems, is being held to blame for the financial meltdown. But what role auditors played, if any, is far from clear.
Alix StuartDecember 1, 2008

In past financial blowups, auditors have paid a heavy price. After the savings-and-loan crisis of the late 1980s, for example, the Federal Deposit Insurance Corp. collected more than $1 billion in settlements from four of the then–Big Six for their alleged complicity. Eight years ago, Arthur Andersen collapsed long before executives at Enron or WorldCom went to trial, and in the wake of that scandal audit firms paid hundreds of millions of dollars to appease investors of other fraud-ridden firms. It’s no surprise, then, that the subprime crisis has fingers once again wagging in the auditors’ direction. Already, at least four private-securities cases related to subprime problems name auditors, according to NERA Consulting, and more are sure to follow. This time, though, it’s far from clear what burden they will bear — or even what they did wrong.

One school of thought says the auditors are at fault for overlooking inflated asset valuations during the mortgage bubble. “You can’t blame the auditors for all the bad loans, but the question is, once the loans were made, were they appropriately valued? Did the auditors stand their ground or not?” says Lynn Turner, former chief accountant at the Securities and Exchange Commission. The fact that Wells Fargo plans to buy Wachovia for $15 billion in stock while Wachovia’s net assets were valued at $50 billion as of September 30, for example, “just begs the question, How is it [an auditor could] think that the balance sheet is right?” Turner asks.

The other camp says auditors were doing fine until they forced banks to take overly severe write-downs on assets, based on fears that they would face punishment from regulators if they allowed banks to use judgment rather than exit prices in illiquid markets. “It’s the rules-based nature of the historic audit profession…running kind of head-on into the principles-based concept of [FAS] 157,” which governs how firms value assets, says David Larsen, a managing director with Duff & Phelps.

Audit firms may yet prove bulletproof, as both federal and private litigators struggle to prove intentional misdoings even at the financial institutions themselves. The audit firms “are attractive targets because they’re financially stable, but I don’t think they’re going to face a lot of liability,” says Lisa Wood, a partner at Foley Hoag who defends auditors. They may even find a silver lining — both PricewaterhouseCoopers and Ernst & Young recently won contracts to help with accounting and auditing for the Troubled Asset Relief Program.

Still, they’re unlikely to avoid all subprime-related pain. With layoffs and hiring freezes already under way, “the downturn they’re going to see in their results will not be made up for by money from projects they’ll do,” says Turner. “They’re going to go through the same very tough times everyone else is.”

Companies and their auditors