Audits Home In On Real Estate

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Editors’s Note:

The print version of this story incorrectly said KPMG had conducted a real estate appraisal for Preferred Bank. KPMG did audit the bank, but it was a third party that conducted the appraisal, and Preferred said it did not dispute the audit.

An unusually large number of local banks have been forced to restate their earnings recently, resulting in millions of dollars in losses at a time when many already are grappling with painful write-downs.

The restatements reflect the rapid decline in the value of real estate-related holdings as well as greater scrutiny by cautious auditors over the pricing of distressed assets. Complicating matters is the so-called mark-to-market rule requiring banks to account for securities at their current depressed market values, though that rule was relaxed somewhat last week.

“The auditors they’re basically not willing to take any risk whatsoever,” said Robert Dennen, chief financial officer of California United Bank, an Encino institution that released earnings in early February and restated March 16. “They’re kind of holding all the cards.”

The bank took an additional $1.4 million charge, dropping its fourth quarter earnings to a $624,000 loss from a modest profit. Among other local institutions revising earnings was downtown L.A.’s Preferred Bank, which saw both its fourth quarter and annual losses balloon to $5 million from just under $500,000, and Center Financial Corp., the Koreatown-based parent of Center Bank, which upped its loan loss reserves by $11.4 million.

The restatements are coming at an inopportune time for the banks, lowering their capital levels when their ability to raise capital is at a low point.

The auditors’ caution, however, may be understandable. The collapse of the real estate market and related securities is presenting the accounting industry with one of its biggest tests since the 2001 Enron scandal, which ultimately brought down firm Arthur Andersen and spurred a series of sweeping reforms through the Sarbanes-Oxley Act of 2002.

And the heat is still on. Just last week, a trustee overseeing the bankruptcy of subprime lender New Century Financial Corp. of Irvine filed a lawsuit in Los Angeles Superior Court alleging KPMG LLP was “reckless and grossly negligent” in its auditing of the company, which went under owing $3 billion. KPMG also is Preferred’s auditor.

The disputes between the L.A. banks and their auditors don’t rise to that level. However, they do point to the difficulty that institutions and their accounting firms are facing in agreeing on the value of assets in a highly distressed market.

“A rash of refilings is quite unique,” said Wade Francis, president of bank consulting firm Unicon Financial Services Inc. in Long Beach. “I would call it unusual, but is there anything unusual in this environment?”

Liar’s loans

In the case of California United, the issue was the mark-to-market accounting rule issued by the Financial Accounting Standards Board in November 2007. Prior to the adoption of the rule, banks could assess securities at their so-called fair value, which in practice allowed them to ignore short-term fluctuations in their market value.

Earlier this year, California United identified a set of collateralized mortgage obligation securities that could result in losses if the bank were to sell them since they were backed by Alt-A mortgages so-called liar’s loans because they were approved with little income documentation.

Dennen said he ran models showing a potential $80,000 loss in five years, but according to the likely current market value of the securities, auditors from McGladrey & Pullen LLP called for the significantly larger write-down of $1.4 million.

“It’s a little like accounting with smoke and mirrors,” said Dennen, who does not believe that California United will even realize losses of $80,000 on the securities and resisted the charge.

Dennen said he was forced to take the charge, however, to avoid receiving a “qualified opinion,” which is a negative assessment from an auditor suggesting management declined to follow recognized reporting standards.

The Bloomington, Minn.-based accounting firm did not return telephone calls for comment, but experts familiar with accounting issues said such disputes are not uncommon though they have been heightened by the financial crisis.

“Accounting is not a black-and-white science. There are many accounting issues for which there are no clear-cut answers,” said Randall Lee, a partner in the downtown L.A. office of law firm WilmerHale and the former director of the Securities and Exchange Commission’s local office, who declined to discuss specific institutions.

Rash of refilings

Indeed, banks and auditors have had a long history of disputes predating the Enron scandal, which prompted the government to scuttle the accounting industry’s self-regulating oversight agency and create the independent Public Company Accounting Oversight Board.

Three of the 10 largest accounting firm lawsuits of all time were a direct result of the savings and loan crisis of the late 1980s, including a $400 million payment by Ernst & Young LLP, according to CPA Trendlines, an accounting newsletter. Still, the level of tension today and the elevated number of earnings revisions have surprised industry insiders.

Ed Czajka, chief financial officer of Preferred, said part of the problem is situational: Banks and auditors are having a difficult time assessing current asset values of all types because the market is distressed and extremely illiquid.

“There’s not active trades going on, so there’s not active price quotes,” Czajka said, adding that he has not seen so many banks restate earnings in 22 years in the industry.

The issue forced regulators hands. Last Thursday, bank stocks temporarily surged on news that the Financial Accounting Standards Board voted to give institutions more leeway in determining market values of their securities though that change will not immediately help the L.A. banks that have taken charges since the changes will not be retroactive.

Indeed, analysts could not agree last week whether the rule change would ultimately help banks much at all. Some predicted earnings increases of as much as 20 percent, while others said the impact would be negligible.

Moreover, the mark-to-market rules apply only to assets available for sale, such as mortgage-backed securities. They do not apply to the valuation of loans held on banks’ books. However, the valuation of real estate loans has emerged as another point of contention between auditors and banks.

Preferred’s $4.5 million revision was largely due to a new appraisal of the value of a loan on a condominium project in San Diego.

Based on an internal model that took into account property value declines in the area, Preferred allocated about $600,000 to its reserves. But a third-party appraisal of the project’s value forced the bank to set aside an additional $3.1 million. That contributed to the bank’s restatement of its earnings, leading to a $5 million loss for the fourth quarter rather than the $500,000 reported in January.

“The level of scrutiny has really, really stepped up,” Czajka said.

The losses dropped the bank’s capital ratio by 29 basis points to 11.65 percent. That is still above the 10 percent level for banks to be considered “well-capitalized,” but revised earnings can become a worry for banks not as financially sound.

“That’s the largest concern as the consequence of a larger loss or turning what was once a net income into a loss,” Czajka said.

Preferred reluctantly revised earnings, but management has hired a third party to review the appraisal.

The bank’s auditor, KPMG, which did not conduct the condo appraisal, did not return telephone calls for comment.

Center Financial, too, revised its earnings after appraisals showed three loans were more impaired than initially thought. Those modifications, along with a recalculation of reserves to cover portfolio losses, resulted in $11.4 million in additional loan loss provisions. Unlike some other local banks, though, Center Financial did not dispute the revisions with its auditors, Grant Thornton LLP.

Center Financial Chief Financial Officer Lonny Robinson said he understands the severity of the current market downturn and the revisions were necessary.

“Nobody likes to do that, but we have to comply with generally accepted accounting principles,” Robinson said.

He is hopeful that the mark-to-market rule changes could benefit the bank going forward, because while previous earnings cannot be retroactively changed, some of the price declines on its securities may be erased in future quarters.

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