Though it's been pretty clear for almost a year now that deals from Spiegel Inc.'s banking subsidiary, First Consumers National Bank, were underperforming, news emerged last week from an independent examiner appointed by the Securities and Exchange Commission that the company was manipulating the performance of its securitizations to avoid an early amortization.
Additionally, forensic accounting specialists Kroll, Zolfo & Cooper LLC allege that FCNB deliberately misled investors about its credit underwriting practices and failed to disclose the use of recency accounting, which significantly reduced delinquencies the portfolio was experiencing.
Recency accounting, as explained by an accountant away from the situation, is when a delinquent account is considered current upon receipt of just a single missed minimum balance payment.
Accountants at Kroll also noted in the filing that FCNB had, unbeknownst to investors, ceased screening potential cardholders and instead had let retail outlets - namely Spiegel Catalog and Newport News - decide independently which consumers qualified. Not surprisingly, the retail outlets, more concerned with boosting sales, maintained a loose credit policy, the accountants said.
"The prospectus stated that FCNB made all of the credit decisions regarding whom to solicit for accounts. This was not true since the Spiegel merchants used the net down process to eliminate many of the better accounts that FCNB wished to solicit and increased the number of subprime borrowers that were offered a credit card," the filing states.
As the portfolio increased subprime exposure, credit limits were often exceeded and thus "this practice put more accounts at risk and put pressure on already inaccurate forecasts and should have been disclosed to investors," Kroll's accountants summed.
As portfolio performance declined, executives at Spiegel reportedly took action to prevent the trusts from tripping excess spread triggers. In April 2001, James Sievers, former co-president and CFO, and Michael R. Moran, former co-president and chief legal officer at Spiegel, were cited by the accounting team as increasing the intercharge fee FCNB assessed to its merchants for its finance services. This fee increase was retroactive to January 2001.
While a fee increase from 1% to 5% is not entirely uncommon, Sievers and Moran did not want to reduce the profitability of the already struggling retail outlets and offset this fee through increased marketing fees charged back to FCNB. The result for FCNB was increased portfolio yield and excess spread well above early amortization triggers. Since the merchants offset the fee increase, it was a wash.
"This would mean that the increase would have little or no effect on Spiegel's merchant units, but it would allow Spiegel to report a higher yield to the securitization trustee (Bank of New York) and avoid a trigger violation," according to the filing.
While some foresaw the troubled retail sector being pressured by the economic downturn, the emergence of chicanery caught many off guard.
At least one researcher is deeply (and vocally) troubled by the can of worms opened by this particular failure, versus other instances of indiscretion and out-and-out fraud seen throughout the last year in the ABS market.
"You used to have to worry about a penny-eating piece of sh*t ripping you off," the researcher said. "But at least, with household names, you could trust them. This is the stuff that's not supposed to happen."
Bankers, by contrast, take the somewhat common view that, in cases of fraud, there is little an underwriter can do in terms of due diligence to prevent it. "As an underwriter, you are more focused on the assets than the accounting practices of the firm in question," one banker said. "You are captive to the information you are presented."
The significance of these allegations coming to light was not lost on Nomura Securities Director of ABS research Mark Adelson, who relished the inside peek at just how Spiegel was able to defraud the market. "This is like an autopsy report from a medical examiner. After the fact you can't do anything for people killed in a train wreck, but you can find out how the crash happened."
"The Spiegel experience expresses to me that we have to think much more broadly about having third-party oversight," said Adelson. Otherwise, in the words of the unnamed banker, "when you can't rely on the data presented to you, you are shooting in the dark."
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