From the NY Times:
Accounting Said to Hide Lender Losses
In the spring of 1998, the chief financial officer of New Century Financial, a lender to home buyers with blemished credit, wrote an unusual paper describing a then little-known accounting technique.
The executive, Edward F. Gotschall, marketed his white paper at industry seminars and conferences, and promoted it to Wall Street analysts as an insider’s look at New Century, according to people who read the paper. New Century was at the time one of the nation’s fastest-growing subprime lenders.
Now that technique, called gain on sale, may be coming back to haunt the company, which filed for bankruptcy protection on April 2 after disclosing a month earlier that federal prosecutors and securities regulators were investigating accounting mistakes and stock sales at the company. The company is expected to file restated results for most of 2006 as early as this month.
The technique promoted by Mr. Gotschall, who stepped down as chief financial officer in 2006 but continued as vice chairman of the board of directors, allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors.
The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through door, were then used to make more loans to risky home buyers.
Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors.
Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.
But some financial analysts say that New Century appears to have also used gain on sale to hide losses as the subprime market began to falter late last year.