New Century and Gain on Sale Accounting

The world once again discovers that Gain on Sale accounting is open to abuse, as if this had not previously happened with subprime lending in 1998. It will also happen some day, in a big way, in derivatives. From the New York Times

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.

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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.

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The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.

Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.

“The thing about gain on sale accounting is that you can create a machine that just manufactures earnings out of thin air,” said Richard Benson

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But Mr. Benson said that the stock prices of subprime home lenders like New Century Financial had “collapsed so fast because the income and balance sheet had been built on gain on sale, which turns out to be imaginary.”

“The market woke up to the fact that there’s no there there,” Mr. Benson said.