A securities expert witness advises on a case involving a civil action filed by the United States alleging the defendant defrauded government-sponsored enterprises (GSE) through its residential mortgage lending business. The government seeks treble damages.
The scheme allegedly involved the defendant using a loan origination model that disregarded all underwriting guidelines and checkpoints in order to generate a large volume of loans. Employees were compensated based solely on the volume of loans. When the loans defaulted, the GSEs incurred more than a billion dollars in unreimbursed losses.
Question(s) For Expert Witness
- 1. Is the defense expert’s profit analysis reliable?
- 2. What is the correct means for assessing civil penalties in this case?
Expert Witness Response
In my opinion, the defendant’s expert’s analysis of profits for purposes of assessing civil penalties is flawed and unreliable. The defendants claim that the appropriate measure of damages is profits, but he defines this term based on accounting – not economic – standards. In fact, his opinion has no basis in economic principles. Rather, he proffers a normative statement that represents his opinion on what I understand to be a legal question, namely how civil penalties based on pecuniary gain derived from fraud should be calculated.
Even to the extent that accounting principles may apply, the defense expert does not explain how profits based on generally accepted accounting principles would represent the true gain defendants derived from loans that were found to have been materially defective. Financial reporting in general, and general accounting principles in particular, were not designed to capture the benefits of fraud or misrepresentation; rather, their objective “is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.”
Based on defendants’ financial statements, he attempts to characterize IEFS as “a revenue figure” which “cannot be a measure of profits.” His approach, however, confounds financial reporting with the economic concept of incremental or marginal benefit. He fails to address the evidence that the IEFS figures provided by defendants already subtract certain associated incremental costs (e.g. the cost of hedging MSR’s). He does not identify any specific costs that would need to be subtracted from IEFS in order to arrive at what he considers to be the net marginal benefit from selling each loan. Moreover, by basing his analysis on how IEFS was recorded for purposes of financial reporting, he ignores those benefits that are not captured in financial statements but which defendants would have received from the HSSL program.
Further, he errs in allocating FSL Division costs to individual loans based on the dollar amount of loans originated by using an overly simplistic and unreliable linear regression model to allocate divisional costs to the HSSL loans. Such an allocation is also inconsistent with his claim that he computes the “marginal contribution of the Materially Defective HSSL loans to the bank’s profits.”
In addition to the other problems with his approach, the expert also provides no basis for assuming that civil penalties based on pecuniary gain should be computed based on post-tax profit.
In summary, it is my opinion that the defense expert’s analysis of defendants’ profits is flawed and unreliable. Therefore, it is of no use in assessing civil penalties in this matter.