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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Mar 28

Written by: Jack Ciesielski
3/28/2008 7:30 AM 

So much has been written on the passing of Bear Stearns and its merger with JP Morgan Chase , it's almost impossible to add much worthwhile to the discussion. I would say, however, that the most cogent analysis of the deal-making by the Fed - including the blatant shafting of shareholders - was provided by Andrew Ross Sorkin in his post on the NY Times DealBook blog .

And there's a wave of electrons and ink coming your way on the findings of the bankruptcy administrator in the case of New Century Financial, whose 581-page report sent reporters riffling through its pages yesterday. (No, I haven't read it yet. Maybe I'll settle for the executive summary.)

There's another story that contains elements of both stories, in a way. Yesterday, the SEC issued a cease-and-desist order to JP Morgan Chase for its negligence in the case of National Century Financial Enterprises, an issuer of asset-backed securities for which JPM had acted as trustee - a role it inherited when it acquired Bank One, which initially had been trustee for the now-failed health care finance outfit.

According to the administrative proceedings, during the period of 1999-2002, National Century Financial - whose name is creepily similary to New Century Financial - "offered and sold nearly $3.5 billion in asset-backed notes to qualified institutional buyers. NCFE and the programs collapsed in November 2002 when investors and others discovered that NCFE had made large improper transfers among program accounts and caused collateral shortfalls. The collapse caused investor losses of approximately $2.6 billion."

Seems like so long ago now - and so many other asset-backed foibles, it's hard to distinguish them from each other. This one might be memorable for another unsavory reason: the ex-CEO of the firm has been convicted of witness tampering in the fraud trial.

How did the fraud take place? In short, NCFE was kiting cash in the reserve accounts of the asset-backed notes:

"A principal feature of the scheme that allowed NCFE to hide investor losses was the transfer of huge amounts of Reserve Account funds on or around the first and last business day of every month (“Month-End Transfers”). The indentures required that the programs maintain Specified Balances in the Reserve Accounts totaling approximately 17% of the value of the outstanding notes issued by the program. However, even though the indenture trustees for the NCFE programs had the ability to look at the balances in the Reserve Accounts at any time, the indentures only required the programs to report on the balances in Reserve Accounts as of one day of the month, called the “Monthly Payment Date.” The largest program for which JPMorgan Chase served as asset-backed indenture trustee was reported on by NCFE and tested by JPMorgan Chase as of the last business day of the month. The largest program for which Bank One served as asset-backed indenture trustee was reported on by NCFE and tested by Bank One as of the first business day of the month. As a result of this structure, NCFE was able to kite large amounts of funds back and forth between the programs to make it appear that the programs were maintaining the Specified Balances. In fact, NCFE was consistently and severely depleting the balances in these Reserve Accounts without telling investors."

Neither Bank One nor, later, JP Morgan Chase caught on - and that was their undoing:

"The Month-End Transfers were large, recurring, and contrary to the requirements of the indentures. In participating in the Month-End Transfers that were contrary to the requirements of the indentures, Bank One and JPMorgan Chase were negligent and should have known that NCFE was misusing the Month-End Transfers."

Let's hope that JP Morgan Chase is a bit more attentive to the sensitive details of the far more complicated acquisition of Bear Stearns - and whatever trustee role it will be assuming in connection with Bear's asset-backed obligations. This story should further convince investors that where there's securitized assets, there's bound to be some stink somewhere.

And it should also convince investors to run away from investments containing the words "Century" and "Financial" in the name of the issuer. The bard Donald Fagen almost had it right in his "Bright Lights, Big City" soundtrack tune "Century's End": Not "dumb love in the City, at century's end." More like "big hurt in the market, when 'Centuries' end."