September 22, 2020

It Teetered, It Tottered, It Was Bound to Fall Down

This article was adapted from “Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon,” by Gretchen Morgenson, a business reporter and columnist for The New York Times, and Joshua Rosner, a managing director at the independent research consultant Graham Fisher. The book is to be published on Tuesday by Times Books.

MARC COHODES had heard the stories.

Heard how these guys would give a mortgage to anyone — even to a corpse, the joke went. How the place was run like a frat house.

You wouldn’t believe the things that go on there, his brother-in-law had told him.

So Mr. Cohodes, a money manager in Marin County, Calif., decided to bet against one of the big names of the subprime age: NovaStar Financial.

NovaStar was part of a crop of new lenders that had sprung up in the 1990s. It had been founded by two hard-charging entrepreneurs, Scott F. Hartman and W. Lance Anderson.

The two men had complementary skills. Handling the financial operations, working with Wall Street — that was Mr. Hartman’s job. Mr. Anderson, a born salesman, was the glad-hander. From the start, the pair was paid handsomely. Each man received almost $700,000 in 1997, even though their company was losing money.

Like others in the subprime industry, NovaStar used aggressive accounting that obscured its increasingly precarious finances. As far back as the 1990s, it had to underwrite loads of new loans to offset losses on older mortgages.

But unlike many of its peers, NovaStar had already survived at least one brush with death. Now, in 2003, Mr. Cohodes was betting that it would not be so lucky again.

Although NovaStar was not a household name in lending, in 2003 the company boasted 430 offices in 39 states. With headquarters on the third floor of an office building in Kansas City, Mo., it was fast becoming one of the top 20 home lenders in the country.

NovaStar was also becoming a Wall Street darling, its shares trading at $30, up from $9.50 in late 2002. Typing NovaStar’s stock symbol into his Bloomberg machine, Mr. Cohodes did a double take. Thirty dollars? Must have used the wrong stock symbol, he thought.

He hadn’t. NovaStar was on a trajectory that would take the shares above $70. Thanks to aggressive management, unscrupulous brokers, inert regulators and a crowd of Wall Street stock promoters, NovaStar’s stock market value would soon reach $1.6 billion.

A beefy, street-smart man fond of sports and sports metaphors, Mr. Cohodes knows every trick executives use to make their companies look better than they are. He prides himself on being able to spot trouble.

Most investors are optimists and believe that companies will increase in value. Short-sellers are the opposite.

And because they challenge company spin, short-sellers are often criticized and refused access to management.

RARE is the corporate executive with an appreciation for naysayers, and NovaStar’s founders were no different. Mr. Anderson and Mr. Hartman had contempt for short-sellers. A Web site sponsored by NovaStar backers, called NFI-info.net, published a picture of a cockroach next to a discussion about investors who had bet against the company’s stock.

But Mr. Cohodes was relentless, and he often shared his research with regulators at the Securities and Exchange Commission.

He figured that if he was right about NovaStar, and he was certain he was, investors everywhere would be better off if he shared his findings with investigators. The sooner the S.E.C. put a stop to improprieties, the better.

The short-sellers would benefit too, of course, if an S.E.C. investigation and civil suit confirmed what Mr. Cohodes and others had found. Even the simple disclosure that an investigation into a company’s practices had been started could crush its stock.

So in February 2003, Mr. Cohodes started corresponding with the S.E.C. about NovaStar. He began “throwing things over the wall,” as he put it, to Amy Miller, a lawyer in the division of enforcement. By this time, loan production at NovaStar was clocking $600 million a month, up from $48 million a month five years earlier.

Among the questionable practices that are the easiest to find are those that appear in a company’s own financial statements. With a little determination and expertise, accounting practices that burnish financial results or make earnings appear out of nowhere can often be spotted in these documents.

Taking his pencil to NovaStar’s statements, Mr. Cohodes found a raft of red flags. “They made their numbers look however they wanted to,” he recalls. “Not even remotely realistic.”

Article source: http://feeds.nytimes.com/click.phdo?i=970ec12ce5dc14cf243749c3de9cbed9

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