Wall Street Intensifies Scrutiny of Fraud After Spate of Loan Losses
Lenders are increasing due diligence and demanding access to more data
Alleged corporate-borrower frauds are prompting Wall Street to increase due diligence and demand more financial data from companies.
A task force of banking, investment-management and accounting firms is examining the nature of the problem and investor protection.
Recent frauds, including First Brands and Tricolor, have affected regional banks and Wall Street giants, raising concerns about systemic issues.
A string of alleged frauds by corporate borrowers is spurring a reckoning across Wall Street, sending bankers and investors scrambling to prevent future blowups.
Lenders are increasing due diligence and demanding a longer history of financial data from companies. Some are inserting conditions that permit them to do more frequent checkups before agreeing to make loans. A group of the biggest names in banking, investment management and accounting have formed a task force that will take a deeper look at the nature of the problem and how to protect investors.
The frauds that have emerged so far, which involve small to midsize companies in sectors such as autos and telecommunications, haven’t sparked widespread trouble in the market or economy. But they have generated fallout for both regional banks and Wall Street giants such as JPMorgan Chase and BlackRock, and the string of revelations has made it harder to dismiss any one case as an isolated event.
“This is sending real ripples in the credit markets,” said Colin Adams, partner at Uzzi & Lall, a restructuring adviser that works with both borrowers and financing providers. “People are really starting to ask: ‘How does this happen?’ ”
The worries emerged in late September, when the aftermarket auto-parts supplier First Brands filed for bankruptcy amid questions over whether it had pledged the same accounts receivable to different lenders. Around the same time, the now-defunct auto dealer and subprime lender Tricolor Holding also filed for bankruptcy, facing similar allegations that it fabricated or double-pledged consumer auto loans.
Since then, regional banks including Utah-based Zions Bancorp have taken losses on loans to California real-estate investors, whom they have accused of fraud. A recent bankruptcy filing also increased scrutiny of an accusation of fraud made by BlackRock’s private-credit arm against one of its borrowers, the owner of two little-known telecom-services companies.
By then, fraud was the talk of industry gatherings. One industry group, the Structured Finance Association, convened a “Fraud Mitigation Task Force,” which will meet regularly over the next few months with the goal of presenting findings at a conference in late February.
The group represents players in one part of the credit market that bundles together pools of loans that are then used to back tiers of bonds of different credit ratings. That corner of the market has only been directly affected by alleged fraud involving Tricolor.
But Michael Bright, the association’s chief executive, said that the new task force will focus on what types of fraud lenders should be looking for and what processes they should follow to detect them—findings that could be relevant to other types of lending. The effort will include representatives from across SFA’s membership, which includes Wall Street banks, asset managers and the big four accounting firms.
Since the structured-finance industry’s infamous role bundling bad loans into supposedly safe bonds ahead of the 2008-09 financial crisis, it has become more regulated and members have taken pride in their improved lending practices. That, Bright said, has added to the sense of urgency to figure out whether recent fraud “is a one-off, or something systemic.”
The collapse of First Brands in particular has brought attention to how a variety of lenders from banks to asset-management and private-credit investors have been jumping into increasingly popular asset-based finance strategies, including providing short-term working-capital financing backed by receivables.
Those strategies remain popular. But now, some of those lenders are asking to take a look at companies’ record of payments on receivables stretching back years rather than months, and inserting language into loan agreements that allow them to do more regular appraisals on the collateral, said Adams of Uzzi & Lall.
Academic studies have suggested that corporate fraud tends to increase during good, if not great, financial environments, when businesses have an incentive to fudge numbers to get funding, said Alexander Dyck, a professor at the Rotman School of Management at the University of Toronto.
In the past, increased revelations of fraud have sometimes coincided with economic downturns and increased default rates. But in this case, default rates on low-rated corporate debt haven’t been surging, and the latest data has generally pointed to a stable economy.
As a result, demand for corporate bonds and loans has remained robust in recent days and weeks, enabling continued borrowing by companies.
One pocket of weakness has been bonds backed by subprime auto loans, where Tricolor’s bankruptcy has exacerbated already existing concerns about low-income car buyers falling behind on their debt payments. Prices of those bonds have slumped in recent weeks, pushing their yields higher relative to those of ultrasafe Treasurys.
Investors are “being cautious around Tricolor, kind of taking a step back, thinking about could this happen to other issuers, and then there’s concern about consumer credit,” said Theresa O’Neil, an asset-backed securities strategist at Bank of America.
George Goudelias, a senior portfolio manager and head of leveraged finance at Seix Investment Advisors, said that fraud allegations were “cause for concern” but still not something that has changed his thinking much about the overall credit market.
His team of analysts remains focused on traditional credit metrics, such as earnings growth and earnings relative to their interest expense, and making sure businesses could withstand an unexpected increase in interest rates.
Investors “really need to look at the whole picture,” he said.