Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New by David Einhorn (tohfa e dulha read online TXT) 📕

in other states. “The committee will be investigating SBA’s involvement and how the agency could have failed to detect this,” Kate L. Davis, a spokeswoman for Velázquez, said. The article reported that the SBA planned to re-examine more than five years of loans and could seek restitution if there were additional cases of fraud.

“He [Harrington] says he made a mistake, but not near to the extent that the government claims,” Harrington’s lawyer said in the article.

Lanny Davis, now working for BLX, told the Times, “This is a good company, with good people, and I believe, in the final analysis, this will be borne out.”

Not one of the Wall Street analysts made a significant comment about the Times article, which described a much larger problem than the analysts or Allied acknowledged. I asked Robert Lacoursiere, the Bank of America analyst, why Wall Street was not responding. In an e-mail he responded, “The Times article has no named sources at the various interested agencies who are willing to be on the record to support your concerns—it therefore is no better than speculation/rumor/innuendo—that’s different from information to rationally form an opinion on.”

Allied responded to the Times article by issuing a press release:

Allied Capital understands that BLX is working cooperatively with the Small Business Administration with respect to this matter. In particular, Allied Capital understands that BLX is working with the SBA so that it may remain a preferred lender in the SBA 7(a) program and retain the ability to sell loans into the secondary market [where they sell the guaranteed pieces]. Allied Capital anticipates that BLX will abide by certain terms and conditions under which they will operate going forward in the program and Allied Capital will stand behind any financial commitments BLX makes to the SBA in this regard to prevent any loss due to fraud.

The release also described Allied’s financial relationship with BLX. “Allied Capital’s total investment in BLX was $284.9 million at value at September 30, 2006, or 6.2% of Allied Capital’s assets. Allied Capital’s investment in BLX is in the equity of the company and this investment at value compares to BLX’s net book value at September 30, 2006, of $190 million. At December 31, 2006, BLX had outstanding borrowings under its line of credit of $322 million and BLX had estimated assets of approximately $600 million to support the borrowings on the line of credit.”

In reality, Allied’s exposure was much larger. Adding in Allied’s guarantee of BLX’s debt, Allied’s commitment was over $500 million. Further, Allied now promised direct restitution to the SBA and risked additional legal exposure from other victims of BLX’s fraud. The release continued, “BLX has a substantial cash flow stream from its residual interests and servicing assets and collected approximately $100 million in cash from its residual interests and servicing assets in fiscal 2006.” Apparently, this wasn’t enough to stop BLX from substantially increasing its bank borrowings.

Allied’s press release spin went further:

If scheduled loan payments were to be received as stated in the loan agreements with no future losses or prepayments, BLX would receive future cash flows of over $1 billion over time.

This was an extremely misleading picture of BLX’s financial status. Of course, prepayments and defaults are a fact of life. The future cash flows were not actually expected to be anything close to $1 billion. In fact, if BLX couldn’t sell new loans into the secondary market, they would have limited ability to originate new loans. No new loans meant BLX was on its way out of business.

The market holds credit rating agencies in a special place, because they are allowed to review confidential inside information in making their assessments. Fitch Ratings gave the all-clear signal. “The news surrounding the indictment suggests that the scope of improper practices may be limited to the Detroit office of BLX. This provides Fitch with comfort that BLX has a sound business model and that the large majority of its nearly $2.7 billion in serviced loans are viable assets.”

Shortly after the Fitch report hit the wires, Mark Roberts from Off Wall Street e-mailed me. “I spoke with Meghan Crowe, CFA, of Fitch, who wrote the Allied rating piece on Bloomberg, and told her that if she had more factual information she might come to a different conclusion, and I told her I could provide her with research that contained this information. She said she was not interested. I told her that I was amazed at her response, if she was at all interested in seeking the truth. She remained unimpressed. What can I say?”

James Lin called her and confirmed that her rating is based on the information disclosed by Allied in conversations with her, their filings, and the press releases. She was taking that information at face value in her rating assessment.

We decided to take the matter back to Allied’s board. We wrote a ten-page letter on January 22, 2007, which we released to the media. I reminded the directors of my 2005 letter, when I alerted them to the fraud at BLX. The letter told the board to remove “the present management team that has presided over the metastasizing fraud at BLX and Allied” and “end the dishonest culture perpetuated by current management.” I wanted new management brought in to clean house. I believed any new management would reveal even greater problems at Allied immediately, because it would not want to be blamed for lingering ethical lapses or accounting abuses.

I advised the board that the Harrington indictment was not the isolated act of a single, rogue employee. I identified seventeen other states where we identified fraudulent BLX loans. I detailed the mounting evidence of fraud at BLX based on Allied’s disclosures and legal and government records. This included the original loan-parking arrangement when Allied formed BLX and Allied’s knowledge of Harrington’s misconduct all the way back to at least Holly Hawley’s testimony about her car wash loans in 2002 with Allied’s lawyers present.

The Harrington indictment and related indictments came just before the deadline