Friday, September 07, 2007

So This Subprime Lender Walks Into an Audit...

Published: September 7, 2007

The auditor got cold feet, and the company may die.

It would no doubt be interesting to hear a tape of conversations last week between the senior management of NovaStar Financial, a subprime mortgage lender, and its auditors at Deloitte & Touche.

NovaStar, like many of its competitors, has seen its business model blow up this year. But in mid-July it got a lifesaving $48 million infusion of capital from two institutional investors, with a promise of $101 million more to come.

Now Deloitte has effectively revoked its audit of NovaStar — evidently without claiming that any number in the report was wrong — and the investors do not have to put up the cash.

Deloitte seems to have invoked a little-known auditing standard that says an auditor cannot allow a previously audited financial report to be cited by a company if there are subsequent events “of such a nature that disclosure of them is required to keep the financial statements from being misleading.”

Deloitte won’t talk, but by NovaStar’s account, the auditors’ qualms did not surface until last week, when Deloitte said it thought that the 2006 annual report should have more disclosures on business problems and that there were questions about the company’s ability to continue as a going concern. But even with those changes, Delolitte was not prepared to quickly recertify the financial statements.

Since the company had to make a filing with the Securities and Exchange Commission to get the additional money, and since it could not do that without Deloitte’s blessing, the additional money will not be coming.

NovaStar says it will soldier on, cutting costs and hoping to get by. Since the stock is still trading around $6 a share, it appears that some investors think it can do so. But at current prices, the company has a market capitalization far below the dividend it is supposed to declare later this month.

NovaStar holds a special place in the market not because of the problems it has encountered, which are similar to those of others in its business, but because of the long and bitter battle waged between investors who believed in the stock and those who did not.

Before, Nova-Star was the stock of focus for those who believed their stocks were being sabotaged by “naked short sellers” who drive a company’s share price down by selling shares they had not bought or borrowed.

It was NovaStar that Patrick Byrne, Overstock’s chief executive, pointed to when he began what he called his “jihad” against naked shorts. There is a suit pending by some NovaStar shareholders against major brokerage firms, charging that they aided naked shorting and thus cost the investors money.

At last report, NovaStar had 9.5 million shares outstanding, and a short position of 8.1 million shares, a very high proportion. Overstock, by contrast, has a short position equal to less than a quarter of the shares outstanding. (It also has confounded the shorts by rising sharply this year.)

In its prime, NovaStar appeared, to its fans anyway, to be a money machine. It was organized as a real estate investment trust, and it reported high taxable income that it paid out in dividends. The high yield attracted investors and made it easy to sell more shares, which it regularly did. Its shares were worth $1.8 billion.

Critics asserted NovaStar used questionable accounting to produce those profits as well as other dubious business practices. One of its current problems is a $46 million judgment won by a competitor who said NovaStar conspired to drive it out of business.

Accounting in the mortgage business is notoriously inexact. NovaStar, like many other companies, sold mortgages on terms that left it with some of the risk. Just how much profit it reported depended on a series of assumptions about those risks.

“If our actual experience differs materially from the assumptions that we use,” NovaStar said in the annual report that Deloitte is no longer willing to certify, “our future cash flows, our financial condition and our results of operations could be negatively affected.”

That warning was prescient. With mortgage defaults rising, it appears NovaStar paid dividends from ephemeral profits.

The REIT status that helped make NovaStar attractive is now its albatross. The company’s last estimate said it would have to pay $157 million more in dividends to satisfy tax rules that require REITs to pay out profits to shareholders. In July, it talked of paying the dividend with preferred stock rather than cash.

But that may be tricky. At current market prices, the entire company is worth far less than $100 million, so how can it give out preferred stock worth more than that?

The $48 million July investment in NovaStar, made by funds affiliated with the Jefferies Group and the MassMutual Corporation, seemed bold at the time. Now it seems foolish, providing for the purchase of preferred stock convertible to common at $28 a share.

The funds will not comment, but there is nothing — other than a fear of throwing good money after bad — to stop them from making a new investment, presumably on better terms. Perhaps significantly, Jefferies and MassMutual have not exercised their right to name two new NovaStar directors.

Had Deloitte not rebelled at the last moment, NovaStar would have the extra $101 million. Without it, the battle for survival will be that much harder.


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