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.”

One tactic gave the company lots of leeway in how it valued the loans held on its books. Another allowed it to record immediately all the income that a loan would generate over its life, even if that was decades. This accounting method ignored the possibility that some of the company’s loans might default. NovaStar assumed that losses on all of its loans would be nonexistent.

This was the same stratagem that killed off almost all subprime lenders when the Russian debt crisis rocked the world’s financial markets in 1998.

NovaStar’s rosy assumption not only padded its profitability but also encouraged the company to make more mortgages, regardless of quality. The more loans it made, the more fees and income the company could record.

After some digging, Mr. Cohodes found that NovaStar’s lending practices were lax and rife with hidden fees.

Promotional memos NovaStar sent to its 16,400 unsupervised mortgage brokers across the country told the tale of easy credit terms. “Did You Know NovaStar Offers to Completely Ignore Consumer Credit!” one screamed. “Ignore the Rules and Qualify More Borrowers with Our Credit Score Override Program!” boasted another.

Mr. Cohodes and other NovaStar critics believed that they had found a company whose success was built on deceptive practices. What they did not recognize was that NovaStar was a microcosm of the nationwide home-lending assembly line that would lead directly to the credit crisis of 2008.

IN Atlanta, Patricia and Ricardo Jordan learned the hard way how NovaStar’s freewheeling lending practices imperiled unsuspecting borrowers.

The Jordans had bought their three-bedroom home in a middle-class section of southwestern Atlanta in 1983 for $30,000. Ms. Jordan had made many improvements on the property, putting up a fence and installing an attic fan and air-conditioning. The sole breadwinner in the family, she supported her husband, a physically and mentally disabled Vietnam veteran. In 2000, she retired and they lived on Social Security and veteran benefits.

In 2004, she had a 9 percent adjustable-rate mortgage that she wanted to change to a fixed-rate loan. She received an offer in the mail from NovaStar and called the toll-free number.

“I told them I wanted to come out of the adjustable and they said they would give me the fixed rate if I would accept it at 10 percent,” Patricia said. “I could have stayed where I was but I told them definitely a 30-year fixed rate.”

The Jordans were more or less perfect targets for a lender like NovaStar. They were financially unsophisticated, and they were trusting.

Unbeknownst to the Jordans, their NovaStar loan was one of the most punitive out there: an adjustable-rate mortgage with an initial interest rate of 10.45 percent that would soon explode to 17.25 percent. Even the initial monthly housing payment, including taxes and insurance, was barely affordable: $1,215.33. As documented in their loan file, the Jordans’ total monthly net income was only $2,697. Their monthly housing and other debt costs totaled $1,642, so after they paid their debts each month, the Jordans had only $1,055 to live on.

And that was just the beginning. Two years after signing up for the loan, its interest rate was set to ratchet up. Only then did Ms. Jordan learn that NovaStar had put her into an adjustable loan, not the fixed rate she had been promised.

“I got duped,” she contended.

The Jordans sued NovaStar in 2007. As part of the lawsuit, their lawyer found that their loan had been placed in a mortgage securitization trust assembled by NovaStar and sold to investors in November 2004. More than half of the loans in the pool were provided with no documentation or limited documentation of borrowers’ financial standing.

But the Jordans had given NovaStar bank statements and other documentation of their income. The lawsuit would show that NovaStar had inflated their monthly income by $500 to make the loan work. The lender had given the Jordans a loan that went against its own underwriting guidelines and that overrode federal lending standards.

The Jordans’ was just one loan. There were literally thousands more like it. (NovaStar settled with the Jordans in 2010. The terms were undisclosed.)

Because NovaStar was not a bank, its lending practices were largely lost on state and federal regulators. Traditional banks operate under the scrutiny of financial regulators like the Federal Deposit Insurance Corporation, which was set up to protect depositors after the huge bank failures of the Great Depression. But for companies like NovaStar, the closest thing to an overseer was an occasional state regulator who took action when it discovered that the company’s independent salespeople were unlicensed.

Massachusetts was one state whose regulators recognized the threats posed by the likes of NovaStar. In October 2003, the state’s commissioner of banks filed a cease-and-desist order against NovaStar, concluding that the company engaged in “acts or practices which warrant the belief that the corporation is not operating honestly, fairly, soundly and efficiently in the public interest.”

Nevada followed with its own order in early 2004. NovaStar started closing operations in Massachusetts and Nevada, but only belatedly told the public about its regulatory reprimands.

As the housing bubble inflated, NovaStar was able to convince many of its shareholders that its mistakes were honest ones and were immaterial to its growing business. The company hired Lanny Davis, a well-connected lobbyist and public relations operative, to run interference. Mr. Davis was used to operating in a crucible; he had been special counsel to President Bill Clinton during the Monica Lewinsky scandal.

But NovaStar’s problems were not limited to a few aggressive state regulators. In the summer of 2004, the inspector general for the Department of Housing and Urban Development produced a damning report on NovaStar’s practices. HUD’s inspector general determined that the company’s branch system did not comply with federal regulations; among the deficiencies HUD cited was the company’s practice of hiring independent contractors as loan officers. NovaStar’s branch system, HUD said, was designed to shift risk from the company to the federal government. HUD recommended that NovaStar pay penalties in the case.

NovaStar did not disclose the HUD report to investors. All the while, Mr. Cohodes was continuing to talk to Ms. Miller and others at the S.E.C. about NovaStar. He sent them information about the company, including the NovaStar fliers indicating its anything-goes lending practices. He annotated the transcript of one of NovaStar’s conference calls with analysts and investors, pointing out to the investigators the many inaccurate statements made by the company’s executives.

Although some of the S.E.C. people he spoke with seemed to recognize the problems in NovaStar’s operations, their investigation did not appear to be gaining traction.

The phone calls with the regulators went over the same material repeatedly, Mr. Cohodes recalls, leading him to conclude that Ms. Miller and her colleagues did not understand what was happening at NovaStar.

“Whenever they seemed to get it, they would either call up or make contact frantically saying, ‘Can you please go over this again?’ ” Mr. Cohodes said. “It was almost like someone was presenting a case to the higher-ups and they would say, ‘Are you sure? Go back and make sure.’ ”

One matter whose importance the agency would surely recognize, Mr. Cohodes thought, was a lawsuit showing that NovaStar’s leading mortgage insurer, the PMI Group, had stopped insuring the lender’s loans. He passed his information along to the S.E.C., including names and phone numbers of people to talk to at PMI.

Mr. Cohodes also gave the agency information about some NovaStar branches that were either nonexistent or questionable. Opening new offices helped the company persuade investors that business was booming. But some strange stuff turned up when Mr. Cohodes and some colleagues took a road trip to see NovaStar’s offices.

“A posse of us went to Vegas, which was their growth market,” he recalls. “We found one branch in a massage parlor, another in a guy’s house,” he says. “After that, I wrote to the S.E.C. again and basically said, ‘Someone should go in here and make sure these numbers are right.’ ”

To most outsiders, NovaStar’s operations seemed to be running on all cylinders. During 2004, the company wrote $8.4 billion in mortgages; that September, the amount of loans held on its books had reached $10 billion. NovaStar ended that year with 600 offices.

It was time for Mr. Hartman and Mr. Anderson to take a victory lap. “The $10 billion mark is a tribute to NovaStar associates and our many partners in the mortgage community,” Mr. Hartman told a reporter at Origination News, an industry publication. But while NovaStar executives high-fived each other, a unit of Lehman Brothers, Wall Street’s largest packager of residential mortgage loans sold to investors, was discovering serious problems in a review of NovaStar mortgages. The findings were so troubling to the Lehman executives overseeing the firm’s purchases of NovaStar loans that they ended their relationship with NovaStar in 2004.

According to documents filed in a borrower lawsuit against NovaStar, Aurora Loan Services, a Lehman subsidiary, studied 16 NovaStar loans for quality-control purposes. What the analysis found: more than half of the loans — 56.25 percent, to be exact — raised red flags. “It is recommended that this broker be terminated,” the report concluded.

Among the problems turned up by the Aurora audit were misrepresentations of employment by the borrower, inflated property values, transactions among parties that were related but not disclosed, and unexplained payoffs to individuals when loans closed.

The details uncovered by Aurora were alarming. One NovaStar loan on a property in Ohio totaled $77,500 even though the average sales price for the neighborhood was $31,685, and the same house had been purchased two months earlier for $20,000.

S.E.C. rules require the disclosure by company management of information considered material to the company’s prospects or an investor’s analysis. In a 1999 S.E.C. bulletin, the commission defined materiality this way: “A matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.” Two Supreme Court cases use the same standard.

Surely, Aurora’s findings that more than half of the sampled NovaStar loans were questionable would have been an important consideration for the S.E.C.’s “reasonable person.”

Still, NovaStar failed to alert investors or the public at large to the Aurora analysis. Nor did NovaStar publicize the fact that Lehman Brothers had stopped buying its loans.

Increasingly frustrated, Mr. Cohodes and the other NovaStar short-sellers kept throwing information over the wall at the S.E.C. But the inquiry soon seemed moribund.

“We kept going to the government from the time the company had a $300 million market cap, a $600 million market cap until it had a $1 billion market cap,” Mr. Cohodes said, referring to NovaStar’s rising stock price.

To keep its money machine running, NovaStar regularly issued new shares to the public. Between 2004 and 2007, for instance, the company raised more than $400 million from investors. To those critical of NovaStar’s practices, this was money the company should never have been allowed to raise from investors who were kept in the dark by the company’s disclosure failings.

Mr. Cohodes reckons that over roughly four years, he conducted hundreds of phone calls with the S.E.C. about NovaStar. Each time, he would walk them through his points. Sometimes, a higher-up would get on the phone and contend that while NovaStar’s practices were indeed aggressive, the company did not appear to be breaking the law. NovaStar’s selective disclosures — it was quick to report good news but failed to own up to problems on many occasions — seemed to be infractions that the S.E.C. should have dealt with. But its investigation went nowhere.

In any case, by 2006, the wheels had started to come off the NovaStar cart. The company’s net income that year was less than half what it earned in 2005. The company faced a number of lawsuits, including a class action filed in Washington State in December 2005 alleging that NovaStar failed to disclose to borrowers the fees earned by brokers. Plaintiffs contended that NovaStar had violated consumer protection laws. In 2007, NovaStar agreed to pay $5.1 million to resolve the claims of about 1,600 Washington borrowers.

Its stock was falling, too. By late 2006, NovaStar was trading at around $30; but in the first few months of 2007, as the money for subprime lenders began drying up and these companies started closing their doors, it plummeted to $5. The company halted mortgage lending and stopped paying its dividend.

In March 2007, Mr. Anderson dismissed as insignificant the HUD report and the lawsuits the company had attracted. “Clearly we’re going through a tough time right now,” he told a reporter. “But we think the loans we are originating today will perform very well. We were surprised by the speed and severity of the downturn, but I think NovaStar will be a survivor.”

He was wrong. NovaStar’s shares collapsed, wiping out roughly $1 billion in market value from the peak of the stock price. Despite the implosion, between 2003 and 2008, Mr. Anderson and Mr. Hartman each made about $8 million in salary, bonuses and stock grants.

Neither man was ever sued by the S.E.C. or any other regulator. As is its custom, the S.E.C. declined to comment on the NovaStar inquiry or the agency’s discussions with short-sellers. But documents supplied by the S.E.C. under the Freedom of Information Act show the extensive communications between Mr. Cohodes and the agency. Ms. Miller, still at the S.E.C., declined to comment.

“It would be interesting to see who exactly dropped the ball, and why,” Mr. Cohodes said. “It would be interesting why nothing was ever brought. The S.E.C. should have sent a plane for us to come to D.C. and say: ‘How do we make sure this doesn’t happen again?’ ”

NOVASTAR no longer underwrites mortgages. Its shares were delisted by the New York Stock Exchange and now trade for about 41 cents a share. The company, a shadow of its former self, runs a property appraiser and a financial services unit that provides banking services “to meet the needs of low- and moderate-income-level individuals.”

In a 2010 report to shareholders, Mr. Anderson reported that the company had “several interesting initiatives under way.” Mr. Hartman has left the company. At the end of 2009, NovaStar management concluded that the company’s financial reporting was “not effective.”

NovaStar had, in essence, confirmed what Mr. Cohodes had been telling the S.E.C. all along. The company’s financial reports just couldn’t be trusted.

A version of this article appeared in print on May 22, 2011, on page BU1 of the New York edition with the headline: It Teetered, It Tottered, It Was Bound To Fall Down.

© 2011 The New York Times Company