International and U.S. banks should benefit from studying Countrywide Financial Corporation’s business practices leading up to the 2008 financial crisis in order to develop lessons learned for improved risk management and corporate governance by both boards of directors and management. Especially for U.S. banks, the 2010 Dodd-Frank Act now requires all U.S. banks supervised by the Federal Reserve Bank to have risk management committees with at least one “risk management expert” on the committee. However, the $6.2 billion “London whale” loss at JPMorgan Chase in 2012 has motivated large institutional shareholders of JPMorgan Chase common stock to demand the removal of three risk management board members. It was hard to determine the “risk management expert” among the four committee members: a JPMorgan Chase director since 1991, the head of Honeywell International, a former KPMG executive, or the president of the American Museum of National History. Internationally, the proportion of bank boards that have risk committees was significantly higher in Europe in 2005 (26.6%) than in the United States (9.6%) (Allemand et al 2013). When a board decides to create a risk committee, it shows greater awareness of the importance of risk management and control (Hermanson 2003). When risks are complex and when the regulatory environment is strong, the creation of a risk committee becomes necessary and a risk management committee can help to make the profile risk of a bank more intelligible to the board. The presence of such a committee should lead to a lower risk (Brown, Steen and Foreman 2009). However, Countrywide had a risk management committee. Although it was repeatedly warned of investment risks by senior Countrywide executives, it ignored such risk warnings. Similarly, a weak system of management control was found to be a key, recurring structural factor in corporate governance implications from the 2008 financial crisis (Grove et al 2012). The following excerpts from the forensic accounting report on Countrywide are used to develop six key risk management lessons that should have been learned by any bank risk management committee for improved corporate governance. This forensic accounting report for Countrywide Financial Services was prepared by Gordon Yale, a practicing forensic accountant in Denver, Colorado. This forensic investigation of Countrywide was performed at the request of the Attorney General of the State of Florida who used the resulting forensic report in litigation against Countrywide’s Chief Executive Officer, Angelo Mozilo. A Florida court threw the Mozilo case out because Mr. Mozilo was not a resident of the state. Before an appeal by the Florida Attorney General was decided, the Mozilo case was dropped because Bank of America, which had acquired Countrywide as it neared financial collapse in 2008, settled a larger action with eleven states, including Florida, for approximately $8.4 billion. In doing so, Bank of America avoided prosecution for Countrywide’s alleged fraudulent conduct – inducing customers into taking out subprime mortgages and other risky, high-cost loans. The State of Florida’s share of that settlement was nearly $1 billion. This forensic report was used to develop key risk management lessons learned from Countrywide which was the largest generator of these risky, “no-doc” (no significant applicant qualifications) subprime mortgages and other high-cost loans which helped precipitate the 2008 financial crisis.
Corporate governance, earnings quality and idiosyncratic crash risk during the 2007–2008 financial crisis
