Question

The following is a description of various factors that affected the operations of Lincoln Federal Savings and Loan, a California savings and loan (S&L). It was a subsidiary of American Continental Company, a real estate development company run by Charles Keating.
Lincoln Federal Savings & Loan
Savings and Loan industry background-The S&L industry was developed in the early part of the twentieth century in response to a perceived need to provide low-cost financing to encourage home ownership. As such, legislation by Congress made the S&L industry the primary financial group allowed to make low-cost home ownership loans (mortgages). For many years, the industry operated by accepting relatively long-term deposits from customers and making 25- to 30-year loans at fixed rates on home mortgages. The industry was generally considered to be safe. Most of the S&Ls (also known as thrifts) were small, federally chartered institutions with deposits insured by the FSLIC. The motto of many S&L managers seemed to be, "Get your deposits in, make loans, sit back, and earn your returns. Get to work by 9 a.m. and out to the golf course by noon."
Changing economic environment-During the 1970s, two major economic events hit the S&L industry. First, the rate of inflation had reached an all-time high. Prime interest rates had gone as high as 19.5%. Second, deposits were being drawn away from the S&Ls by new competitors that offered short-term variable rates substantially higher than current passbook savings rates. The S&Ls responded by increasing the rates on certificates of deposit to extraordinary levels (15-16%) while servicing mortgages with 20- to 30-year maturities made at old rates of 7-8%. The S&Ls attempted to mitigate the problem by offering variable-rate mortgages or by selling off some of their mortgages (at substantial losses) to other firms.
However, following regulatory accounting principles, the S&Ls were not required to recognize market values of loans that were not sold. Thus, even if loan values were substantially less than the book value, they would continue to be carried at book value as long as the mortgage holder was not in default. Changing regulatory environment-In the early 1980s, Congress moved to deregulate the S&L industry. During the first half of 1982, the S&L industry lost a record $3.3 billion (even without marking loans down to real value). In August 1982, President Reagan signed the Garn-St. Germain Depository Institutions Act of 1982, hailing it as the most important legislation for financial institutions in 50 years. The bill had several key elements:
● S&Ls would be allowed to offer money market funds free from withdrawal penalties or interest rate regulation.
● S&Ls could invest up to 40% of their assets in nonresidential real estate lending. Commercial lending was much riskier than home lending, but the potential returns were greater. In addition, the regulators helped the deregulatory fever by removing a regulation that had required a savings and loan institution to have 400 stockholders with no one owning more than 25%-allowing a single shareholder to own a savings and loan institution.
● The bill made it easier for an entrepreneur to purchase a savings and loan. Regulators allowed buyers to start (capitalize) their thrift with land or other noncash assets rather than money.
● The bill allowed thrifts to stop requiring traditional down payments and to provide 100% financing, with the borrower not required to invest a dime of personal money in the deal.
● The bill permitted thrifts to make real estate loans anywhere.
They had previously been required to make loans on property located only in their own geographic area.
Accounting-In addition to these revolutionary changes, owners of troubled thrifts began stretching already liberal accounting rule (with regulators' blessings) to squeeze their balance sheets into (regulatory) compliance. For example, goodwill, defined as customer loyalty, market share, and other intangibles, accounted for over 40% of the thrift industry's net worth by 1986.
Lincoln Federal S&L-American Continental Corporation, a land development company run by Charles Keating and headquartered in Phoenix, purchased Lincoln Federal S&L in 1984. Immediately, Keating expanded the lending activity of Lincoln to assist in the development of American Continental projects, including the Phoenician Resort in Scottsdale.1 Additionally, Keating sought higher returns by purchasing junk bonds marketed by Drexel Burnham and Michael Millken. Nine of Keating's relatives were on the Lincoln payroll at salaries ranging from over $500,000 to over $1 million.
Keating came up with novel ideas to raise capital. Rather than raising funds through deposits, he had commissioned agents working in the Lincoln offices who sold special bonds of American Continental Corporation. The investors were assured that their investments would be safe. Unfortunately, many elderly individuals put their life savings into these bonds, thinking they were backed by the FSLIC because they were sold at an S&L-but they were not. Keating continued investments in real estate deals, such as a planned mega community in the desert outside of Phoenix. He relied on appraisals, some obviously of dubious value, to serve as a basis for the loan valuation.
a. Discuss the risks identified and the implication of those risks for the conduct of the audit.
b. The auditor did review a few independent appraisals indicating the market value of the real estate in folders for loans. How convincing are such appraisals? In other words, what attributes are necessary in order for the appraisals to constitute appropriate (relevant and reliable) evidence?



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  • CreatedSeptember 22, 2014
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