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Meltdown in Detroit; Companies Clamor for Auditor Blessing; OFHEO Rule on Corporate Governance

April 12, 2005

Our prognostications about an impending credit crisis affecting Detroit, namely with respect to Ford (NYSE:F) and General Motors (NYSE:GM), have been borne out by recent developments. This is one of those cases where being right is small pleasure.

Last week, Standard & Poor's said it may drop Ford's credit rating to junk, confirming the similar statement by Moody's on April 5th and our prediction of several years ago. A GM downgrade seems inevitable, but the Street is desperately trying to rationalize no change with respect to Ford, the largest non-financial debt issuer in the world.

For example, S&P; analyst Scott Sprinzen said Ford's current long-term rating, which stands at one notch above "junk" status, can tolerate several quarters of weak profitability and cash flow, "but only under the assumption that financial performance will improve to more satisfactory levels thereafter."

The continued shrinkage in market share and production capacity by the Big Two means that they cannot shoulder their legacy costs to current and retired workers. Period, end of story. An eventual restructuring, a once unthinkable event, will leave Uncle Sam holding tens of billions in pension liabilities and will also drag down dozens of major suppliers.

Look at the airlines if you want to know how this story ends. The impending implosion of the US auto industry, not Social Security, should be Topic A in Washington. The Wall Street Journal summarizes the situation: "As Detroit's auto makers struggle with slowing sales, a slew of the parts manufacturers who depend on them have skidded into financial trouble."

Companies Clamor for Auditor Blessing

The Public Company Accounting Oversight Board (PCAOB) voted last week to propose a new standard for auditors to report on the elimination by public companies of material weaknesses in internal control over financial reporting. Corporate & Financial Weekly Digest, published by Katten Muchin Zavis Rosenman in Chicago, reports that companies who have made improvements in heretofore deficient internal systems and controls have "have apparently sought to obtain the concurrence of auditors as to such remediation."

It appears that auditors could be forced to provide updates on a company's systems and controls as frequently as quarterly. C&FWD; reports that the PCAOB will seek comments on the proposed standard until May 16, after which the Board will determine whether to adopt a final standard. Any final standard adopted will be submitted to the Securities and Exchange Commission for approval.

Read the full text: http://www.pcaobus.org/News_and_Events/News/2005/03-31.asp

OFHEO Rule on Corporate Governance Stings Audit Firms

Meanwhile, across town from the SEC, the Office of Federal Housing Enterprise Oversight (OFHEO) has sent to the Federal Register a final corporate governance rule that "amends and strengthens the existing regulation and reduces the potential for future corporate misconduct at Fannie Mae and Freddie Mac." The final shot from outgoing director Armando Falcon, the rule makes some serious allegations against the audit profession and the GSEs.

Of interest to readers of the IRA is the rule that requires the audit partners for the GSEs to be changed as often as every five years and the entire firm no less frequently than every ten years.

The final rule now states that "would prohibit an Enterprise from accepting audit services from an external auditor if either the lead (or coordinating) external audit partner, who has primary responsibility for the external audit of the Enterprise, or the external audit partner, who has responsibility for reviewing the external audit, has performed audit services for the Enterprise in each of the five previous fiscal years."

This prohibition relates to section 203 of the SOA that makes it unlawful for a registered public accounting firm to provide audit services to a public company by such audit partners in excess of five previous fiscal years. The rule also imposes an absolute provision that the audit firm of a GSE must change every ten years. Below is the passage dealing with the question of rotation of audit firms of GSEs:

"The existence of long term accounting relationships has been demonstrated, in the review of the Enterprises by OFHEO, to pose specific risks. The difficulty of changing auditing firms would not outweigh the finding of threatened harm that may be occasioned by certain long term audit relationships. Freddie Mac maintained the same accounting relationship for over 32 years and its accounting problems were only uncovered after it changed auditors in 2002. In 2005, Fannie Mae has announced that it will replace its auditor with which it has had a relationship for over 36 years. A central argument of commenters was that the required change undermines the pressure on an audit firm, that is, if a firm has a contract and produces less than satisfactory work, then a termination of that contract brings the firm into the public eye. Also, the requirement to change firms, it is argued, removes the incentive to move against a firm as the requirement would change the firm at a set point. This, the argument goes, would remove positive pressures on the engaging company and the auditing firm. OFHEO disagrees with respect to the Enterprises."

Read the full text of the Rule:

Troubled Company Index Down Third Month

Kamakura Corporation reports that its monthly index of troubled companies in the United States rose for the third consecutive month, reaching 13.6% of the public company universe in March. The Kamakura troubled company index was up from 13.0% in February and compares with the 12.0% level in December. The index hit its most recent low of 11.1% in April, 2004. Kamakura classifies any company with a default probability of more than one percent as troubled.

Mortgage & High Yield Defaults

Daily Bankruptcy News, published by Fulbright & Jaworski, reported last week that one mortgage servicing company it monitors experienced a 50% jump in new residential foreclosure listings from February to March, the largest monthly increase since the company began maintaining the statistics in 1999.

It is too soon to know whether March was a blip or a trend, report's DBN, which also notes that the global junk bond default rate maintained by S&P; fell at the end of March to 1.47% from 1.69% in February. The 23 year average junk default rate is 4.91%. The default rate has been below average for 16 months straight running, indicating that either that the junk market is badly named or investors are pouring money into these firms faster than the blood runs out.

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