WASHINGTON, D.C. -

The Securities and Exchange Commission on Thursday charged Capital One and two senior executives for understating millions of dollars in auto loan losses incurred during the months leading into the financial crisis.

Officials said an SEC investigation found that in financial reporting for the second and third quarters of 2007, Capital One failed to properly account for losses in its auto finance business when they became higher than originally forecasted.

The SEC determined the profitability of Capital One’s auto loan business was primarily derived from extending credit to subprime consumers. As credit markets began to deteriorate, Capital One’s internal loss forecasting tool found that the declining credit environment had a significant impact on its loan loss expense.

However, federal regulators said Capital One failed to properly incorporate these internal assessments into its financial reporting, and thus understated its loan loss expense by approximately 18 percent in the second quarter and 9 percent in the third quarter.

The SEC indicated Capital One agreed to pay $3.5 million to settle the agency’s charges.

Officials added the two executives — former chief risk officer Peter Schnall and former divisional credit officer David LaGassa — also agreed to settle the charges against them.

“Accurate financial reporting is a fundamental obligation for any public company, particularly a bank’s accounting for its provision for loan losses during a time of severe financial distress,” said George Canellos, co-director of the SEC’s division of enforcement.

“Capital One failed in this responsibility by underreporting expenses relating to its loan losses even as its own internal forecasting tool had signaled an increase in incurred losses due to the impending financial crisis,” Canellos said.

According to the SEC’s order instituting settled administrative proceedings, beginning in October 2006 and continuing through the third quarter of 2007, Capital One Auto Finance experienced significantly higher charge-offs and delinquencies for its auto loans than it had originally forecasted. The elevated losses occurred within every type of loan in each of company’s lines of business.

Officials determined Capital One’s internal loss forecasting tool assessed that its escalating loss variances were attributable to an increase in a forecasting factor it called the “exogenous.” SEC officials explained the term was used to measure the impact on credit losses from conditions external to the business such as macroeconomic conditions.

The SEC found a change in this exogenous factor generally had a significant impact on Capial One’s auto loan loss expense, and it was closely monitored by the company through its loss forecasting tool.

“Capital One determined that incorporating the full exogenous levels into its loss forecast would have resulted in a second quarter allowance build of $72 million by year-end. Since no such expense was incorporated for the second quarter, it would have resulted in a third quarter allowance build of $85 million by year-end,” officials said.

However, according to the SEC’s order, instead of incorporating the results of its loss forecasting tool, Capital One failed to include any of its auto finance exogenous-driven losses in its second quarter provision for loan losses and included only one-third of such losses in the third quarter.

The SEC said the exogenous losses were an integral component of Capital One’s methodology for calculating its provision for loan losses. As a result, the agency found Capital One’s second and third quarter loan loss expense for its auto loans did not appropriately estimate probable incurred losses in accordance with accounting requirements.

The SEC’s order also found that Schnall and LaGassa caused Capital One’s understatements of its loan loss expense by deviating from established policies and procedures and failing to implement proper internal controls for determining its loan loss expense.

Officials determined Schnall, who oversaw Capital One’s credit management function, took inadequate steps to communicate the auto finance dvision’s exogenous treatment to the senior management committee in charge of ensuring that the company’s allowance was compliant with accounting requirements.

Despite warnings, the SEC said Schnall also failed to ensure that the exogenous treatment was properly documented.

Furthermore, the agency said LaGassa, who managed the auto finance loss forecasting process, failed to ensure that the proper exogenous levels were incorporated into the vehicle loan loss forecast.

The SEC also said LaGassa also failed to ensure that the exogenous treatment was documented consistent with policies and procedures.

“Financial institutions, especially those engaged in subprime lending practices, must have rigorous controls surrounding their process for estimating loan losses to prevent material misstatements of those expenses,” said Gerald Hodgkins, the SEC’s associate director of the division of enforcement.

“The SEC will not tolerate deficient controls surrounding an issuer’s financial reporting obligations, including quarterly reporting obligations,” Hodgkins continued.

The agency noted Capital One’s material understatements of its loan loss expense and internal controls failures violated the reporting, books and records, and internal controls provisions of the federal securities laws, namely Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-13.

The SEC also said Schnall and LaGassa caused Capital One’s violations of Section 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rule 13a-13 thereunder and violated Exchange Act Rule 13b2-1 by indirectly causing Capital One’s books and records violations.

Officials indicated Schnall agreed to pay an $85,000 penalty and LaGassa agreed to pay a $50,000 penalty to settle the SEC’s charges.

The SEC added Capital One and the two executives neither admitted nor denied the findings in consenting to the SEC’s order requiring them to cease and desist from committing or causing any violations of these federal securities laws.

The SEC’s investigation was conducted by senior counsel Anita Bandy and assistant chief accountant Amanda deRoo and supervised by assistant director Conway Dodge.

Continue the conversation with Auto Remarketing on both LinkedIn and Twitter.