The Securities and Exchange Commission has charged Capital One Financial Corporation and two of its senior executives with understating millions of dollars in losses on auto loans in the months leading up to the financial crisis.

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 profitability of its 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, 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.

Capital One agreed to pay $3.5 million to settle the SEC’s charges. The two executives—former chief risk officer Peter A. Schnall and former divisional credit officer David A. 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, in a statement. “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.”

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 COAF’s lines of business. Its internal loss-forecasting tool assessed that its escalating loss variances were attributable to an increase in a forecasting factor it called the “exogenous,” which measured the impact on credit losses from conditions external to the business such as macroeconomic conditions. A change in this exogenous factor generally had a significant impact on COAF’s 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.

However, according to the SEC’s order, instead of incorporating the results of its loss forecasting tool, Capital One failed to include any of COAF’s exogenous-driven losses in its second quarter provision for loan losses and included only one-third of such losses in the third quarter. The exogenous losses were an integral component of Capital One’s methodology for calculating its provision for loan losses. As a result, Capital One’s second- and third-quarter loan loss expense for COAF did not appropriately estimate probable incurred losses in accordance with accounting requirements.

The SEC’s order also finds 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.

Schnall, who oversaw Capital One’s credit management function, took inadequate steps to communicate COAF’s exogenous treatment to the senior management committee in charge of ensuring that the company’s allowance was compliant with accounting requirements, according to the SEC. Despite warnings, he also failed to ensure that the exogenous treatment was properly documented. LaGassa, who managed the COAF loss forecasting process, failed to ensure that the proper exogenous levels were incorporated into the COAF loss forecast. He 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 W. Hodgkins, associate director of the SEC Division of Enforcement. “The SEC will not tolerate deficient controls surrounding an issuer’s financial reporting obligations, including quarterly reporting obligations.”

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, according to the SEC, and Schnall and LaGassa caused indirectly caused Capital One’s books and records violations.

Schnall agreed to pay an $85,000 penalty and LaGassa agreed to pay a $50,000 penalty to settle the SEC’s charges. Capital One and the two executives neither admitted nor denied the findings in consenting to the 7SEC’s order requiring them to cease and desist from committing or causing any violations of these federal securities laws.

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