Opening

In 2013, Homex was the largest real estate development company in Mexico.  The Mexican government had pushed to increase the amount of affordable housing, and Homex had responded.  It rapidly built homes in cities across Mexico, while investors made millions.  But just one year later Homex was bankrupt, and under investigation by the SEC.  It turns out that much of the company’s revenue was completely bogus.  And the SEC had satellite images to prove it…

I’m Michael McLaughlin, and this is Scheme.

The founding of Homex

Homex was founded in 1989 in Culiacan, Mexico.  It was just a small construction company back then, founded by 4 brothers from the de Nicolás family.  One of those brothers, Gerardo, would serve as the CEO for 20 years.  Gerardo led Homex through its period of explosive growth in the early 2000’s.

Homex’s growth phase

There are two main reasons that Homex was transformed from a small, family-owned construction company into a publicly-traded housing developer.  First, Vicente Fox was elected president of Mexico in 2000.  This was historic, because the presidency had been held by the members of the same political party for more than 70 years, ever since the Mexican Revolution.

Fox was elected by promising reforms; and after he took office, he took action.  Fox declared that all Mexicans should have access to affordable housing.  Rather than building your own house room-by-room over a period of years, Mexicans should be able to purchase a house on credit.  And this credit would come from a federal agency, Infonavit.  The Mexican government started providing thousands of loans through Infonavit, which led to increased demand for housing. Homex, along with several other companies, stepped in to meet the demand.

But Homex needed capital to build homes, and this leads to the second reason for Homex’s growth.  In 2002, the U.S. investor Sam Zell invested $32 million in Homex in exchange for 26.5% of the company.  Zell was a billionaire, and he had a private equity firm that invested in real estate in emerging markets.  Zell saw the Mexican government’s commitment to housing development as an opportunity to make lots of money.  Zell would later sell his shares and make a tidy profit, but not before he had taken the company public.  On June 29, 2004 Homex did an IPO and raised well over a hundred million dollars.

So what seems to be the problem? 

At this point, Homex had everything going for it: plenty of capital to build homes, and a government that loaned people money to buy those homes.  Homex spread to more cities across Mexico and dramatically increased the number of homes it was building.  It was held up as a great example of a public-private partnership.  Investors make money, and the affordable housing crisis gets solved.  Except it didn’t…

Many of the homes built by Homex had serious problems.  In some cases the land wasn’t properly graded, resulting in cracked sidewalks, walls, and floors.  Storms washed away some of the streets, and caused homes to collapse; some of the homes had been built on flood plains. There were rolling blackouts and sewage wasn’t being processed.  In some cases residents didn’t even have water, and Homex failed to provide schools it had promised.

These issues arose within just a couple years of Homex going public, but Homex blamed homeowners for failing to maintain their homes.  But the real problem was that Homex had a strong incentive to build houses, but no incentive to ensure that those homes were structurally sound or that the neighborhoods would have basic utilities.  Residents complained, and many of them simply abandoned their homes.  A report by the OECD in 2015 said that nearly half a million Homex homes were vacant.

But it gets worse for Homex…

The Mexican government changed its policy.  The president who succeeded Vicente Fox, Felipe Calderon, began steering government loans to urban housing instead of the suburbs.  Mexico’s next president, Enrique Peña Nieto, took office in 2012 and went a step further, declaring that almost all governmental loans would be directed to vertical housing in Mexico’s cities.

Homex said it could meet the demand for vertical housing, but its revenue fell precipitously in 2013.  The company was in shambles; the stock price had fallen from $69/share to $1/share in six years’ time.  Homex owed $2.5 billion in debt and had just $8 million of cash by 2014, so it declared bankruptcy.  The company’s fall from grace was sudden, with Homex having raised $400 million with a bond issuance just two years prior.

Homex blamed the change in government policy for its problems, and surely this played a significant role. But then just as Homex was emerging from bankruptcy in 2015, the SEC brought charges of fraud and things got really interesting…

Fake sales

According to the SEC, Homex had been lying to investors for years.  You might be thinking this is going to have something to do with the poor quality homes they had built, but people had been complaining about that as far back as 2004.  What came to light from the SEC’s investigation was something more sinister.

Homex had been recognizing revenue for homes it hadn’t even built.  That’s right; this is a case of bogus revenue.  Homex’s accounting policies stated that it didn’t recognize revenue until a home had been built and title had transferred to the buyer.  But the SEC said that Homex had recorded revenue for homes when it hadn’t even broken ground, or sold the homes.  And the SEC proved this using satellite images from Google Earth.

Photos of Homex’s best-selling housing developments showed empty patches of dirt.  For example, Homex reported that it had built and sold all of the planned homes for its Benevento development. But hundreds of these homes hadn’t been built, and Homex still recorded revenue anyway.  The SEC said Homex had overstated revenue by $3.3 billion from 2010 to 2012 alone and had faked the sale of more than 100,000 homes. 

The cover-up

You might be wondering how Homex got away with this for so long.  The executives completely made up sales over a period of several years.  Wouldn’t Homex’s receivables explode due to the fake sales?  Why didn’t Homex run out of cash, since its “sales” weren’t even real?  The Homex executives were aware of these issues, and they adopted countermeasures to avoid being caught.

First, they kept 2 sets of books. They literally had a spreadsheet with one part called “real sales” and another part called “accounting sales”.  No, I’m not making this up.  This allowed executives to track the company’s actual progress while reporting fake numbers.

Second, they recorded fake data for Cost of Goods Sold and inventory.  It might seem weird that they recorded fake expenses, but think about it: the auditor is going to get suspicious if you report sales revenue without reporting Cost of Goods Sold.  They had to pretend like it was an actual sale; they couldn’t just fake the revenue, they had to fake the corresponding expense.

Third, they had to do something about the growing receivables. They knew even an entry-level auditor would start asking questions if receivables grew a lot faster than sales.  Thus, they sold the fake receivables to banks.  This actually solved two problems: it prevented the receivables account from skyrocketing, and it generated cash.  This last part was critical, as you don’t get cash from fake home sales.  You can get cash from selling phony receivables, however, and that’s what Homex did.

How did the banks get fooled?

If you’re thinking, “Hey, won’t the banks realize what’s happening when they aren’t able to collect any of the receivables?”  Yes they absolutely would—except that Homex generated cash for them, by selling more fake homes and thus more fake receivables.  Thus, the “receivables” were more like short-term loans, which Homex paid by getting more short-term loans.  Homex did this with $7.7 billion in receivables using 13 Mexican banks, and the SEC called it a giant check-kiting scheme.

Thus, by faking the Cost of Goods Sold and selling phony receivables, Homex was able to stay afloat for a while. But it couldn’t keep the fraud going forever, and began defaulting on its debt payments.  This is what led to Homex filing for bankruptcy in April of 2014.

So why did this all happen?

You might be wondering, “why did this all happen?” and I’m wondering the same thing.  Here’s my theory.

Once Homex took money from outside investors and went public, there was tremendous pressure for the company to grow.  The company did grow, but at the expense of quality, which explains why the homes had so many defects.  Then when the Mexican government began steering loans toward a different type of housing, Homex wasn’t able to adjust, and its executives resorted to fraud.

They faked the sales so Homex could continue to raise money in bond issuances and sell fake receivables, which kept the company afloat (at least for a while) and delayed the firing of the executives.  In short, the company used the fraud to buy more time.  And the executives surely knew the walls were closing in on them toward the end, as the CEO Gerardo de Nicolás sold a lot of his Homex stock the year before Homex went bankrupt. 

Aftermath

Homex settled with the SEC in March of 2017.  It didn’t admit to doing anything wrong, but was banned from U.S. markets for 5 years.  Homex also had to pay a $1.2 million fine to the National Banking and Securities Commission in Mexico, which seems trivial given the losses of its investors.  Later that same year (October, 2017), the SEC charged Gerardo and 3 executives with fraud. Surprisingly, Homex managed to raise an additional $48 million from investors that same month.

It’s unlikely the executives will face any serious punishment. Gerardo is a Mexican citizen and isn’t likely to return to the United States.  Gerardo was fired, and his brother Eustaquio briefly become CEO.  A former executive at Banco Santander, José Alberto Baños López, took over Homex in 2017, but Eustaquio was still on the board as of 2019.

Homex reported that it was profitable in fiscal year 2019, and that its revenue had increased each of the past two years.  But I’m not sure I’d trust their financial statements. 

Takeaways

So how this happen?  What went wrong here?  In my opinion, 2 critical things allowed this fraud to take place.

First, there was an audit failure.  To be clear: the purpose of the external auditor is not to detect fraud.  However, the auditor is supposed to conduct tests to provide reasonable assurance that the financial statements are free from material misstatement.  For example, the auditor is supposed to test for the existence of inventory; in this case, the existence of the homes.  The auditor can’t verify that every single home was actually built and must rely on a sample, so there’s always a chance the auditor will be fooled by management.  But in this case there were so many fake homes, it’s shocking that the auditor didn’t discover this.

Second, people badly wanted to believe this would work; it was a great cause.  Who wouldn’t want to ensure that everyone in Mexico had access to affordable housing? Even the World Bank invested in Homex.  And the de Nicolás brothers were held up as successful entrepreneurs.  Everyone wanted to believe this was a success story, not a combination of dilapidated housing and fake sales

I hope that this fraud doesn’t make investors less likely to invest in Mexican firms.  I used to work in Mexico, and it’s a great place.  But the fact that Homex’s executives didn’t go to jail or face serious punishment sends a message that CEOs can get away with this type of behavior.

And that used to be the case in the U.S., prior to the Sarbanes-Oxley Act.  Several executives have since been sentenced to long prison terms in the U.S., and I’d like to think that’s had a deterrent effect with respect to accounting fraud.  But executives still play accounting games, in both the U.S. and in Mexico.  I guess death, taxes, and accounting scandals are inevitable.

References

Gorman, T. (2017, October 11). SEC files financial fraud action “caught on camera.” SEC Actions.
Guthrie, A. (2014, May 4). Mexican home builder Homex files for bankruptcy protection: Homex hopes to restructure, remain viable. The Wall Street Journal.
Guthrie, A., & Glazer, E. Mexican builder Homex reaches deal with creditors: bankruptcy filing in Mexico is imminent, creditors say. The Wall Street Journal.
Homex. (2019). Annual Report
Homex. (2020). Website
Marosi, R. (2017, November 26). The Homex story: A boom and a bust. Los Angeles Times.
Marosi, R. (2018, March 2). Mexico’s Homex faces accusations of a massive fraud from the SEC, but the case has stalled. Los Angeles Times.
U.S. Securities and Exchange Commission. (2016, May). Form 6-K
U.S. Securities and Exchange Commission. (2016, October). Form 6-K
U.S. Securities and Exchange Commission (2017). SEC charges Mexico-based homebuilder in $3.3 Billion accounting fraud.
U.S. Securities and Exchange Commission (2017). Securities and Exchange Commission vs. Desarrolladora Homex S.A.B. DE C.V.
U.S. Securities and Exchange Commission (2017). Litigation Release No. 23964
U.S. Securities and Exchange Commission (2017). Securities and Exchange Commission vs. Gerardo de Nicolás Gutiérrez, Carlos Javier Moctezuma Velasco, Ramón Lafarga Bátiz and Noe Corrales Reyes.
Whelan, R. (2017, March 3). Mexican home builder Homex settles SEC fraud charges: Homex overstated its revenue by roughly $3.3 billion, SEC says. The Wall Street Journal.

General info about Homex

“Homex’s equity securities were dually listed on the New York Stock Exchange (“NYSE”) and the Mexican Stock Exchange (“BMV”).”
“Homex exited from bankruptcy through a Court Judgment issued on July 3, 2015”