Thursday, January 31, 2008

Subprime Lenders Get Big Accounting Break at SEC: Jonathan Weil

Jan. 30 (Bloomberg) -- Just when it seemed as if the mortgage mess had hit a new low, now comes this: The Securities and Exchange Commission's staff has granted the subprime-lending industry a huge exemption from the normal rules for off-balance- sheet accounting.

In effect, the move will let home lenders keep their balance sheets looking much smaller and less leveraged, even while the off-the-books loans they made get a makeover.

For months, banking regulators and politicians have been pressing lenders to freeze the interest rates on many adjustable-rate subprime mortgages that are scheduled to reset soon at higher interest rates. The idea is to minimize defaults and foreclosures.

While that's a noble objective, all good deeds must be accounted for, and that's been a sticking point for many banks. Through September, just 3.5 percent of subprime mortgages that reset in the first eight months of 2007 had been modified, according to Moody's Investors Service. Even lenders inclined to help don't want to hurt their financial results. And now they might not have to, thanks to a Jan. 8 letter from the SEC's chief accountant, Conrad Hewitt.

Here's the background: Many lenders recorded upfront profits by selling loans in bulk to off-balance-sheet trusts -- known as qualified special purpose entities, or QSPEs -- which then repackaged the loan pools into mortgage-backed securities. The trusts are supposed to be beyond the lenders' control. And if the companies servicing the loans tinker with them in ways that aren't spelled out in the trusts' charters, the sales must be reversed, and the trusts must come onto the lenders' books, under the Financial Accounting Standards Board's rules.

Financial Constraints
That would mean much more assets and debt, possibly limiting banks' ability to make new loans. Not surprisingly, some of the biggest mortgage lenders, including Washington Mutual Inc., Countrywide Financial Corp. and Wells Fargo & Co., had been pushing regulators for a break.

By following new guidelines issued last month by a banking- industry group called the American Securitization Forum, Hewitt said servicers will be allowed to modify subprime mortgages where defaults are ``reasonably foreseeable,'' without jeopardizing the trusts' off-balance-sheet treatment.

Hewitt's letter came in response to requests by the ASF, as well as the Treasury Department and others. On Dec. 6, the ASF published a ``streamlined'' framework for evaluating subprime mortgages issued from January 2005 to July 2007, where the initial rates are scheduled to reset before August 2010.

Loans that meet certain criteria -- based on things such as low credit scores, the number of days delinquent, and high loan- to-value ratios -- are eligible for ``fast-track'' modifications, on the basis that it's foreseeable they'll default, the ASF said.

Losing Status
The wholesale approach includes lots of room for discretion. For instance, if a borrower's credit score is too high, mortgage servicers can use an ``alternate analysis'' and consider a ``tailored modification for a borrower.''

Hewitt said such modifications wouldn't cause the QSPEs to lose their off-the-books status, though he did call for more disclosures by lenders about QSPEs' activities.

Hewitt said he realized there's no way to know how accurate the ASF criteria might be at predicting actual defaults, because there ``is a lack of relevant, observable market data that can be used to perform an objective statistical analysis of the correlation.'' Still, he said the group's criteria looked reasonable, ``based upon a qualitative consideration of the expectation of defaults.''

Hewitt declined to be interviewed, as did FASB officials.
Little Discretion
The accounting standard at issue is FASB Statement No. 140. Its rules had envisioned QSPEs as brain-dead vehicles, akin to wind-up toys. Their actions are supposed to be automatic responses that ``were entirely specified in the legal documents that established'' the trusts. When servicers do exercise discretion, it must be ``significantly limited.''

``I do not believe mortgage modification in such a wholesale and proactive fashion can be reasonably viewed as significantly limited,'' says Stephen Ryan, an accounting professor at New York University, who specializes in financial instruments and institutions.

According to the ASF, many QSPEs' legal documents say loan modifications are permitted where default is ``reasonably foreseeable.'' However, the ASF framework wasn't published until last month. So there's no way the activities it describes could be fully specified in the charters at any of the affected QSPEs.

While it may be a good thing under current circumstances to give servicers incentives to modify lots of subprime mortgages, Ryan says, ``I think the chief accountant should have indicated he was providing an exemption to, rather than interpreting a vague area in, FAS 140.''

Changed Rules
The ASF's executive director, George Miller, says that ``the framework itself cannot be specified in trust documents that existed before the framework was issued.'' However, he says ``it does not need to be'' and that Hewitt's letter is ``not an exemption, just an interpretation'' of whether applying the group's criteria would comply with Statement 140.

This might be a slippery slope. Perhaps the auto industry could be saved, for example, if only we devise new accounting ``interpretations'' of the rules governing their massive pension liabilities.

Hewitt couldn't call his Jan. 8 letter an outright exemption, of course. Unlike the SEC itself, he doesn't have the authority to overturn the FASB's rules. Practically speaking, however, that's what he did.

The SEC and the FASB at least should acknowledge this subterfuge for what it is. Don't count on it, though.

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