SEC Gives Help on Sub-prime Disclosures

The turmoil in the credit markets may be exposing weak accounting rules that let companies keep plunging security values off the balance sheet, but regulators and rulemakers are reminding folks to follow valuation and disclosure rules rather than let companies go too far.

The Securities and Exchange Commission recently sent a letter to public companies that it identified as having investments in structured investment vehicles, conduits, or collateralized debt obligations—all of which are off-balance-sheet entities that can contain substantially troubled securities. The letter details off-balance-sheet disclosure requirements that companies might want to scrutinize as they prepare management discussion and analysis for their next year-end filing.

For example, the letter from the SEC’s Division of Corporation Finance says companies may want to consider disclosing (to the extent applicable and material) categories and rating of assets held in the off-balance-sheet entity, weighted-average life of assets, forms of funding and weighted-average life of the funding, and material difficulties the entity has experienced, including any write-downs or downgrades of assets. The letter then calls for a raft of additional disclosures that would characterize the full scope of the off-balance-sheet entity’s financial condition.

The letter also reminds companies of their requirement to predict a bottom line. “Discuss any known trends or uncertainties that you may reasonably expect to have a material favorable or unfavorable impact on your income from operations, liquidity, and capital resources,” it says. “In this regard, please consider … disclosing the amount of any material loss you expect to realize as a result of your involvement with any material off-balance-sheet entity.”

The SEC letter comes on the heels of an initiative of the American Securitization Forum to map out a framework for how loan servicers can work out nearly two-thirds of the 1.8 million sub-prime, adjustable-rate mortgage borrowers who are facing interest rate increases in the next two years. The ASF says the framework is supported by Treasury Secretary Henry Paulson and by the Department of Housing and Urban Development and federal bank regulators.

Titled, “Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans,” the ASF framework was developed to include servicers, investors, and issuers. It advises servicers of troubled mortgages to work out loan modifications or refinancings where appropriate and recommends standards for those servicers to use when reporting loan modification activity to investors holding securities based on those troubled loans.

The ASF’s instructions to work out troubled loans push the provisions of existing accounting rules, because many of those mortgages are securitized—that is, wrapped into new securities and sold to investors via off-balance-sheet entities. Modifying the loans in those securities calls into question who controls the underlying debt and how much latitude loan servicers have to change terms.

Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, maps out the proper accounting for financial assets like mortgages that are bought and sold, but current transactions have become so complicated the lines defining when an asset actually transfers and a sale has happened have blurred.

The ASF’s goal is to minimize foreclosures and preserve homeownership as much as possible, but the guidance also tells loan servicers to take no action prohibited by the agreements that govern securitized loans. That includes provisions to ensure that any modifications are in the best interests of investors.

EXPOSURE DISCLOSURE

Below is an excerpt of the SEC's expectations for disclosure of risk to sub-prime mortgage securities.

In addressing the Item 303(a)(4) of Regulation S-K off-balance sheet arrangements disclosure requirement, you may want to consider disclosing the following items, to the extent they are applicable and material, for any non-consolidated conduit, [structured investment vehicle] or CDO for which you have material exposure:

Categories and rating of assets the off-balance sheet entity holds;

Weighted-average life of assets the off-balance sheet entity holds;

Forms of funding (commercial paper, medium-term notes, etc) and weighted-average life of the funding the off-balance sheet entity holds;

Any material difficulties the off-balance sheet entity has experienced in issuing its commercial paper or other financing during the period;

Any material write-downs or downgrades of assets the off-balance sheet entity holds;

Maximum limit of the losses to be borne by any first loss note holders;

Types of variable interests you hold in the off-balance sheet entity;

Detailed disclosure regarding your obligations under the liquidity facilities;

Whether you purchased commercial paper or other securities issued by any off- balance sheet entities that you manage, and whether any agreement required you to make these purchases. If not, consider discussing your reasons for the purchase;

Whether you provided or assisted the off-balance sheet entity in obtaining any other type of support, or whether it is your current intention to do so; and

Potential impact on debt covenants, capital ratios, credit ratings, or dividends, should you be required to consolidate the entity or incur significant losses associated with the entity.

Source

SEC (December 2007)

In a statement, ASF Deputy Director Tom Deutsch said his group wants to facilitate refinancings and prevent unnecessary foreclosures, but also hopes to “balance the interests of borrowers and investors and preserve the benefits of the securitization market. This includes protecting the contractual entitlements and economic interests of investors and other transaction participants.”

Crooch

The Financial Accounting Standards Board has a long-term project under way to revise FAS 140 and eliminate the concept of the qualifying special purpose entity. FASB Cochairman Michael Crooch told a conference of the American Institute of Certified Public Accountants last month that angst over FAS 140 has existed for nearly his entire seven-plus-year tenure on the board. He acknowledged that today’s rules allow off-balance-sheet treatment, but said the current turmoil stems more from lending policy than accounting rules.

“I would never tell Treasury they’re doing something wrong,” he said. “This isn’t in my view primarily a problem of accounting. It’s a problem of anticipating that those people would be able to pay their loans.”

SEC Deputy Chief Jim Kroeker said at the AICPA conference that a “productive process” was started over the summer to determine whether FAS 140 does not preclude off-balance-sheet loans from being modified, so long as no contractual obligations prohibit such workouts. SEC Chairman Christopher Cox published a letter saying it’s not unreasonable to work out loans that are reasonably expected to default.

Now, Kroeker says, questions are surfacing about how servicers will distinguish loans where default is reasonably foreseeable. Some may question whether some borrowers will simply get better interest rates under the veil of off-balance-sheet accounting treatment. “We don’t have an answer for that, and I’m not going to roll one out here,” he said. “But we’re certainly open to participating in the dialogue around this issue.”

Walter Ricciardi, SEC deputy director of enforcement, said his staff will carefully watch the accounting around troubled securities, looking for any evidence of abuses. But, he warned, today’s accounting mechanisms are more complicated than the savings-and-loan crisis of the 1980s. “All these loans have been sliced and diced and sold,” he said.

Ricciardi said the SEC’s enforcement division currently has about three dozen investigations stemming from problems in the sub-prime arena, but he couldn’t predict whether any enforcement actions will arise. Ricciardi said investors are paying close attention to topside management adjustments, where upper management overrules the findings or estimates of lower-level staff, as well as side agreements that modify the terms of transactions.

“We’ll be looking for indications that people had information to indicate what they were telling people was fraudulent,” he said. “We’re not in the business of trying to second-guess good faith judgments. We try to find situations where people committed fraud.”