Sub-prime Accounting Rule Shows Its Strain

Policymakers are leaning hard on a razor-thin interpretation of an accounting rule to help contain the sub-prime mortgage collapse and prevent it from infecting the broader financial markets. Yet simultaneously, that same accounting rule may be headed for the shredder.

A pivotal point in policymakers’ plan for minimizing mortgage default is an interpretation of Financial Accounting Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Banking regulators issued a notice Sept. 4 advising financial institutions to study the provisions of FAS 140 and determine the extent to which they may allow banks to work out troubled mortgages before slipping into default.

Cox

The regulators’ notice follows a flurry of correspondence in the final weeks of summer involving Securities and Exchange Commission Chairman Christopher Cox, members of Congress, and Big-4 accounting firms, among others, dissecting provisions of FAS 140 that allow loans to be worked out to a greater extent than banks initially believed possible.

FAS 140 maps out the proper accounting for financial assets like mortgages that are bought and sold, but transactions have become sufficiently complicated to blur the lines defining when an asset actually transfers and a sale has taken place. John Rossi, associate accounting professor at Moravian College, says the focus of FAS 140 is to distinguish when a receivable such as a mortgage or a note is sold from when it is collateralized.

For a sale, a gain is recognized and the receivable no longer appears on the balance sheet. Collateralizing, or borrowing against the receivable, gives rise to an asset and liability on the balance sheet and related interest to record, he says.

“Sometimes it’s difficult to determine within the rules of accounting whether someone sold the receivable or collateralized it,” Rossi says. “It can be a difficult question to answer.”

Originators of mortgages and other types of debt often finance their lending activities by packaging and reselling the debts via securitization, or turning illiquid assets into tradable securities. Such securities often are sold via special-purpose entities, enabling originators to qualify for FAS 140's favorable sale treatment by moving the assets off the balance sheet.

Rossi says the rules look to two critical criteria—isolation and control—to help determine if an asset like a mortgage has in fact been sold. If a receivable is adequately isolated and control adequately transferred, it is regarded as sold, allowing the entity to avail itself of FAS 140's favorable accounting treatment.

Mortgage originators—watching subprime mortgages creep toward trouble—started asking if mortgages held in qualifying SPEs could be worked out with the borrowers, or if such workouts would threaten the favorable, off-balance-sheet accounting treatment. Those questions gave rise to a June 22 roundtable discussion hosted by the Financial Accounting Standards Board with regulators, bankers, auditors, and investors to hash out whether FAS 140 would allow troubled subprime mortgages, even those held in SPEs, to be worked out before defaulting.

COX LETTER

Below is an excerpt of a July 24, 2007, letter from SEC Chairman Christopher Cox to Barney Frank, chairman of the House Financial Services Committee, on FAS 140 adjustments.

As you indicate in your letter, many securitization trusts hold subprime residential mortgage loans that are troubled or may be nearing default. One approach the servicers of such trusts may take in response to anticipated residential mortgage loan defaults is to modify the terms of the mortgage loans in the trusts when default is “reasonably foreseeable,” rather than when a default or delinquency has already occurred. Examples of such modifications could include: reducing interest rates, extending loan maturity, or granting other concessions to debtors. In your letter, you noted that loan modifications are generally permitted by the trust agreements when used appropriately to maximize the value to bondholders, and asked for our views on the accounting consequences to the sponsoring companies of modifying mortgage loans held in certain securitization trusts.

At the request of the Commission’s staff, on June 22,2007, the Financial Accounting Standards Board (FASB) hosted an educational forum to discuss the relevant accounting issues associated with the potential activities that servicers may take in response to anticipated residential mortgage loan defaults. In addition to SEC and FASB staff, other individuals represented at the forum included investors, preparers, auditors, servicers, and banking regulators. A central question that was discussed was whether the ability to modify a loan when default is “reasonably foreseeable” would preclude off-balance sheet treatment under FAS 140.

As described more fully in the enclosed memo prepared by the SEC’s Office of the Chief Accountant, the Commission’s professional staff believes that, consistent with general agreement in practice, such loan modifications would result in a requirement for entities to account for those securitized assets on their balance sheets. In this case, modifications undertaken when loan default is reasonably foreseeable should be consistent with the nature of modification activities that would have been permitted if a default had occurred.

Source

SEC (July 24, 2007)

Chairman Cox followed with a July 24 letter to Barney Frank, chairman of the House Financial Services Committee. “The Commission’s professional staff believes that, consistent with general agreement in practice, such loan modifications would not result in a requirement for entities to account for those securitized assets on their balance sheets,” he wrote. “In this case, modifications undertaken when loan default is reasonably foreseeable should be consistent with the nature of modification activities that would have been permitted if a default had occurred.”

Herz

Aside from hosting the roundtable, FASB has remained quiet on FAS 140 interpretations related to the subprime mortgage crisis. FASB Chairman Robert Herz reportedly told FASB’s oversight body, the Financial Accounting Foundation, that it deliberately chose to stay out of FAS 140 questions, deferring to the SEC’s role as enforcer of existing accounting rules. FASB declined Compliance Week’s request to discuss recent events.

Out With the Old …

At the same time, however, FASB is proceeding with projects to revise FAS 140, authorizing its staff in May to begin research on the possibility of eliminating the qualified special-purpose entity concept. FASB has been plucking away at a FAS 140 project since 2003, issuing at least two exposure drafts amending the statement.

Following little public discussion in late 2006 and early 2007, FASB took it up again in May and turned an apparent corner. “The Board decided that removing the qualifying special-purpose entity concept from [FAS 140] is an approach worthy of further research,” read the minutes to the May 30 FASB meeting. That is the very concept that now allows banks and other mortgage originators to keep troubled mortgages, now securitized, off the balance sheet.

The Board instructed the staff to develop a “linked-presentation model” that would amend FAS 140 to remove the concept of a qualifying SPE for those transferring financial assets. A linked presentation would require the gross assets and liabilities in a secured borrowing to be displayed on the balance sheet with additional footnote disclosures. The objective of such an approach would be to reduce the complexity of FAS 140 by removing the qualifying SPE concept and to record the transfers of financial assets according to the economics of the transaction.

Meanwhile, the Board also took up a project in March to provide new guidance on repurchase finance agreements, issuing a proposed staff position in July that allows two parties to the same transaction to apply different accounting of the event if it meets certain criteria. The proposed staff position notes that questions about proper accounting for repurchase financings first arose with mortgage real estate investment trusts.

In a block of bold type not typically seen in FASB pronouncements, the proposed staff position says the event can be recorded differently by the two parties (the one transferring the assets and the one receiving the transfer) if the transactions “have a valid and distinct business or economic purpose for being entered into separately and the repurchase financing does not result in the initial transferors regaining control over the financial asset.” A transaction lacking a valid business or economic purpose would be one where it is executed solely to circumvent an accounting standard or achieve some desired accounting result.

While FASB churns away on its FAS 140 revisions—fleeing questions on current events—financial reporting experts say the current regulatory approach encouraging mortgage originators to alter the terms of existing mortgages held in securities is a sound interpretation of rules on the books today.

A KPMG spokesman says the firm had already issued guidance to its auditors echoing the views Cox expressed in his July 24 letter. Walter Viola, director of technical accounting for Jefferson Wells, says that even with politics and crisis aside, troubled mortgages can be worked out off the balance sheet as long as the governing documents allow it. “It is not inconsistent with the notion of continued off-balance-sheet treatment,” he says.

Turner

Lynn Turner, however, a former chief accountant at the SEC and well-respected in the reporting community, says the approach leads to “greater obfuscation and a lack of transparency.” In Turner’s view, the economics of the situation are not reflected when loans are worked out off the balance sheet of the servicers or originators holding the debt. “If borrowers can’t pay all the required payments, someone has incurred a loss, which is less than transparent in these SPEs.”

Rossi says the accounting rules aren’t trying to confuse readers of financial statements, but simply reflect the complexity of the transactions.

“People seem to be wondering how we got to where we are,” he says. “When most mortgages are written, there are two separate things: the service rights and the cash flow. The mortgage may be serviced by the issuer but the underlying receivable is sold, so it’s two separate products.”

It does present a problem for the audit process, he concedes. “Auditors never see it because it’s off the books,” he says. “They're not going to ask about something that isn’t there.”