Sub-prime Accounting Rules Turbulence

The nation’s chief accountant has given his temporary blessing to an accounting maneuver that lets banks keep workouts of troubled loans off the balance sheet, even as he urges new rules to address the issue in future reporting periods.

The mortgage industry, meanwhile, is asking those same standard setters for yet another accounting maneuver that probably would soften the hit to earnings that loan failures will cause.

The developments are just the latest in the protracted debate about how mortgages likely to lurch into default should be accounted for, since many of them have been bundled into collateralized debt obligations and other complicated derivative financial instruments. So far, after months of wrangling from Congress, the Securities and Exchange Commission, mortgage banks, and many others, nobody has had a clear answer.

Hewitt

Conrad Hewitt, the SEC’s chief accountant, recently penned an open letter to the financial reporting and audit communities saying his office won’t object to use of a framework offered by the American Securitization Forum for how loan servicers can work out nearly two-thirds of the 1.8 million sub-prime adjustable-rate mortgages facing interest rate hikes over the next two years. The framework advises servicers to work out loan modifications or refinancings where appropriate, and it recommends standards for those servicers to use when reporting loan modification activity to investors in securities based on those troubled loans.

The framework leans heavily on an interpretation of Financial Accounting Standard No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, that SEC Chairman Christopher Cox offered last summer. His interpretation says loans that have been securitized—that is, wrapped into new securities and sold to investors via off-balance-sheet trusts known as qualified special-purpose entities—can still be reworked if default is reasonably foreseeable.

Hewitt says he reviewed the ASF framework and saw no problem with continued off-balance-sheet treatment of troubled, near-default loans, so long as the specific screening criteria and disclosures described in the framework are met. He also acknowledges that historic market data typically used to judge the chance of default is irrelevant given current market conditions, so it would be reasonable to apply qualitative analysis instead of quantitative analysis as prescribed in the framework to determine which loans qualify for an off-balance-sheet workout.

“Because the vast majority of modifications … expected to occur beginning in early 2008, [Hewitt's office] believes this is an appropriate interim step at this time to address this issue, given the complexity and lack of specific guidance on the accounting and disclosure for these types of modifications,” his letter said. He emphasized that he had no view on whether specific loans legally can be worked out, since that is determined by the contract governing any particular trust holding troubled loans.

Hewitt also called on the Financial Accounting Standards Board to finish its work revising FAS 140 (it has been a work-in-progress at FASB for years) so that it can take effect for fiscal years beginning after 2008. FASB issued its exposure draft of a FAS 140 rewrite in 2005, and it discussed a FAS 140 implementation issue at its board meeting last week.

Sam Ranzilla, chairman of the professional practice committee for the Center for Audit Quality and a partner with KPMG, says CAQ is supportive of SEC’s view. “We’re supportive of SEC’s efforts to provide an interim solution for all servicers, so that people can go forward with some degree of certainty as to how this might affect their” qualified special-purpose entities, he says.

Ranzilla says the disclosures required in the ASF framework, Hewitt’s open letter, and various other guidance published on the issue will assure transparency for investors. “It’s important to note the SEC has asked FASB to address the broader issue of QSPEs on a holistic basis, and we definitely support that request,” he says.

Deutsch

Tom Deutsch, deputy executive director of the ASF, says the SEC guidance will give loan servicers confidence in implementing ASF’s fast-track loan modification approach. “With their conclusions, the SEC has provided extremely useful guidance to help servicers move forward with the implementation of the ASF Framework,” he said in a written statement.

The Newest Accounting Crisis

Just as the SEC puts to rest questions over FAS 140 implementation, however, the Mortgage Bankers Association is sounding a new alarm at FASB, asking for guidance that would allow a sidestep to existing rules regarding accounting for bad loans.

“It appears to me that MBA members want an exception from Statement 114 because, in large part, the application of Statement 114 will result in a more accurate reporting of the loan impairments.”

— Jeff Mahoney,

General Counsel,

Council of Institutional Investors

The MBA wrote to FASB in December and again in early January asking the Board to consider relief from the requirements of FAS 114, Accounting by Creditors for Impairment of a Loan, because banks don’t have the systems to cope with the huge, sudden onslaught of loans that need to be evaluated and modified.

The MBA says that under FAS 114, its members would have to use discounted cash flow analysis to evaluate loans. But in a letter to FASB, Jonathan Kempner, president of the MBA, warned that “the vast majority of MBA members do not have the systems capability to project the cash inflows to be received on enormous numbers of loans either initially or on an ongoing basis.” Kempner said mortgage banking companies typically hold relatively few loans in portfolio, but find themselves holding a much larger stash these days because the secondary market for mortgage-backed securities has virtually disappeared.

Instead, the MBA wants to evaluate troubled loans using FAS 5, Accounting for Contingencies. That standard requires loan loss allowances for credit losses that are probable and can be reasonably estimated as of the reporting date, Kempner wrote.

FASB spokesman Chris Klimak says the Board is treating the letter as a formal agenda request but has no timeline for action. Alison Utermohlen, the MBA’s senior director of government affairs, says FASB submitted a series of questions to the MBA, which it answered in a nine-page Jan. 8 letter to the Board.

The follow-up letter says MBA members believe that when FAS 114 was adopted in 1993, no one anticipated the current volume of loans that need to be evaluated for impairment currently and on an ongoing basis.

Jeff Mahoney, general counsel for the Council of Institutional Investors, says the MBA request seems to indicate that its members are scrambling for a way to avoid reporting big losses. “It appears to me that MBA members want an exception from Statement 114 because, in large part, the application of Statement 114 will result in a more accurate reporting of the loan impairments—a bigger loss and hence lower net income—than what would be reported if MBA members were permitted to use an older and inferior accounting standard,” he says.

Jay Hanson, national director of accounting for McGladrey & Pullen, says financial institutions dislike the losses that FAS 114 calculations are likely to produce. But the MBA is a powerful lobby, he adds, so it will be interesting to see how the issue plays out.

Hanson

“It’s interesting they’re saying this is hard because they don’t have the systems in place, when seemingly that’s what they’re in business to do,” Hanson says. “The real issue is they don’t like the accounting result. The secondary issue is it’s going to be hard because there are so many loans to be restructured.”

Glenn Tyranski, head of financial compliance for NYSE Regulation and a former Big 4 auditor, says applying FAS 5 to the current circumstances potentially would allow banks to record no loss on current loans if they determine the loss can’t be reasonably estimated. “If they apply FAS 5 to the current predicament, they might determine a reserve for an estimate probably isn’t accessible at the moment, and they wouldn’t record a loss,” he says.