Saving Banks: How the Mortgage Bailout Strains Accounting

Unveiling an industry-developed plan late last week to freeze the interest rates on thousands of mortgages, President Bush and Treasury Secretary Paulson emphasized the shared interest among homeowners, banks, and investors in avoiding mass foreclosures. "Lenders and investors would face enormous losses," the president said.

But while a rash of foreclosures would cost investors dearly, the plan allows the financial institutions that wrote it to declare large swaths of mortgages in danger of default, and to rewrite those loans without sign-off from homeowners or the investors who own the loans. That may help investors "in the aggregate," as the plan says, but it also may limit the ability of individual investors to sue, and represents a further blow to investor confidence in the practice of securitization.

Written by the American Securitization Forum, the plan represents a dramatic increase in leeway for banks since June, when ASF issued an earlier plan that also gave banks wider license to act. With tens of thousands of supbrime mortgages at risk this past spring, policymakers agreed with industry groups such as the ASF and the Mortgage Bankers Association that banks could step in to rework loans if their default was "reasonably foreseeable." That in itself was a big change. A securitized mortgage is technically owned by investors, with the banks that originally wrote the loan typically acting only as bill collectors. Historically — and under accounting rules — banks stepped in to rework loans only if they were actually in default, when it became the bill collector's responsibility to minimize investor loss.

Of course, few homeowners are likely to object to the friendlier terms unveiled Thursday, and banks are still theoretically acting to minimize investor losses. But individual investors who own asset-backed securities have no say in how they are altered, or how much of their money banks can spend to protect them. At the same time, banks continue to keep those loans off their own balance sheets via an increasingly flexible interpretation of existing accounting rules, a move which may have the added benefit of helping protect the banks themselves from investor lawsuits.

Accounting and Liability

In a securitization, a bank or other mortgage lender sells the future proceeds of a mortgage loan to a trust, or special purpose entity (SPE). The trust then pools them with other loans and issues bonds backed by the loan payments. Under accounting rule FAS 140, lenders must make a "true sale" to the trust, so that it, and not the lender, is the actual owner of the loan proceeds. That allows the lender that originally made the loan to remove it from its balance sheet.

After Enron, which frequently set up SPEs that it secretly controlled, the Financial Accounting Standards Board (FASB) issued stricter guidelines for such trusts. To keep an SPE off of a bank's books, and ensure that it isn't used for nefarious purposes, accounting rules require that its activities be strictly limited to passively receiving and disbursing securitized funds. Such trusts are known as "qualifying SPE" or QSPEs.

But that passive role — QSPEs are variously described as "brain-dead" or "on autopilot" — came under fire as the subprime crisis grew. Because banks merely acted as servicers of the loans, they resisted calls to work with borrowers or restructure loans for fear that doing so would violate the QSPE structure.

For the most part, that reluctance has been chalked up to banks' fears that they would have to consolidate the QSPE's assets and liabilities on their own balance sheets. That happened in November, when HSBC was forced to put $45 billion back on its balance sheet. On Thursday, Amsterdam-based Rabobank did the same, taking $7.6 billion onto its balance sheet. Although investors still eat most of the losses, such moves make banks' balance sheets look worse, and wreak havoc with the amounts of regulatory capital they are deemed to have on hand.

But critics say another important reason banks and policy makers are straining accounting rules to preserve the QSPE structure is that the legal and accounting structure of the "true sale" is designed to shield banks from investor lawsuits. Rating agencies require an attorney's letter stating that a securitization trust is "non-recourse" to the bank that sold the loans. If forced to consolidate the trusts back on their own balance sheets, banks would have a harder time denying liability for the QSPE and shielding their own assets from investors seeking to recover their losses.

"The primary reason that a Q is set up in the first place is protection against legal liability and it would seem to me to be the preeminent reason for trying to keep it intact," says attorney Mark Maddox.

With Federal Reserve president Ben Bernanke saying mortgage defaults could reach $300 billion, and some critics saying the amount could be three times that, the potential liability for banks that set up these securitization structures could vastly outnumber the tens of billions banks paid out after Enron. "That sort of liability exceeds anything I've seen Wall Street involved in in the last 20 years," says Maddox. Indeed, Treasury Secretary Paulson attempted to assuage the banks' litigation fears in his Thursday remarks unveiling the plan, noting that "with the investor community on board and as a clear beneficiary of this approach, the risk of litigation should be manageable."

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