Can Accounting Principles Survive the Mortgage Crisis?

With the subprime crisis weighing heavily on the economy, the chief accountant of the Securities and Exchange Commission this week blessed a banking-industry plan to modify thousands of troubled mortgages. That may bring relief to homeowners; it certainly relieved the banking industry, which cheered his move.

But it also raises questions about the SEC's apparent plans to eventually move the United States to international accounting standards, which are considered more "principles-based" than the rules-laden U.S. system. This week's guidance by SEC chief accountant Conrad Hewitt to address concerns over subprime mortgages seems to strain the accounting principle in question, while also presumably narrowing the options for accounting standards-setters who are considering some of the same questions. And it clearly demonstrates how industry itself often clamors for guidance and rules, particularly when its own interpretation of an accounting principle suddenly proves painful to follow.

In a letter Tuesday, Hewitt assured auditors, regulators, and the banking industry that his office "will not object" to continued off-balance-sheet treatment for securitized loans — even if the banks that supposedly sold all rights to the loans are now changing their terms. The letter also noted that certain questions about FAS 140, the accounting standard that controls securitization, have been on the Financial Accounting Standards Board's agenda since 2003. Hewitt said his letter is meant to provide "interim accounting and disclosure guidance" and urged FASB to speed up its process so that any changes to the accounting standard would be effective by the beginning of 2009.

FASB has since announced that it will hold a related meeting next week, but until then, the board had been largely silent while industry groups and regulators alike adopted increasingly flexible interpretations of FAS 140. "I'm not looking to make a ruling" on the industry's plan, FASB chairman Robert Herz told CFO.com in December. "Everyone wants principles-based standards. That means letting the system operate."

That, said Herz, means letting audit firms and the SEC decide whether banks can modify the terms of troubled mortgages that have been securitized. Yet the principle at the heart of securitization, known as a "true sale," is that the loans have been sold to investors. If banks then tinker with the terms of the loans, their action risks undermining both the legal and accounting claim that the banks no longer control them.

Indeed, that was how most banks interpreted the principle as the subprime-mortgage crisis worsened last spring. While banks typically continue to collect payments on securitized loans, most refused at the time to negotiate with homeowners for fear that doing so would force them to reclaim the loans.

As Hewitt's own letter explained, "the basic underlying principle . . . is that assets transferred to a securitization trust should be accounted for as a sale, and recorded off-balance-sheet, only when the transferor has given up control, including decision-making ability, over those assets." If the bank still effectively controls the loan, wrote Hewitt, then it can't use off-balance-sheet accounting.

But that accounting principle ran into a political buzz saw in June, when House Financial Services chairman Barney Frank (D-Mass.) asked SEC chairman Christopher Cox if FAS 140 could "be clarified in a way that will benefit both borrowers and investors." That prompted Cox and Hewitt to sign off in July on the idea that a "reasonably foreseeable" default gave banks the same authority as an actual default. (In an actual default, the bank, acting as bill collector, has authority to try to get maximum recovery.) Cox and Hewitt cited a June 22 roundtable hosted by FASB — at their request — as justification for that ruling.

As CFO.com reported at the time, the mortgage and banking industry responded to that opening with a plan, written by the American Securitization Forum (ASF), that gave banks far greater leeway than even the ASF itself had been willing to accede to earlier. Not only did the plan allow banks to declare all loans in a certain category to be at risk of default, but they could also change the terms simply by sending a letter of notification. Once borrowers made two payments under the new terms, they were deemed to have agreed to them, whether or not they had ever been in contact with the bank.

In his letter this week, Hewitt laid out the SEC's support for that plan, noting that FAS 140 is silent about whether or not banks can modify troubled loans "prior to actual delinquency or default." Moreover, he wrote, it is "impracticable to precisely quantify" the percentage of certain troubled loans that would actually end up in default. Therefore, he argued, it is reasonable for banks to conclude that all loans in that category will default if not modified.

ASF executive director George Miller told CFO.com last month that the organization was "seeking an additional level of comfort and clarification from the SEC and FASB," and it immediately applauded Hewitt's letter this week. In an announcement issued the same day, deputy executive director Tom Deutsch noted that banks needed confidence that adopting the ASF's plan "will not alter the accounting treatment of securitization trusts."

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