What's Wrong with Subprime Accounting?

"Kill the Q," was the Financial Accounting Standards Board's response to a self-examination about how to prevent a future subprime mortgage crisis. During a two-day meeting held in London last week, FASB and the International Accounting Standards Board met to discuss, among other things, whether a failure to comply with accounting rules, or in the standards themselves, contributed to the mortgage meltdown.

One fix, emphasized by FASB chairman Robert Herz, is to eliminate qualified special purpose entities (QSPEs) — or "Qs" — from the accounting literature. Currently, FASB is working on an exposure draft to do just that, and is expected to release the proposal for public comment sometime in June. SPEs are the dummy securitization trusts set up to allow banks take assets off their balance sheets.

Further, Herz and IASB chairman David Tweedie said that both boards are considering what to do with a trio of accounting concepts tied to the mortgage crisis — consolidation of SPEs, derecognition of the vehicles, and measuring financial assets and liabilities at fair value. "If you manage to produce good consolidation standards, all the pressure will then be placed on derecognition, as people try to get [assets] out of subsidiaries and into special purpose vehicles, and simply pretend to sort them," added Tweedie, describing how fixing just one of the three problems would not solve the quandry.

SPEs became the subject of intense regulatory scrutiny after investigations revealed that Enron CFO Andy Fastow used the vehicles to hide massive losses before the company's demise in 2001. But preventing Fastow-style shell companies also threatened the existence of trusts supporting billions in securitization, potentially forcing banks to consolidate them on their own balance sheets. As a result, FASB issued stricter guidelines to make sure that the so-called QSPEs could not be used for nefarious purposes. To 'qualify' as an SPE that can stay off a bank's books, U.S. accounting rules require that the activities of QSPE's be strictly limited to passively receiving and disbursing securitized funds.

Fast forward to the beginning of the subprime crisis, when suddenly the requirement that QSPEs be "brain-dead" machines itself seemed nefarious. Because banks merely acted as servicers of the loans they had securitized, they resisted calls to work with borrowers or restructure loans for fear that doing so would violate the QSPE structure.

Politicians had no such qualms. Faced with the spectacle of massive home foreclosures in an election season, both parties in Congress and the Bush Administration pushed the Securities and Exchange Commission to sign off on a banking industry plan to allow banks to rework mortgage terms without having to bring the trust assets onto their balance sheets.

Despite pages of careful rationalization by the American Securitization Forum, many accounting observers say that the act of breaking into the structure and altering the cash flow arrangement should have negated the bank's passive status. That, in turn, should have cost many banks their off-balance sheet treatment, forcing them to increase the amount of regulatory capital they keep on hand.

If nothing else, the free pass from the SEC proved that the Q structure could not stand the market pressure of the current credit crisis. "I think [QSPEs] were tolerable until recently," opined Herz. Once subprime mortgages were put into QSPEs, they were, "and I'll use the pejorative term, ticking time bombs," said Herz. "And the bombs started to explode." He continued: "The real problem, in hindsight, was that the assets were not Q-able," stressed Herz, who said that the vehicles required "intensive restructuring" that went beyond what would have been allowable for a QSPE.

"They've been stretched, it didn't work," Herz said about the securitization vehicles. As a result, FASB is on a "rapid" schedule to amend FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to eliminate the concept of the QSPE by the end of the year. Herz said that FASB is under direction from the SEC and the President's working group on the credit crisis — which includes members of the SEC, the Treasury Department, the Federal Reserve Board, and others — to fast track the FAS 140 project, as well as amending FIN 46R, Consolidation of Variable Interest Entities to make off-balance sheet transactions more transparent.

In February, Senate Democrat Jack Reed, chairman of the Banking Subcommittee on Securities, Insurance, and Investments, sent a letter to Herz and IASB chairman David Tweedie, calling for the rule revision. At last week's meeting, Tweedie noted that the IASB also was under pressure to deal with the same set of issues FASB is considering. Tweedie cited a report released earlier this month by Global Stability Forum , a trade group comprising G7 Finance Ministers, central banks, and national regulators, that expressed concern about consolidation and derecognition of SPEs, as well as fair value measurement of financial assets. "We've accelerated all these issues, and they are a very high priority for us now," emphasized Tweedie.

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