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Do accounting rules allow a company to sell a loan and then change its terms? Faced with worsening foreclosures for subprime borrowers, the SEC says they do.
Alan Rappeport, CFO.com | US
July 27, 2007
In theory, once a lender securitizes a loan, it stays off the lender's books, and its terms may not be changed. But as the subprime mortgage market has tumbled, regulators and Congress have interpreted the accounting rule that governs securitizations to provide a certain degree of flexibility. The Securities and Exchange Commission said Wednesday that companies that made home loans and then securitized the proceeds can modify them if a default seems likely, without taking those assets back on their balance sheets.
The announcement came in a letter sent Tuesday by SEC chairman Christopher Cox to Rep. Barney Frank (D-Mass.), chairman of the House Committee on Financial Services, in response to his request in June for clarification of the accounting rule, known as FAS 140.
FAS 140 governs accounting for securitizations, in which a lender sells the future proceeds from a loan into a pool of similar assets held by a trust. Those trusts then issue bonds, backed by the loan payments. Although the lenders in question typically continue to service the loans — collecting them and handling other transactions with the borrowers — securitization accounting requires that the lender make a "true sale" to the trust, so that it, and not the lender, is the owner of the future loan proceeds. That typically limits the ability of the lenders to modify the loans unless they are already in default.
But exactly what those limits are has become a key public-policy question. Even as subprime borrowers seek ways to maintain good credit and avoid foreclosures, many mortgage lenders have been afraid to renegotiate the terms of the mortgages for fear that doing so would destroy the true sale treatment and bring the securitized loans back onto their own balance sheets. Because that made lenders reluctant to offer homeowners relief, members of Congress demanded clarity on what makes the likelihood of a default "reasonably foreseeable." Although FAS 140 does not explicitly say that a reasonably foreseeable default is the equivalent of a default, Congress — and, apparently, the SEC — believe that it is sufficient grounds for making modifications to securitized loans without violating FAS 140.
In his letter, Cox said that "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." Conrad Hewitt, the SEC's chief accountant, explained in an accompanying memorandum that the ability to restructure mortgages when default is foreseeable is "not inconsistent" with the notion of "continued off-balance sheet accounting treatment."
The clarification seemed to appease Frank, who lauded the SEC's response. "This is a constructive approach that will allow mortgage lenders to provide help at the earliest possible moments to people who might otherwise be trapped in bad loans or forced into foreclosure," he said.
Cox's response comes as the Financial Accounting Standards Board has been pushing ahead to make changes to FAS 140, potentially altering the treatment of qualified special-purpose entities (SPEs) to create specific criteria for determining when assets and liabilities that arise from transfers of assets should appear on the originator's balance sheet. Also on Wednesday, FASB issued a staff position paper and is seeking comments about the rules of accounting for repurchases and previously transferred assets.
As the rule stands, some argue that modifying the terms of a securitized loan could erode the notion that the transfer of debt to the SPE is an actual sale and make it appear more like a borrowing. Most institutions that service loans cannot alter them until a month after the borrower defaults. Critics of a more flexible standard have also expressed concern that allowing more liberal use of loan modification as a result of problems in the subprime mortgage market could have negative effects for other securitization markets.
The American Securitization Forum issued a report last month suggesting that loan modifications should be made on a loan-by-loan basis, and that allowances should be made for changing interest rates, forgiving principal payments and extending the maturity date to reduce the risk of losses. "You have an accounting standard which very clearly embraces, and within the SPE rules, acknowledges the existence of servicing rights," George Miller, executive director of the ASF, told CFO.com in June.
Although Congress sought clarification of FAS 140 through the SEC, FASB remains responsible for setting the accounting standards. Cox said his decision was informed by a forum held with FASB on June 22. Christine Klimek, a FASB spokesperson, declined to comment on whether Cox's ruling conformed with the board's understanding of its own accounting rule. "We set the rules, they enforce them," she said.
Jack Ciesielski, publisher of the Analyst's Accounting Observer, says leaving room for minor modification might be a good thing, and that the SEC was not necessarily contradicting FASB. "I think they just left the door open that some renegotiation might be minor and might not be construed as 'managing the assets,'" Ciesielski told CFO.com in an E-mail. "They didn't draw a clear line, and that's probably better."