Congress Seeks Clarity on FAS 140

Concerned about subprime mortgage defaults, lawmakers take a sudden strong interest in the details of securitization accounting.
Alan RappeportJune 21, 2007

Members of Congress sent a letter to Christopher Cox, chairman of the Securities and Exchange Commission, last week asking for clarification of an accounting rule that has hindered subprime mortgage borrowers from modifying the terms of their loans.

The rule in question is FAS 140, which governs accounting for securitizations (debt that is chopped up and sold to new investors as bonds). The letter, signed by 11 Democrats including Rep. Barney Frank, chairman of the House of Representatives Committee on Financial Services, asked, “Does FAS 140 clearly address whether a loan held in a trust can be modified when default is reasonably foreseeable or only once a delinquency or default has already occurred? If not, can it be clarified in a way that will benefit both borrowers and investors?”

The question comes as subprime borrowers seek ways of maintaining good credit and remaining in their homes despite the rising rate of mortgage foreclosures. Members of Congress seek clarity on what makes the likelihood of a default “reasonably foreseeable” so that institutions could make modifications to loans without violating FAS 140.

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“Their motivations are understandable,” says George Miller, executive director of the American Securitization Forum (ASF). “They, like industry participants, are interested in taking proactive steps to prevent foreclosures.”

The ASF issued a report earlier this 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.

The letter comes as the Financial Accounting Standards Board (FASB) 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 be linked on a balance sheet.

As the rule stands, 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.

At a House Committee on Financial Services hearing on subprime mortgage lending last month, Warren Kornfeld, managing director for the residential mortgage-backed securities at Moody’s said that restrictions limiting servicers’ ability to modify distressed loans are not beneficial to holders of bonds. “We believe loan modification can typically have positive credit implications for securities backed by subprime mortgage loans,” he said.

Some 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.

At the same hearing, Larry Litton, CEO of Litton Loan Servicing, said that a “modify everybody” approach could harm investors who purchased mortgage-backed securities, as most borrowers are able to make their payments. “We believe that modifications have to be made one loan at a time as each borrower, his loan and his financial circumstances are different,” Litton said. “Now, one problem we have is that more work needs to be done on accounting rules which prevent servicers from being more proactive in terms of reaching out to borrowers.”

The ASF agrees, arguing that the accounting rules are intended to give servicers the ability to minimize losses and maximize recoveries. “You have an accounting standard which very clearly embraces, and within the SPE rules, acknowledges the existence of servicing rights,” says Miller.

Although Congress sent its letter to Cox, the FASB remains responsible for setting the accounting standards. The letter asked to know if a clarification would be possible from the SEC, saying that if it was not they would evaluate “other options.” Rep. Carolyn Maloney, chair of the House Financial Services subcommittee on financial institutions, has said that Congress will be “putting pressure and bringing pressure to bear” to get a FASB ruling clarifying the issue.