Can Accounting Principles Survive the Mortgage Crisis?

Looser accounting gets SEC staff approval this week, while mortgage bankers petition FASB for more breaks.
Tim ReasonJanuary 11, 2008

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 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 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 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.”

The SEC, of course, is empowered to provide guidance on U.S. generally accepted accounting principles; indeed, is the agency that endows FASB with the authority to set GAAP.

But FASB’s role has been a curious one. Hewitt’s letter cites the views of “the participants at a June 22, 2007 Financial Accounting Standards Board educational forum.” Yet that forum was hosted by FASB at the SEC’s request and, according to FASB chairman Herz, was attended by only “two or three” of the seven FASB board members.

Herz told at the time the plan was unveiled that FASB will “look at [the plan] if someone asks us.” That now appears to have happened. Indeed, the SEC has essentially ordered FASB to conclude its various FAS 140 projects by the end of the year. By then, however, most of the mortgages in question will already have been modified. The question then will be how FASB, which has already gone through a mighty struggle to address Enron-style abuses of special-purpose entities without threatening securitization, will reconcile accounting standards with this latest reinterpretation.

Indeed, this is not the first time political considerations have affected accounting policy — nor is it the first time that FASB’s efforts to define securitization accounting have run afoul of the banking lobby. Indeed, the board’s stricter interpretation of FAS 140, known as FIN 46, ran into opposition from banks in 2002 precisely because it threatened to put securitized assets back on their balance sheets. As Herz told CFO magazine shortly afterward, the SEC supported the immediate rollout of that rule, but the Federal Reserve demanded a delay, which allowed banks time to restructure.

FAS 140 also is not the only standard now under fire because of the mortgage crisis. On the same day Hewitt issued his letter, the Mortgage Bankers Association wrote to FASB seeking accounting flexibility in the face of the crisis. In a letter to Herz, Alison B. Utermohlen, the MBA’s senior director of government affairs, asked that banks be allowed to use FAS 5, known as Accounting for Contingencies, rather than FAS 114, Accounting by Creditors for Impairment of a Loan, when accounting for defaulting mortgages.

“Unfortunately no one at that time [that FAS 114 was drafted], the MBA included, could have foreseen a day in which thousands of loans that are in default (or in reasonably foreseeable default) might be modified within the same reporting periods,” wrote Utermohlen.”

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