Last December, as they unveiled a plan to freeze the interest rates on thousands of subprime mortgages, President George Bush and Treasury Secretary Henry Paulson Jr. emphasized the shared interest among homeowners, banks, and investors. Thousands of people, the President said, were in danger of losing their homes, while "lenders and investors would face enormous losses."
But the plan puts banks in the driver's seat. It allows them to declare large swaths of mortgages in danger of default and to rewrite them — even though those mortgages are securitized and technically are owned by investors. What's more, the banks can now redo home loans without sign-off from homeowners or investors.
This marks a big departure from prior practice. Until recently, banks have operated as little more than bill collectors for securitized mortgages, stepping in to rework them only if they were in actual default. This largely passive role was mandated by FAS 140, the accounting rule that specifies the conditions for keeping securitized assets off balance sheets. That was a potentially serious stumbling block for the plan, which was drafted by the American Securitization Forum (ASF), a banking-industry trade group.
In January, however, the chief accountant of the Securities and Exchange Commission, Conrad Hewitt, blessed the plan by issuing a flexible interpretation of FAS 140 that allows banks to take a more active role, yet maintains the off-balance-sheet status quo. The looser accounting seems to be acceptable to industry and regulators alike — primarily because the alternatives are unthinkable.
Those alternatives, of course, include many more people losing their homes. For banks, the fear is that a strict accounting construction could force them to consolidate billions of dollars worth of securitized loans onto their balance sheets. That, in turn, could expose them to billions more in liabilities stemming from investor lawsuits.
One thing seems certain: the bending of accounting rules will further erode investor confidence in the practice of securitization.
In a securitization, a lender sells the future proceeds of a loan to a trust, or special-purpose entity (SPE). The trust pools them with other loan proceeds and issues bonds backed by the payments. Under FAS 140, the lender must make a "true sale" to the trust, so that the trust is the actual owner of the loan proceeds. That allows the lender that originally made the loan to remove it from its balance sheet.
After Enron, which frequently set up SPEs that it secretly controlled, FASB issued stricter guidelines for such trusts. Now, for an SPE to remain off the books, its activities must be limited strictly to passively receiving and disbursing securitized funds. Such trusts are known as qualifying SPEs, or QSPEs.
But that passive role — QSPEs are variously described as "brain-dead" or "on autopilot" — came under fire as the subprime crisis grew. Because banks merely acted as servicers of the loans, they initially resisted calls to work with borrowers or restructure loans, for fear that doing so would violate the QSPE structure.
For the most part, that reluctance has been chalked up to banks' fears that they would be forced to consolidate the QSPEs' assets and liabilities on their own balance sheets. Those fears were surely heightened in November by the decision of UK-based HSBC to put $45 billion worth of mortgage-backed assets on its books, a move several other banks have since followed. Although investors still eat most of the losses, such moves make banks' balance sheets look worse, and threaten to wreak havoc on the amounts of regulatory capital they are deemed to have on hand.
But critics say another important reason banks and policymakers are straining accounting rules to preserve the QSPE structure is that its basic purpose is to shield QSPEs from lawsuits against banks — and vice versa. If forced to consolidate the trusts back on their own balance sheets, banks would have a harder time denying liability for the QSPE and shielding their own assets from investors seeking to recover losses.
And those losses, ultimately, could be staggering. The potential liability for banks that set up these securitization structures could vastly outnumber the tens of billions of dollars banks paid out after Enron. Federal Reserve chairman Ben Bernanke has said that mortgage defaults could total $300 billion, while some critics say the final bill could be three times higher.
Mark Maddox, an Indiana attorney who represents about a dozen subprime-mortgage investors in lawsuits against Bear Stearns, Credit Suisse First Boston, and others, says the QSPE structure forms a significant barrier in several of his cases. "In order to get around it, you have to show a pretty close relationship between the trust and the bank," says Maddox. "It is something we have to overcome."
"Clarifying" FAS 140
Regardless of why banks fear compromising the QSPE treatment, their reluctance to help struggling homeowners in the spring of 2007 prompted Congress, regulators, policymakers, and the ASF to create increasingly elastic interpretations of the accounting rule. The effort started 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, along with chief accountant Hewitt, to sign off on the idea that a "reasonably foreseeable" default gave banks the same authority as an actual default. Both Cox and Hewitt cited a June 22 educational forum hosted by FASB — at their request — as justification for that ruling.
The SEC, of course, is the ultimate arbiter of U.S. generally accepted accounting principles. But it's far from clear that Cox and Hewitt's frequent references to the FASB educational forum mean the accounting board agrees with the new interpretation. Only two of the seven FASB members actually attended the forum. "The board has never formally endorsed it," said FASB chairman Robert Herz in December.
Still, any regulatory squeamishness that banks might have had has since been quelled by Hewitt's January announcement. In it, he said the SEC's Office of the Chief Accountant "will not object" if banks following the ASF plan continue to consider themselves in compliance with FAS 140.
Under the plan, lenders can apply loan modifications to large groups of borrowers without even speaking to them. Banks should "endeavor to discuss the modification with the borrower in a live call," advise the ASF guidelines, but it is sufficient for banks simply to send a letter outlining the new terms of the mortgage. Moreover, there's no requirement that borrowers respond or sign any documents agreeing to change the terms of their mortgages. According to the ASF, a bank can simply declare that the borrower has agreed to the modification once the borrower has made two payments under the new terms.
The ASF's increasingly flexible guidance, says executive director George Miller, reflects industry recognition "that there is a fairly formidable loss mitigation challenge that servicers are facing." Treasury Secretary Paulson made the same point in his December speech: "The standard loan-by-loan evaluation process that is current industry practice would not be able to handle the volume of work that will be required."
Still, that comes as small comfort to investors that have already suffered losses, or that must stand idly by while the banks that sold them securities decide how best to salvage them. In his speech, Paulson noted that the new standards "are the product of discussions among investors and servicers." Attorney Maddox scoffs at that idea, theorizing that the investors that are said to have signed off on the new plan are likely the same Wall Street banks that set up the securitization structures. "They sampled their own product pretty heavily," he says. "I've never been asked to sit down with those guys, nor do I expect an invitation."
Tim Reason is editorial director of CFO.com.