What’s Wrong with Subprime Accounting?

FASB and IASB search for a fix to future credit crunches, and take aim at a familiar culprit.

“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.


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