Saving Banks: How the Mortgage Bailout Strains Accounting

Efforts to contain damage from the subprime mortgage meltdown are stretching accounting safeguards put in place after Enron.

Unveiling an industry-developed plan late last week to freeze the interest rates on thousands of mortgages, President Bush and Treasury Secretary Paulson emphasized the shared interest among homeowners, banks, and investors in avoiding mass foreclosures. “Lenders and investors would face enormous losses,” the president said.

But while a rash of foreclosures would cost investors dearly, the plan allows the financial institutions that wrote it to declare large swaths of mortgages in danger of default, and to rewrite those loans without sign-off from homeowners or the investors who own the loans. That may help investors “in the aggregate,” as the plan says, but it also may limit the ability of individual investors to sue, and represents a further blow to investor confidence in the practice of securitization.

Written by the American Securitization Forum, the plan represents a dramatic increase in leeway for banks since June, when ASF issued an earlier plan that also gave banks wider license to act. With tens of thousands of supbrime mortgages at risk this past spring, policymakers agreed with industry groups such as the ASF and the Mortgage Bankers Association that banks could step in to rework loans if their default was “reasonably foreseeable.” That in itself was a big change. A securitized mortgage is technically owned by investors, with the banks that originally wrote the loan typically acting only as bill collectors. Historically — and under accounting rules — banks stepped in to rework loans only if they were actually in default, when it became the bill collector’s responsibility to minimize investor loss.

Of course, few homeowners are likely to object to the friendlier terms unveiled Thursday, and banks are still theoretically acting to minimize investor losses. But individual investors who own asset-backed securities have no say in how they are altered, or how much of their money banks can spend to protect them. At the same time, banks continue to keep those loans off their own balance sheets via an increasingly flexible interpretation of existing accounting rules, a move which may have the added benefit of helping protect the banks themselves from investor lawsuits.

Accounting and Liability

In a securitization, a bank or other mortgage lender sells the future proceeds of a mortgage loan to a trust, or special purpose entity (SPE). The trust then pools them with other loans and issues bonds backed by the loan payments. Under accounting rule FAS 140, lenders must make a “true sale” to the trust, so that it, and not the lender, 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, the Financial Accounting Standards Board (FASB) issued stricter guidelines for such trusts. To keep an SPE off of a bank’s books, and ensure that it isn’t used for nefarious purposes, accounting rules require that its activities be strictly limited to passively receiving and disbursing securitized funds. Such trusts are known as “qualifying SPE” or QSPEs.

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