Can Accounting Principles Survive the Mortgage Crisis?

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

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 CFO.com 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.

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