naked capitalism

Things seem to come full circle. 30% to 70% of the subprime loans issued in 2006 that later defaulted involved borrower fraud, according to the FBI, although people would say in many cases it might more accurately be called lender fraud (”oh, just sign the application, we’ll fill it out for you”). The FBI is now also investigating fraud at 14 companies over their actions at later stages in the securitization process. The attorneys general of Connecticut and New York are investigating whether adequate disclosures were made of loans included in pools that didn’t meet the lenders’ minimum standards.

But it seems that duplicity, um, creativity of various sorts is not only being encouraged but actually endorsed. First we had the Federal Home Loan Banks making massive loans to subprime lenders, particularly Countrywide. Now we have the SEC permitting subprime lenders to engage in what can only be described as misleading accounting.

If a mortgage servicer modifies a loan in a mortgage trust, an off balance sheet entity, in ways not comtemplated by the trust’s charter, the trust dissolves and the loans go back to the lender. But even though loan mods are often the best of the bad choices available when dealing with underwater borrowers, if the servicer does mods in a way that violates the trust charter, that means the poor overstrapped subprime lender has to take more assets onto its already not-so-hot balance sheet.

Enter the SEC with a magic wand. You can have your off balance sheet treatment, meddle with it like it really isn’t off balance sheet, but still keep your preferred accounting treatment.

I hate to sound difficult, but this society is supposed to operate under the rule of law. But it is becoming apparent on every level that it doesn’t, that this is increasingly a nation of might makes right and expediency. And the results that this new system is delivering are hardly encouraging, yet the prime actors are giving us more rather than less of the same.

Update 1/31, 6:00 PM. Alert readers have pointed out that the well respected housing mavens Paul Jackson and Tanta take issue with the Weil article.

I must note the following. Loan commitments entered into after March 31, 2004 were required to be reported under the previous accounting treatment, SAB 105. Thus, we had over three years of use of this standard until the Mortgage Bankers Association sent a letter to the SEC objecting to the treatment in July 2007 and the amended standard, SAB 109, was implemented November 5, 2007.

That means that reporting entities means three years of audited reports (2004, 2005, and 2006) before an industry lobbying group found this practice objectionable. If it was problemmatic, one would have expected it to have been flagged much earlier.

Similarly, this issue was not opened up for comment. The SEC may have assumed that it was sufficiently technical that no one really cared, but cynics will observe that the timing suggests that this change was required for the New Hope Alliance program (launched December 2007) to be viable, and thus the change would be made regardless.

Now Paul Jackson implies that Wall Street stuffed up on the design of the trust charters, and that certainly appears to be true. And not changing the rules seems to be an impediment to loan mods, which we all agree is a good thing.

But they are missing the bigger point. If you or I set up an irrevocable trust and then went to meddle with it, it would lose its preferred status. Now you can say these are different trusts used for different purposes, but the point is that the financial services industry is getting redos when mere individuals don’t.

As others have said at much greater length than I have, the fact that individuals are more willing to walk from bad debts, even abandon mortgages when their house has negative equity even when they have the ability to pay says that people increasingly think rules don’t count, rules are for chumps. Although it has been years in the making, this change in values is a fundamental shift, and one that is dangerous to our society, because it says the respect for honoring one’s commitments is waning.

So even though the SEC’s action is a minor illustration, it is the sort of measure that ordinary citizens use to rationalize that rules can be bent and ignored. At a minimum, as Weil pointed out, it would behoove the SEC to be more forthcoming about the reasons for and implications of its move.

From Bloomberg’s Jonathan Weil (hat tip reader tom):

Just when it seemed as if the mortgage mess had hit a new low, now comes this: The Securities and Exchange Commission’s staff has granted the subprime-lending industry a huge exemption from the normal rules for off-balance- sheet accounting.

In effect, the move will let home lenders keep their balance sheets looking much smaller and less leveraged, even while the off-the-books loans they made get a makeover.

For months, banking regulators and politicians have been pressing lenders to freeze the interest rates on many adjustable-rate subprime mortgages that are scheduled to reset soon at higher interest rates. The idea is to minimize defaults and foreclosures.

While that’s a noble objective, all good deeds must be accounted for, and that’s been a sticking point for many banks. Through September, just 3.5 percent of subprime mortgages that reset in the first eight months of 2007 had been modified, according to Moody’s Investors Service. Even lenders inclined to help don’t want to hurt their financial results. And now they might not have to, thanks to a Jan. 8 letter from the SEC’s chief accountant, Conrad Hewitt.

Here’s the background: Many lenders recorded upfront profits by selling loans in bulk to off-balance-sheet trusts — known as qualified special purpose entities, or QSPEs — which then repackaged the loan pools into mortgage-backed securities. The trusts are supposed to be beyond the lenders’ control. And if the companies servicing the loans tinker with them in ways that aren’t spelled out in the trusts’ charters, the sales must be reversed, and the trusts must come onto the lenders’ books, under the Financial Accounting Standards Board’s rules.

Financial Constraints

That would mean much more assets and debt, possibly limiting banks’ ability to make new loans. Not surprisingly, some of the biggest mortgage lenders, including Washington Mutual Inc., Countrywide Financial Corp. and Wells Fargo & Co., had been pushing regulators for a break.

By following new guidelines issued last month by a banking- industry group called the American Securitization Forum, Hewitt said servicers will be allowed to modify subprime mortgages where defaults are “reasonably foreseeable,” without jeopardizing the trusts’ off-balance-sheet treatment.

Hewitt’s letter came in response to requests by the ASF, as well as the Treasury Department and others. On Dec. 6, the ASF published a “streamlined” framework for evaluating subprime mortgages issued from January 2005 to July 2007, where the initial rates are scheduled to reset before August 2010.

Loans that meet certain criteria — based on things such as low credit scores, the number of days delinquent, and high loan- to-value ratios — are eligible for “fast-track” modifications, on the basis that it’s foreseeable they’ll default, the ASF said.

Losing Status

The wholesale approach includes lots of room for discretion. For instance, if a borrower’s credit score is too high, mortgage servicers can use an “alternate analysis” and consider a “tailored modification for a borrower.”

Hewitt said such modifications wouldn’t cause the QSPEs to lose their off-the-books status, though he did call for more disclosures by lenders about QSPEs’ activities.

Hewitt said he realized there’s no way to know how accurate the ASF criteria might be at predicting actual defaults, because there “is a lack of relevant, observable market data that can be used to perform an objective statistical analysis of the correlation.” Still, he said the group’s criteria looked reasonable, “based upon a qualitative consideration of the expectation of defaults.”

Hewitt declined to be interviewed, as did FASB officials.

Little Discretion

The accounting standard at issue is FASB Statement No. 140. Its rules had envisioned QSPEs as brain-dead vehicles, akin to wind-up toys. Their actions are supposed to be automatic responses that “were entirely specified in the legal documents that established” the trusts. When servicers do exercise discretion, it must be “significantly limited.”

“I do not believe mortgage modification in such a wholesale and proactive fashion can be reasonably viewed as significantly limited,” says Stephen Ryan, an accounting professor at New York University, who specializes in financial instruments and institutions.

According to the ASF, many QSPEs’ legal documents say loan modifications are permitted where default is “reasonably foreseeable.” However, the ASF framework wasn’t published until last month. So there’s no way the activities it describes could be fully specified in the charters at any of the affected QSPEs.

While it may be a good thing under current circumstances to give servicers incentives to modify lots of subprime mortgages, Ryan says, “I think the chief accountant should have indicated he was providing an exemption to, rather than interpreting a vague area in, FAS 140.”

Changed Rules

The ASF’s executive director, George Miller, says that “the framework itself cannot be specified in trust documents that existed before the framework was issued.” However, he says “it does not need to be” and that Hewitt’s letter is “not an exemption, just an interpretation” of whether applying the group’s criteria would comply with Statement 140.

This might be a slippery slope. Perhaps the auto industry could be saved, for example, if only we devise new accounting “interpretations” of the rules governing their massive pension liabilities.

Hewitt couldn’t call his Jan. 8 letter an outright exemption, of course. Unlike the SEC itself, he doesn’t have the authority to overturn the FASB’s rules. Practically speaking, however, that’s what he did.

The SEC and the FASB at least should acknowledge this subterfuge for what it is. Don’t count on it, though.