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Sunday, August 05, 2007

SFAS 140: Like A Bridge Over Troubled Bong Water

by Tanta on 8/05/2007 10:25:00 AM

(Look. I have to keep up with my betters in the MMI basket of Big Paid Media Foolishness. Besides, you made me read the New York Post again. Don't do that.)

Horror item from that staid publication, NYP:

Defaults are ripping through the entire mortgage bond industry at the fastest pace in years.

Investors hold about $6.5 trillion in mortgage bonds, the world's largest such fixed-income market, says the Securities Industry Financial Markets Association.

Meanwhile, Securities and Exchange Commission chief Chris Cox said the SEC is coming up with new, more flexible accounting rule interpretations that companies and others could use to avoid declaring their mortgage securities in default.
Either the SEC is up to something I don't know about--sure, it could happen--or the Post writer has managed one of the more fearfully tendentious descriptions of an accounting rule interpretation in living memory. It would be easier to decide this had the Post writer supplied something like "detail." I am going to assume he means the recent clarification on SFAS 140 treatment of loan modifications. If he means something else, now would be a good time to act like a reporter instead of Emily Latella.

Of course it's not just the NYP writer whose knickers got thoroughly knotted over this. Jonathan Weil at Bloomberg became downright hysterical on the subject in "Subprime Mess Fueled by Crack Cocaine Accounting":
On May 30, the board said it will look hard at eliminating the concept of off-balance-sheet trusts -- called qualifying special purpose entities, or QSPEs -- from Statement 140 entirely. The likely effect: Lenders no longer could record sales on transfers of loans or other financial assets to securitization trusts in which they have continuing involvement.

Instead, the transactions would be treated as secured borrowings, and the assets would stay on the lender's balance sheet, though possibly in a way that would show the specific liabilities to which they're linked. . . .

While that wouldn't get rid of gain-on-sale, it would be much more difficult for lenders to record immediate profits, unless they sold their loans to independent third parties lock, stock and barrel. Such a change would affect any company that securitizes loans or accounts receivable, including credit-card companies and many manufacturers.

If it weren't for QSPEs, the securitization industry might look very different today. That's partly because mortgage lenders might not have lent so much money to people with poor credit, if the rules hadn't let them front-load their profits and show smaller balance sheets to investors.

Adding to the complexity, gain-on-sale calculations are based on lots of estimates and guesswork about future events, such as customer defaults, prepayments and interest rates. Things like these normally are impossible for mere mortals to predict consistently. Yet the absence of any right answers also makes it difficult for outsiders to challenge the numbers. Armed with that insight, practitioners of gain-on-sale accounting can create profits through sheer optimism. . . .

Time and again, gain-on-sale has proved its power to addict, from the crashes at FirstPlus Financial Group Inc. and Mercury Finance Co. back in 1998, to the 2007 wave of collapses led by New Century Financial Corp. Take one puff, and it feels euphoric. To keep getting the same high, however, you must take bigger and bigger hits. Before long, you may end up in Chapter 11 rehab.

Statement 140 had envisioned QSPEs as ``brain-dead'' entities akin to wind-up toys, meaning they aren't supposed to exercise judgment or discretion. Any actions they take -- such as responding to a customer's default -- are supposed to be automatic responses to circumstances clearly spelled out in the documents that created the trusts. If lenders remain involved in servicing a QSPE's mortgages, they're supposed to take limited roles, like collecting borrowers' payments or executing foreclosures if needed.

In practice, servicing has taken a much broader role, and FASB officials say the QSPE concept has proven unworkable. At a June 22 meeting with FASB members, the Mortgage Bankers Association presented a paper taking the position that Statement 140 permits QSPEs to grant ``concessions to debtors experiencing financial difficulty'' on the grounds that this, too, is part of servicing activities.
The issue here is the "Q Election," and this is a problem Lewis Ranieri raised the alarm about several months ago. When a mortgage securitization is structured as an off-balance sheet sale (for which gains on sale may be taken) rather than an on-balance sheet financing, SFAS 140 requires that the transaction (the sale of the pool of mortgage loans) to the qualifying trust entity or QSPE be a "true sale." One of the conditions of a true sale is that the seller not retain control over the assets being sold. The point of this is to avoid sham sale transactions (like the famous Enron Nigerian barges).

The trouble with mortgage loans is that they must be serviced, and securitized mortgage loans are frequently serviced by the originator, under the terms of a servicing agreement with the QSPE. SFAS 140 has always allowed "normal servicing activity" by the originator without endangering the true sale status of the transaction, as long as the servicing activity does not exceed the terms of the servicing agreement. If the servicing agreement says that the servicer can modify loans that are currently in default, then the servicer can do that without jeopardizing the Q-status of the securitization (that is, without forcing the whole deal back onto the originator's balance sheet and taking back the gain on sale that was originally booked when the transaction closed).

The trouble arose when servicers began modifying--or began recommending that they be allowed to modify--loans that are in a "reasonably foreseeable danger of default," but not yet defaulted. The problem is that the "in default" standard is pretty clear: a mortgagor has missed one or more payments, this can be established by reference to the remittance reports, and so modification can be justified as a work-out of a loan that is not performing. When you begin to contemplate modifications of loans that are actually still performing today, but that you believe will stop performing if you don't do something about them, you can cross into murky territory: are you "servicing" the pool or "managing" it?

Lew Ranieri, Tanta, and about eleventy-jillion other mortgage market participants would say that as long as you are verifying your facts, and proceeding in the same way you would if the loan were defaulted, you are "servicing" the pool. We say this because the lines have never been as clear and simple as those hysterics at the NYP or Bloomberg seem to think. Since approximately several months after the first mortgage loan was serviced by the first mortgage lender, someone has called up and said "I just got laid off today. I want to keep making my house payment, but I'm going to have some trouble for the next couple of months. Is there anything you can do to help me?" Since about ten minutes after that, servicers have contacted the borrower's employer to verify the layoff story, ordered a new credit report to make sure this isn't someone on a debt-binge, reviewed the past payment history and current value of the property, and said "OK, we can put you in forbearance for three months, then if you start making payments again we'll modfiy your loan to add the three past-due payments to the balance and bring you current again."

What's "new" these days is all those stupid 2/28 ARMs everybody made, counting on the borrowers to refinance or sell the property before the adjustment blew their capacity to repay out of the bong water. Now that we're hip-deep in actual defaults of these loans, we're realizing that we'll be ear-deep in them unless servicers take a proactive stance, and start calling up those borrowers who haven't reset yet but are about to. The point of that is to find out whether they understand that they're about to adjust, whether they know how bad it could be (many borrowers, unlike, say, Bloomberg columnists, don't really follow LIBOR every day), and to find out what they're going to do about it if they can't manage the new payment. Nobody I know of is just blindly offering modifications to these folks; quite honestly, a huge percentage of them can't get anywhere with a mod. They are being counseled to list the property now, while there's some chance they can sell with their credit records intact. But clearly, in some cases, a modification is going to be offered to a borrower who isn't in default yet.

When I first read Weil's frothing about "wind-up toys," I remember remarking to my computer monitor, "that's the most profoundly retarded thing I've read in weeks." With the passage of time my opinion has changed somewhat; I shouldn't be that unfair to the profoundly retarded, who as a class are not, as far as I know, agitating for skinning consumers just so that investors in mortgage-backed securities and financial sector stocks don't have to understand anything more complicated than "I got mine, screw you." So let me apologize to everyone on the short bus.

Do you really want to live in a world in which mortgage servicers--I'm talking mortgages, kids, the loan for the roof over the family's heads here, not your basic yacht financing--work on the "collect payments or foreclose, no judgement exercised" basis? You like doing business with outfits like that? You happy calling up the customer service line and getting some untrained bored squirrel on the other side who tells you nothing can be done if you're not late, but that nothing can be done if you are late? You like paying .25-.50 extra in interest every month so that your mortgage servicer can act like Major Major? You think it's not bad enough that we made 100% loans to people, giving them little incentive to repay the debt, we should make it worse by giving them no hope if they try to pay it? You think people who are asking for forbearance should be told just to walk away?

Oh, I suppose, if you're some perfect righteous Bloomberg columnist investor type, you'd never ever have such a problem and you don't give a rat's patootie about the unwashed masses who might need "judgement exercised" instead of Catch-22. You're free to feel that way, but as far as I'm concerned you're not free to pretend like this is some conspiracy on the part of some crackheads to mess with your NAV. There are huge, massive, deeply important public policy issues around home mortgage lending, which makes it a little bit of a problem to treat mortgages like any other "financial asset." We have entire neighborhoods and communities falling apart because of the Wall Streetization of mortgage finance, and now that someone's trying to deal with the mess, it's not a good time to suggest that we pile on the punishments just so you can figure out how to read a balance sheet.

What, exactly, did those Krazy Kommies at the SEC say?
Currently, the Commission's staff does not believe that additional interpretive guidance is necessary in order to clarify the application of FAS 140 to the contemplated types of securitized mortgage loan work-out activities. Rather, after considering the information gathered at the FASB educational forum and information we have received from other sources, there appears to be general agreement in practice regarding the application of FAS 140 to these fact patterns. Specifically, there appears to be a consensus in practice, and it is our view, that entering into loan restructuring or modification activities (consistent with the nature of activities permitted when a default has occurred) when default is reasonably foreseeable does not preclude continued off balance sheet treatment under FAS 140.
Translation: we asked the accountants who have actually had exposure to the mortgage industry before, and they said "What? We've always done that." This is "hiding default" or "crack-cocaine accounting" only to those folks who thought that investing in mortgages was just like buying pork bellies. Not.

The time to have gotten fired up about the real issues around off balance sheet securitization--the great "de-linking" of risk that was openly advertised as the benefit to the investor of all of this--was back when those 2/28s were being originated. We here at Calculated Risk were on it back then, and being dismissed as "bubbleheads." Absolutely nobody, as far as I know, is happy with any of the bad choices we now have since we've gone into cleanup mode. But this desperate attempt to keep the moral hazard in place, whether it's Cramer begging for a rate cut or bond investors demanding that FASB shoot the wounded, sink the lifeboats, and close the gates of mercy to protect the interests of the AAA crowd, is a little hard to take.

Sit down, boys and girls. There has always been an "information asymmetry" issue with mortgage-backeds. The originator has always known more than you know. The servicer has always known more than you know. The auditors have always known more about the balance sheet ingredients than you have. This problem did not arise a couple of months ago when the ABX tanked.

It has also always been the case that the party on the other side of that cash-flow is Joe and Jane Homeowner. Taxpayer, voter, citizen, parent, child, grannie and gramps, your neighbor. This is a group of folks it's a bit hard to demonize. We've been trying, with this "it's all subprime and all subprime borrowers are deadbeats" meme, but except for a few dead-ender holdouts, that dog is no longer barking. No one will be less surprised than I to find many politicians doing the wrong thing here, out of a misguided sense that something must be done, and seen to be done. Possibly someone will do something sane and useful.

But if you are surprised that this is now, fully and inescapably, a political issue, and it's homeowners against Wall Street, then you never realized that it's about mortgages. After Social Security, this is the closest thing to a Third Rail that there is. They call it the "American Dream" for a reason. If you thought this was just a socially-neutral "asset class" you could simply suck dry forever, a little wind-up toy that would never fight back, you're Part. Of. The. Problem. And I for one raise my mechanical pencil, as lama says, in salute to all the nerds at FASB who are ignoring you.