January 24, 2008
Gerald Baldwin

In December, the American Securitization Forum, whose members include representation from all aspects of the securitization industry, issued a document entitled Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime and Adjustable Rate Mortgage Loans.  The document’s purpose is to assist the holders of subprime adjustable rate mortgage loans in the evaluation of existing loans and designing appropriate solutions for those loans as their interest rates reset or as the loans approach default.  On December 6, President Bush endorsed the ASF Framework as part of the efforts of the administration to cope with the volatile housing market.  The Framework would encourage servicers of some subprime loans to modify the existing terms of the loans to accommodate borrowers and avoid foreclosure or other consequences which might result from anticipated resetting of interest rates and payment defaults.

This week, the Office of Chief Accountant of the Securities and Exchange Commission addressed one of the potential consequences which could arise from the application of the ASF Framework and the resulting modification of some loans.  Because the vast majority of the subprime loans which have been causing problems for the borrowers, the lenders and the economy in general are held by qualified special purpose entities (“QSPE”) (that is, off the balance sheet of the banks and institutions that package and securitize the loans), special accounting rules have traditionally applied.  For example, unless the QSPE holding the mortgage can certify that a default is not reasonably foreseeable, the financial condition of the QSPE and the loans which it holds may be required to be reported in the financial statements of the bank that assembled the mortgage pool.  Inclusion on the bank’s financial statements may create significant reporting and regulatory issues for the bank.

Recently, questions were raised as to whether the modification of subprime loans pursuant to the ASF guidelines would mandate a conclusion that a default in the loans was reasonably foreseeable and, therefore, the QSPEs holding the mortgages would lose their independent status for financial purposes.  That result is one of several that the banks had hoped to avoid in any program to deal with these loans  On January 9, the SEC’s accounting office appeared to support the modification plan, at least for the time being, stating that it believed that “it was an appropriate interim step . . . given the complexity and lack of specific guidance on the accounting and disclosure for these types of modifications.”  The statement went on to say that the SEC did expect subject companies to provide sufficient disclosures in their filings with the SEC regarding the impact that the Framework has on the entities holding the loans.  This appears to mean that it is acceptable to the SEC, for the present, if banks apply the Framework and do not treat the QSPE as integral to their financial statements, as long as there is adequate disclosure of the true impact loan modifications in the bank’s financial statements.  What that requires is yet to be determined.

Whatever treatment is required in the long term by the SEC may be better defined in the upcoming year.  The SEC has asked the Financial Accounting Standards Board to complete a study of the matter and provide guidance by the end of 2008.