Lifting the Lid: Subprime accounting sparks transparency concern

By Emily Chasan

NEW YORK, Aug 10 (Reuters) - If the mess in the subprime housing sector gets worse next quarter, chances are investors will not find out from the balance sheets of mortgage lenders and banks that service loans.

Thanks to a new accounting interpretation from the U.S. Securities and Exchange Commission, banks will be allowed to modify mortgage loans they otherwise might not have -- effectively slapping a bandage over the subprime loan market.

While the SEC's "clarification" of the principle that governs accounting for mortgage-backed securities could help banks and troubled homeowners dig out of the subprime mortgage meltdown, some worry it is a setback for investor transparency.

"If it doesn't go on the balance sheet you won't know what

(the company's) responsibility is for those things," said Jack Ciesielski, publisher of The Analyst's Accounting Observer. "You really don't have good visibility into how much risk there is."

Subprime loans, made to borrowers with poor or untraditional credit histories, have wreaked havoc in the mortgage market for months as higher interest rates led to rising defaults and delinquencies among borrowers.

But until last month, banks have felt they were restricted from helping troubled borrowers modify their mortgage terms by a complex web of accounting and legal rules that govern mortgage loans that are pooled into mortgage-backed securities.

Banks and lenders had worried they would have to wait at least a month after a borrower defaulted on a loan to modify mortgage terms without violating accounting rules that allow them to keep mortgage-backed securities off their balance sheets.

But last month, SEC Chairman Christopher Cox sent a letter to U.S. House Financial Services Committee Chairman Barney Frank saying mortgage servicers may modify individual mortgage loans when a default is "reasonably foreseeable" without violating accounting rules.

"This was a good sign for the industry as it moved forward, to try to provide relief to borrowers in financial distress," said Steve O'Connor, senior vice president for public policy at the Mortgage Bankers Association. "We think it gives the industry the assurance that it has the latitude it needs on the accounting front."

CONTROLLED OR SOLD

But for investors, the accounting principle at issue is still whether the banks have sold their loans or retain control of them.

Traditionally, banks claim they sold a loan into a security and retain servicing rights to that loan so they can collect monthly payments, foreclose on a loan or manage the mortgage in other ways.

Under that system, the banks get to recognize a gain on the sale from the loan -- and because they say they have sold it and no longer control it, they can leave it off their balance sheets.