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.

But if they have to manage the loans and effectively take back control, they would have to repurchase the loans and recognize an asset on their balance sheet.

That worked perfectly when interest rates were low and housing prices were skyrocketing. But faced with the subprime meltdown, banks have looked to help borrowers more aggressively.

But does it border on management activity?

Under the SEC's new interpretation, banks could collect a fee from borrowers for modifying their loans, do slightly more management of the mortgage through the modifications, avoid recognizing any extra assets or obligations on their balance sheets and possibly escape telling investors anything is different.

Cox said in his letter to Frank that the SEC would not issue formal guidance on the clarification, and said banks must verify the financial situation of the borrower. But the letter did not say whether banks should disclose to investors how they are changing the way they modify their loans.

"No matter how much the lenders restructure these things, the only thing you could probably do that would change things is if you forgive them," Ciesielski said. "The servicers should do what they have to do to keep things moving, but don't keep shareholders in the dark. If you negated a sale, put the assets on the balance sheet."

An SEC spokesman said the regulatory agency was "not in a position to comment" on whether companies should disclose that they have changed the way they modify their mortgage loans.

Some worry that the change is setting investors up for a shock later.

"Back in the 1980s when the savings & loans got into trouble, Congress and the regulators took steps to trivialize the problem rather than deal with it head on," said Lynn Turner, former chief accountant at the SEC. "That is what we are beginning to see again. And I fear once again it could be costly to investors or taxpayers."

And the Financial Accounting Standards Board, which sets U.S. accounting rules, has effectively had its hands tied by the SEC, unless it wants to completely revisit the standard.

"We set the rules, the SEC enforces them," FASB spokeswoman Christine Klimek said.

((Reporting by Emily Chasan; editing by Mark Porter; Reuters Messaging: rm://emily.chasan.reuters.com@reuters.net;Tel: +1 646 223 6114)) Keywords: COLUMN LIFTING/

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