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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Apr 21

Written by: Jack Ciesielski
4/21/2005 6:25 AM 

It's been a while since we tuned in the restatement channel, so let's pull away from the SEC settlement blitz for a bit. An interesting sort of non-reliance 8-K was filed yesterday by Doral Financial, a diversified financial services company. Nifty little company: it's the fourth largest commercial bank in Puerto Rico, and the largest mortgage banker there, too; it also has a presence in New York it's aiming to grow. At $15 billion in assets at year end 2004, it's not an insubstantial player. And being a mortgage banker, the firm employs loan securitizations to loosen up cash for further investment.

The reason for the non-reliance notice was due to the determination that the wrong interest rates had been used in estimating the fair value of the firm's floating rate interest-only securities. IOs, as they are known are extremely sensitive to changes in interest rate assumptions because, as their name implies, they aren't anything but interest. The firm decided that rather than using contractual rates or actual 90-day LIBOR rates at the end of each reporting period, it should be valuing the IOs with rates embedded in the forward yield curve. (Which makes sense: if you're trying to come up with a fair value for an IO, it would be logical to use the same interest rates the rest of the world would use - which is what's shown in the market's yield curve.)

Switching to the forward yield curve will make for an adjustment that will be reflected as a restatement of prior periods, not as a catch-up adjustment. And it might report a material weakness in internal controls as of year end 2004; the firm isn't sure yet.

Doral isn't the only firm to rethink its securitizations this year: it joins Countrywide Financial, Providian Financial and last but not least, Fannie Mae. Interest rates have been building this year, too; they might be forcing more critical reviews of securitization policies. Keep tuned.