Accounting Observer > Public Blog - The Securitization Storm Continues

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The Securitization Storm Continues

Sep 24

Written by: Jack Ciesielski
9/24/2007 7:43 AM

There’s a good post by Edith Orenstein over at the FEI Financial Reporting Blog, covering the current events surrounding securitizations and the accounting for them. Like it or not (mostly not), there are politics aplenty ahead in the reporting for these financial Pandora’s boxes.

As reported in the Wall Street Journal ($), a 10-state task force of attorneys general and banking regulators has been formed. Their purpose: “to persuade mortgage-servicing companies and investors in mortgage-backed securities to increase the number of troubled subprime loans they restructure.” A position paper has been issued by the group, and it contains some real nuggets about the nature of securitizations and how they have contributed to the foreclosure wave. Like this one:

“Securitization has played a central role in lenders placing borrowers in unaffordable loans because it has separated the origination of a loan from its consequences. It is often repeated that no rational lender would put a borrower in a loan that the borrower cannot afford. That may well have been true in the past, when most loans were made by portfolio lenders, but is not true in today’s complicated and fractured system. While no investor would want to buy a loan that is destined to fail, many players in the current mortgage system were all too happy to originate loans without regard to the borrower’s ability to repay because when it comes time to foreclose on a loan, the originator often is long removed from the picture and does not take the loss. Thus, originators have engaged in predatory practices that a portfolio lender would never engage in, such as inflating an appraisal or inventing borrower income, because the originator can sell the loan to the secondary market...

In short, the secondary market dramatically changed the incentives for originators. Many subprime originators are no longer concerned with the terms of the loan or whether the borrower ultimately is able to afford the loan. Instead, the originators’ incentive is to close the loan as quickly as possible, no matter what, in order to be paid their origination fees, and then sell the loan to the secondary market.”

The group’s recommendation: restructure loans early and often. Pay the servicers a fee for modifications. Hire more staff with resources to actually make modifications. Forge alliances with third parties with whom borrowers are willing to work. (50% of defaulting borrowers never talk to the servicer.) The recommendations are pretty much basic common sense: do what it takes to avert problems, do it well and charge a fair price for doing it.

Nowhere did they say that the accounting shouldn’t reflect what happened - but that’s apparently not what others believe. It was noted in this space a couple weeks ago that Senator Charles Schumer was encouraging the Big Four that they should lighten up on the financial reporting of lenders who give it up for defaulting borrowers; on the letter, he also copied Cynthia Fornelli, head of the AICPA's Center for Audit Quality, just to be sure that the good news got spread even more widely. Schumer asserted that the SEC Chairman Christopher Cox "unequivocally" stated that the SEC's position on loan modifications in advance of defaults was benign and that lenders needn’t worry about losing off balance sheet status for securitizations. Frankly, the discussion by the SEC seemed more fact-and-circumstances than “unequivocal.”

If securitization issuers make modifications to loans, don’t put the obligations back on the balance sheets and don’t provide any other disclosures, it’ll make for some puzzling results later if they’re recognizing fees for reworking loans. In fact, if firms don’t discuss their activities involving renegotiations but account for them as if nothing happened, there’s going to be some very close parsing of every sentence uttered by managers of financial institutions.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

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