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Staff Issues Guidance on Modified Subprime Adjustable Rate Mortgages

The SEC's Office of the Chief Accountant has issued interim guidance with respect to the application of Financial Accounting Standards Board Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to modifications of subprime adjustable rate mortgage loans. The chief accountant's office was asked by preparers, auditors, the American Securitization Forum and the U.S. Department of the Treasury whether the modification of certain loans would result in a change in the status of a transferee as a qualifying special purpose entity, or QSPE, under FAS 140.

The American Securitization Forum has issued a framework to provide a standardized approach to prevent foreclosures and losses in connection with securitized subprime adjustable rate mortgage loans. The ASF framework helps servicers evaluate the various foreclosure and loss prevention efforts for borrowers such as refinancings, workout plans and loan modifications.

The framework focuses on first-lien, adjustable rate residential mortgages that have an initial fixed interest rate period of 36 months or less, are included in securitized pools, were originated between January 1, 2005 and July 31, 2007, and have an initial interest rate reset date between January 1, 2008 and July 31, 2010. The loans are categorized into three segments, the second of which are eligible for a fast track loan modification. These loans are known as segment 2 loans. The modification permits the interest rate to remain at the initial rate, generally for five years following the upcoming reset.

According to ASF, this segment of borrowers can be presumed to be unable to pay under the original terms of their loans after the interest rate reset, so it is "reasonably foreseeable" that the loan will default unless it is modified. In a letter to Chief Accountant Conrad Hewitt, Undersecretary of the Treasury Robert Steel wrote that the framework is an important tool to prevent unavoidable foreclosures. There is no simple solution to address the housing excesses of the past few years, he said, but the Department of the Treasury is committed to avoiding preventable foreclosures where possible while ensuring the health of the mortgage market.

In a January 8, 2008, letter to Financial Executives International's committee on corporate reporting and the Center for Audit Quality, Chief Accountant Hewitt acknowledged that FAS 140 and the related guidance does not indicate whether it would be appropriate for a servicer to modify a securitized mortgage in a QSPE prior to an actual delinquency or default, or the disclosure that may be necessary.

Mr. Hewitt referred to a July 24, 2007, letter to the House Committee on Financial Services which addressed this accounting issue. The Office of the Chief Accountant advised that mortgage modifications that occur when default is reasonably foreseeable would not invalidate the status of a trust as a QSPE provided that the modification activities are consistent with those when a mortgage becomes delinquent or when a default has occurred.

When the ASF framework was issued, Hewitt noted that it raised a new accounting issue as to whether a default was reasonably foreseeable absent the modifications to the segment 2 subprime ARM loans. He advised that the Office of the Chief Accountant will not object to the continued status of a QSPE if the segment 2 subprime ARM loans are modified pursuant to the specific screening criteria outlined in the ASF framework. The Office of the Chief Accountant expects registrants to provide sufficient disclosure in their SEC filings about the impact the framework has had on their QSPEs that hold subprime ARM loans.

Chief Accountant Hewitt said the staff reached its view based on the lack of relevant, observable market data that can be used to perform an objective statistical analysis of the correlation between the screening criteria in segment 2 loans in the ASF framework and the probability of default. The historical default statistics for older subprime adjustable rate residential mortgages would not be representative of the default characteristics of the segment 2 loans because of the differences in underwriting characteristics, the housing market and credit conditions, according to the chief accountant.

The Office of the Chief Accountant believes that it would be reasonable to conclude that the segment 2 loans are reasonably foreseeable to default in the absence of modifications based upon a qualitative consideration of the expectation of defaults. Mr. Hewitt also noted that the vast majority of the modifications to these loans are expected to occur in early 2008, so the staff guidance is an appropriate interim step given the complexity of the issue and the lack of specific guidance.

Mr. Hewitt added that his office has asked the Financial Accounting Standards Board to immediately address these issues and to complete the project in time for the guidance to be effective no later than fiscal years beginning after December 31, 2008. In an attachment to the letter, the staff outlined the disclosure the staff expects registrants to include in their filings with the Commission, both in the MD&A and in the notes to the financial statements.