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SEC Responds to Congressional Inquiry About FAS 140

SEC Chairman Christopher Cox last week responded to Rep. Barney Frank's inquiry about whether FAS 140, the accounting standard that guides securitizations, is clear about the point at which a loan may be modified and if not, whether it could be modified in a way that would benefit borrowers and investors. Chairman Cox enclosed a memorandum from the Office of the Chief Accountant that fully describes the staff's position, but advised that loan modifications would not require entities to account for the securitized assets on their balance sheets. For many financial institutions, the chief accountant's memorandum notes that it is important to receive off-balance sheet treatment for securitized assets because of regulatory capital requirements.

Rep. Frank, the chairman of the House Committee on Financial Services, explained that his committee has been monitoring the rising foreclosure rate in the country and possible solutions to help borrowers keep their homes. In a recent letter, Rep. Frank advised that some members of Congress have been encouraging mortgage companies to modify loans and, if possible, to hold off on foreclosing on the loans. Rep. Frank noted that the recent subprime lending boom was driven by mortgage securitization and many troubled loans are held in trust for the benefit of investors. Loan modifications are generally permitted by the trust agreements if the modification will maximize the value to bondholders. However, a number of parties have raised concerns that FAS 140 does not clearly state the point at which a loan may be modified, whether it is when default is reasonably foreseeable or once a default or delinquency has already occurred.

Chairman Cox advised that the staff has been actively following the developments in this area and that FASB recently held an educational forum to discuss the accounting issues related to the potential actions that servicers may take in response to residential mortgage loan defaults. One approach that servicers may take is to modify the terms of mortgage loans held in trust when default is reasonably foreseeable, rather than when a default or a delinquency has already occurred. Mr. Cox said that such modifications could include a reduction of interest rates, an extension of the loan's maturity or other concessions. The central question addressed at the FASB educational forum was whether the ability to modify a loan when default is reasonably foreseeable would preclude off-balance sheet treatment under FAS 140.

The SEC chairman said the general agreement among participants at FASB's educational forum and the SEC staff is that the loan modifications would not result in a requirement for entities to account for the securities assets on their balance sheets. Modifications that are made when loan defaults are reasonably foreseeable should be consistent with the nature of modification activities that would have been permitted if a default had occurred, he added.

Chief Accountant Conrad Hewitt advised in his memorandum that the staff does not believe that additional interpretive guidance is needed to clarify the application of FAS 140 to the types of securitized mortgage loan work-out activities that have been described. The consensus view, including the staff's, is that entering into loan restructuring or modification activities when default is reasonable foreseeable does not preclude continued off-balance sheet treatment under FAS 140.