SEC Won’t Object to Treatment of Certain Mortgage Modifications; Disclosures Required

January 8, 2008

FEI Summary

On Jan. 8, 2008, the U.S. Securities and Exchange Commission’s (SEC) Chief Accountant, Conrad Hewitt, sent a letter to Sam Ranzilla, chairman of the American Institute of Certified Public Accountants' (AICPA) Professional Practice Committee, and Arnold C. Hanish, chairman of Financial Executives International’s (FEI) Committee on Corporate Reporting (CCR), providing the views of the staff of the SEC’s Office of the Chief Accountant (OCA) on accounting for modifications of subprime Adjustable Rate Mortgage (ARM) loans under Segment 2 of the "Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans" (the "ASF Framework").

By addressing the letter to the AICPA and FEI committees, the SEC is trying to get the word out to auditors and financial statement preparers regarding its position.

As detailed further below, U.S. Treasury Secretary Henry M. Paulson has supported use of the ASF Framework, to help stem the tide of mortgage defaults and foreclosures which have accelerated in the subprime mortgage market, due to steep interest rate resets and other factors.

SEC Will Not Object to QSPE Status When Certain Modifications Occur; Disclosures Required

The SEC’s January 8 letter notes OCA “has concluded that it will not object to continued status as a QSPE if Segment 2 subprime ARM loans are modified pursuant to the specific screening criteria in the ASF Framework," concludes Hewitt in his letter to the AICPA and FEI.

"Additionally,” states the SEC letter, “given the unique nature of the contemplated modifications and other loss mitigation activities that are recommended in the ASF Framework, OCA expects registrants to provide sufficient disclosures in filings with the Commission regarding the impact that the ASF Framework has had on QSPEs that hold subprime ARM loans."

Appendix A to the SEC’s January 8 letter lists certain disclosures for which both the SEC’s Office of Chief Accountant and Division of Corporation Finance “believe that registrants that have transferred subprime ARM loans to QSPEs should consider” providing in SEC filings, including in the Management’s  Discussion and Analysis (MD&A) section, and in the Notes to the Financial Statements.   

Lack of Relevant, Observable Market Data Influenced SEC’s Conclusion

The SEC letter noted among the reasons for its conclusion were that “OCA was recently informed by preparers, auditors, ASF, the U.S. Department of the Treasury and others that there currently is a lack of relevant, observable market data that can be used to perform an objective statistical analysis of the correlation between the specific screening criteria in Segment 2 of the ASF Framework and the probability of default.”

“Therefore,” said Hewitt, “it would be impracticable to precisely quantify the percentage of Segment 2 subprime ARM loans that would experience a default in absence of a modification.”

Additionally, the letter noted, “OCA understands that a quantitative analysis of default probability using that historical data would be expected to significantly underestimate the percentage of Segment 2 subprime ARM loans that would default in absence of a modification.”

“Although there is insufficient observable market data to form a conclusion based solely on quantitative information,” the letter continued, “OCA believes that it would be reasonable to conclude that Segment 2 subprime  ARM loans are 'reasonably foreseeable' of default in absence of a modification based upon a qualitative consideration of the expectation of defaults (made in the context of how defaults would be expected to differ from historical defaults of older subprime adjustable-rate residential mortgages).”

Letter Provides 'Interim Guidance;' SEC Asks FASB To Complete FAS 140 Project in 2008

Questions have arisen, states the SEC letter, on “whether modifications of Segment 2 subprime ARM loans that occur pursuant to the ASF Framework would result in a change in the status of a transferee as a Qualified Special Purpose Entity [QSPE]” under FASB Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (FAS 140).

FAS 140 requires transferors of mortgages to give up control over the assets transferred to obtain sale treatment, and requires servicers of assets held by QSPEs to have a passive role with respect to the assets, which some have viewed as precluding their ability to modify mortgages under the ASF framework.

The SEC letter notes, "because the vast majority of modifications of Segment 2 subprime ARM loans are expected to occur beginning in early 2008, OCA believes this is an appropriate interim step at this time to address this issue given the complexity and lack of specific guidance on the accounting and disclosure for these types of modifications."

Thus, the purpose of the SEC’s guidance, says the letter, is to “provide interim accounting and disclosure guidance" until FASB finishes its current project addressing certain issues in FASB Statement of Financial Accounting Standards No. 140, “

Among the issues to be addressed in FASB’s project, says the SEC, are issues pertaining to servicer discretion. FAS 140 requires transferors of mortgages to relinquish control over the assets transferred in order to get sale treatment, and requires that servicers of mortgages held by Qualified Special Purpose Entities (QSPEs) play a passive role with respect to those assets.

The SEC reiterates at the end of its letter that it is providing interim guidance on one issue only, and that it has asked FASB to complete its project to amend FAS 140 in 2008.

“Concurrent with the issuance of this letter, OCA has requested the FASB to immediately address the issues that have arisen in the application of the QSPE guidance in Statement 140.”

The letter adds, “OCA has requested that the FASB complete its project addressing the guidance in … [FAS 140] to be effective no later than years beginning after December 31, 2008”

Paulson Supports ASF Framework

In remarks on Dec. 6, 2007, the day the ASF Framework was released, U.S. Treasury Secretary Henry M. Paulson said, "The American Securitization Forum represents mortgage investors and mortgage servicers, and they have announced today a set of guidelines to streamline the process of refinancing and modifying subprime loans for able homeowners. We hope that these guidelines will be adopted as reasonable and customary standard practice across the entire servicing industry."

In followup remarks about the housing market at a meeting of the New York Society of Securities Analysts on Jan. 7, 2008, Paulson said, "Servicers are also moving to quickly implement the framework for streamlined refinancings and modifications announced by the [ASF]."

However, he noted, “This is not simple; there are legal, accounting and operational considerations.” Paulson added, “Servicers are collaborating to share best practices so all borrowers and investors may benefit from the ASF framework, regardless of who their servicer happens to be."

Among those cc’d on the SEC letter to the AICPA and FEI were Treasury Secretary Paulson, Public Company Accounting Oversight Board (PCAOB) Chairman Mark W. Olson, Financial Accounting Standards Board (FASB) Chairman Robert H. Herz, American Securitization Forum Executive Director George P. Miller and Mortgage Bankers Association President and CEO Jonathan L. Kempner.

Prepared Jan. 8, 2008 by Edith Orenstein, Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion unless specifically noted above.

© Financial Executives International, 2007