Proposals For The Mortgage Mess … Including Other Proposals That Should Be Ignored

September 2007

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Last week, proposals to address the sub-prime lending problems actually got more attention than the war on terrorism and the War in Iraq. President Bush tried to get ahead of the Democrats last Friday with his own proposal. However, as soon as congressional Democrats return from their summer break, the list of proposals of how to help borrowers who got in over their heads will certainly get longer. The debate over who is to pay for this will be (and should be) deafening.

Accounting rules for lender workouts are not acerbating the subprime problem

Some have suggested that the applicable accounting rules might be discouraging lenders from being flexible with borrowers. Although accounting rules can affect behavior when the rules do not reflect the underlying economic behavior, such is not the case here.

SFAS 140 (“Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”) is one of the accounting pronouncements involving subprime loan modifications. Specifically, SFAS 140 involves loan securitizations, such as those that have been commonly performed for subprime mortgages. In a loan securitization, loans are packaged and sold as bond groups, with each group having a different risk level in the loan pools. The original lender continues to service the loans, and is not able to modify the loans unless the loans are in default. A concern exists that, under SFAS 140, if the lender modifies a loan that is not in default, the original sale reporting will be undone, and the loans will need to be placed back on the lender’s financial statements.

Last month, the SEC clarified its view that this accounting treatment was not necessary. In written guidance, the SEC stated:

“Subject to certain constraints, the ability to restructure mortgages when default is reasonably foreseeable is an activity that is not inconsistent with the notion of continued off-balance sheet accounting treatment. …. Specifically, there appears to be a consensus in practice, and it is our view, that entering into loan restructuring or modification activities (consistent with the nature of activities permitted when a default has occurred) when default is reasonably foreseeable does not preclude continued off-balance sheet treatment under FAS 140.”

Leave the auditors out of this

In the midst of last week’s debate, Senator Schumer (the senior senator from New York) made a stupid proposal involving the accounting profession. Senator Schumer wrote an August 23 letter that asked the Big Four accounting firms become more actively involved in pushing loan workouts, as follows:

“to assist this country’s mortgage crisis [by] … encouraging [your clients] to do their part to keep our housing markets afloat by modifying subprime loans that are at risk of default”.

The auditors should be independent of the managements that they are auditing. This allows the auditors to ensure that the accounting is proper, and not influenced by conflicts of interest. Just a short while ago, laws were passed (Sarbanes-Oxley and similar state laws) which mandated that auditors stop providing advice to management and then auditing the results of their own advice. Those changes were appropriate and should not be altered by a meddling Senator Schumer.

Here is what will happen if the existing auditing rules are not followed. Suppose a lender is about to send default notices to borrowers who got over their heads by purchasing a home that they could not afford once the teaser rates expired. The auditors follow Senator Schumer’s advice and tell the lender that they really should be patriotic (at least in Senator Schumer’s eyes) by giving the borrowers a break. A discussion then ensues as to how this “break” is to be reported in the lender’s financial statements.

Later, the auditors and management are addressing the lender’s audited financial statements. No shockingly, management suggests that the loan loss reserves for those problem subprime loans should not be increased. After all, the Company did what you (the auditors) requested, so you cannot punish us for following your own advice. Instead, management proposes to address any increase in those annoying loan loss reserves after the borrowers have had a chance to get back on their feet (wink, wink).

Senator Schumer ends his letter to the Big Four accounting firms by saying:

“The auditing firms of this country have played a critical role in keeping our economy strong, and I am confident that you will continue to do so. To that end, I would like to know what steps you are taking to ensure that your clients are aware of this guidance.”

Actually, the auditors’ job is not to keep the economy strong. Instead, their job is to ensure that financial statements are presented fairly, so that the rest of us can make decisions that will keep the economy strong. Any competent auditor already knows this, but the Big Four firms are too polite to tell the Senator what he deserves.

Therefore, we will do it for them. Here is our draft:

Dear Senator Schumer:

We reject your August 23, 2007 proposal to violate U.S. and state laws that govern the conduct of financial statement audits. If you want to be part of the solution, go pass some laws that will fix the underlying problems (we give you some suggestions below). Meanwhile, please leave us alone.

Sincerely,
The independent auditors that protect fair financial reporting

Our proposals for lending reform

Most of the existing proposals do not address the underlying problem that (i) borrowers purchased homes that they could not afford once the teaser rates expired, and (ii) lenders made imprudent loans. Government should not bail anyone out of these mistakes. In short, lenders who took risks with these loans should face the consequences of having a bad loan. Similarly, a borrower should not be rewarded for (i) living beyond one’s means, and/or (ii) lying on a loan application.

Based on these fundamental principles, the following proposals should be rejected:

1. Senator Hilary Clinton’ proposed one-billion bailout fund to help borrowers avoid foreclosure

2. Senator Chris Dodd’s proposal to force government-backed lenders Freddie Mac and Fannie Mae to refinance loans regardless of underwriting requirements that would otherwise prevent such loans. (Senator Dodd is Chairman of the Banking Committee. Because his committee will address any legislation in these areas, his proposals will continue to get attention.)

Give-aways do not help the long-run health of markets. The following proposals address some of the poor practices that created the current mess, while providing modest relief to homeowners that already have a problem:

1. “Stated income” loans are an invitation to lie. Besides encouraging a borrower to live beyond his realistic means, no-income-verification loans also encourage the underground economy by allowing tax cheats to get loans on untaxed income. “Stated income” or no-income-verification loans should be banned. Not allowing a tax cheat to finance a home might encourage the fraudster to report his income and pay at least some of the taxes that are legitimately owed.

2. Prepayment penalties make it more difficult to refinance. More than 35 states now regulate prepayment penalties, and at least ten states ban them outright. Most teaser rates would disappear if the lenders had no means of recovering the initial low rates upon a refinance. Prepayment penalties should be unlawful on all consumer transactions. It would be great if legislatures or courts could lawfully make existing prepayment penalties unenforceable.

3. Those facing the loss of their homes should be allowed to stay in their home so long as they pay rent equal to the fair rental value of the home. The fair rental value should be determined by an independent appraisal. The families taking this option should have an opportunity to reclaim their ownership if they pay back payments (i.e., what the original lending contract says), less the fair rental value already paid under the workout arrangement. If the borrowers do not want to or cannot make such payments, then the lender gets the collateral and a rental stream that equals what the collateral could legitimately earn (i.e., a fair monthly rent).

4. President Bush’s proposals to increase lending limits of the government programs (to as large as $417,000 in some markets like California) should be passed. These lending limits are too low to facilitate refinancing by certain credit-worthy owners. However, Bush’s proposals to lower down payment requirements should be rejected.

5. Currently, a short sale or foreclosure generates taxable income. Tax relief for forgiveness-of-debt income already has bipartisan support, and will pass. This will provide affected borrowers with an opportunity to get back on their feet by not having a large income tax bill.

Fulcrum Inquiry is a licensed CPA firm. Our services include financial statement investigations, fraud audits, and royalty audits.