Paulson's Plan Impact on Banks, Investors: FAS140

One more reason why fixing the mortgage mess is so complex has to do with an accounting rule that, ironically, was enhanced after the Enron scandal. Unless the SEC and the Financial Accounting Standards Board (FASB) give their blessings to a changing interpretation of this rule, plans like Paulson’s that require mortgage servicing companies (servicers) to assist borrowers may result in a credit crunch. Alternatively the changes may further shake investor confidence in the mortgage backed securities market.

As Noah mentioned some time ago (How Mortgaged Backed Securities Work), banks package loans into mortgaged backed securities and sell them off their balance sheets as a way to reduce the capital they must hold aside as required by regulators. FAS140 is the accounting rule that allows this sale to be recognized for financial reasons.

So how would this affect homeowners?

It could dry up the mortgage market in these 2 ways:

(1) Shaking investor confidence: Any change to the servicer’s role may compromise its fiduciary responsibilities to investors. Servicers may assist borrowers in default with special payment programs – but not borrowers AT RISK OF DEFAULT, those supported by the Paulson plan. The result is a breach of contract between investors and the trust and lawsuits to follow. Investor confidence would be undermined and liquidity in the mortgage market would dry up.

(2) Weakening a bank’s financial health: Because the change to the servicer’s role may compromise the loan’s status as a “true sale”, banks would then have to bring these loans back onto their balance sheets. The result would require banks to raise more capital and, if the loans were in default, write them off at a loss. HSBC and Rabobank have recently faced this, with an increase of $45 billion and $7.6 billion respectively. A worse case scenario: banks may hold off on making more loans, thereby generating a credit crunch.

This was not the intention of FAS140. The idea behind further defining a “true sale” was to prevent the mysterious transactions that got Enron into trouble. That said, requests to expand the “true sale” definition under FAS140 was proposed by trade groups and endorsed by others including Secretary Paulson and Congress. The SEC and the FASB must accept these changes – so far they have acknowledged but have not officially sanctioned the idea.

My view is that the SEC and FASB, understanding the gravity of the situation, will ratify the idea, assisting banks and ultimately homeowners.

The downside is that the action will further affect investor confidence because it would - like the Paulson plan - further change the rules of the game regarding fiduciary duties for investors of mortgage backed securities. This sets a precedent that can have major consequences for our capital markets. This may, however, be a short-lived reaction and the lesser of the two evils (save homes & banks vs. some investors? Hmm….). Something policymakers have to consider. Stay tuned.

SOURCE: Saving Banks: How The Mortgage Bailout Strains Accounting (CFO.com)

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