Wednesday, February 6, 2008

The Treasury and the Banks

"Just when it seemed as if the mortgage mess had hit a new low, now comes this: the [SEC's] staff has granted the subprime-lending industry a huge exemption from the normal rules for off--balance-sheet accounting. ... For months, banking regulators and politicians have been pressing lenders to freeze the interest rates on many adjustable-rate subprime mortgages that are scheduled to reset soon at higher rates. The idea is to minimize defaults and foreclosures. ... The trusts are supposed to be beyond the lenders' control. And if the companies servicing the loans tinker with them in ways that aren't spelled out in the trusts' charters, the sales must be reversed, and the trusts must come onto the lenders' books, under the [FASB's] rules. ... Not surprisingly, some of the biggest mortgage lenders, including Washington Mutual Inc., Countrywide Financial Corp. and Wells Fargo & Co., had been pushing regulators for a break. ... [Conrad] Hewitt's [CH] letter came in response to requests by the ASF, as well as the Treasury Department and others. On Dec. 6, the ASF published a 'streamlined' framework for evaluating subprime mortgages issued from January 2005 to July 2007, where the initial rates are scheduled to reset before August 2010. ... The wholesale approach includes lots of room for discretion. ... Hewitt declined to be interviewed, as did FASB officials. ... [SFAS] No. 140 ... envisioned QSPEs as brain-dead vehicles, akin to wind-up toys. ... Hewitt couldn't call his Jan. 8 letter an outright exemption, of course. Unlike the SEC itself, he doesn't have the authority to overturn the FASB's rules. Practically speaking, however, that's what he did", Jonathan Weil (JW), at, 30 January 2008.

Reader PH brought JW's article to my attention. Thanks. "If a mortgage servicer modifies a loan in a mortgage trust, an off balance sheet entity, in ways not contemplated by the trust's charter, the trust dissolves and the loans go back to the lender. ... I hate to sound difficult, but this society is supposed to operate under the rule of law. But it is becoming apparent on every level that it doesn't, that this is increasingly a nation of might makes right and expediency", Yves Smith (YS) at, 31 January 2008.

"The reality is that [pools of mortgage loans] cannot, they are not [wind-up toys], and anyone who pretended otherwise was an idiot (I'm looking at you, Wall Street). ... There is and has always been the recognition that mortgage loans, unlike, say, Treasury notes, need to be 'serviced'. ... All I know is that a bunch of geniuses on Wall Street, did, actually fall for the idea that residential home mortgages were 'wind-up toys,' just 'asset classes' instead of messy complicated things that involve real people ... on the other side of the cash flow, who don't always behave the way your models said they would. ... Demanding that issuers take it all back on their balance sheets as punishment for trying to mitigate losses is beyond perverse", Tanta at, 31 January 2008.

"When you are shoveling money, keeping track of the paperwork is an awful burden. ... And now the banks are begging the accounting rule makers to allow them to ignore a rule that has been on the books for almost 15 years. They explain that they never had any idea that they would have to restructure a lot of home mortgages, and thus had not reason to develop systems to deal with the accounting for such restructurings. ... Some may doubt that the issue is a systems problem at the banks, given that the accounting the banks prefer would allow them to report smaller losses as they restructure the loans--and thus make their financial statements look better. ... The accounting rule in question [SFAS] No. 114, was adopted in 1993. Lynn E. Turner, a former chief accountant of the [SEC], recalls it was enacted becuase of abuses by financial institutions during the savings and loan debacle. ... But the banks argue [doing the calculations] would take too much effort, given the volume of loans likely to be restructured. It was banking regulators who originally asked for F.A.S. 114 to be adopted, but some now might prefer to minimize reported losses at a time when the banking system is under great pressure. No one will admit that the goal is to fudge financial statements, of course. ... What a choice for the banks to face: report big losses or claim that they are not sophisiticated enough to comply with an accounting rule that has been on the books for more than a decade", Floyd Norris (FN) at, 11 January 2008.

There is so much here, I barely know where to begin. I previously posted on related topics on: 16 October, 20 and 27 November, 9 and 11 December 2007. YS's point about dissolving trusts, is a legal, not an accounting issue. If the trust charter requires it dissolve and the "loans go back to the lender", then the banks need record the assets and liabilities. His comment, "might makes right and expediency" echoes my sentiments precisely. So? "Rule of law"? The Mogambu Guru would say, "Hahahaha". I add my own, "Hahahaha".

Tanta, I agree, "Demanding that issuers take it all back on the balance sheets as punishment for trying to mitigate losses is beyond perverse". So? Consider: T. Rowe Price (TRP), Fidelity and Vanguard manage mutual funds for fees. No fund management company records fund assets on its balance sheet. Does this thinking apply here? Suppose TRP New Era fund sells Newmont Mining and buys Chevron, does TRP make an entry? No. What's different here, if anything? My conclusion: the banks never effected "true sales" in the first place! Tanta, I disagree, no "bunch of geniuses on Wall Street did, actually, fall for the idea that residential home mortgages were just 'wind-up' toys". You think they were stupid; I refer you to Ben Stein's 27 January 2008 article, you confuse what they said to get their desired accounting treatment with what I conclude they believed. "Pretended"? Oh, was the accounting always wrong? I say, ready the indictments; Mike Garcia, get to work. If necessary, farm out writing the indictments to "former" public servant Mary Jo White. I bet she remembers how. Have bank officials tell us they: ignored certain provisions of SFAS 140, lied and now each will fall on his sword in the interest of good accounting for their now, former employers. Sure. "Punishment" Tanta? Are your geniuses six-year olds who were sent on 30-minute "time outs"?

The banks SFAS 114 problem looks like another canard. If a bank had this problem, did it report it in its management internal control evaluation? Where were the CPAs? Why didn't they find the problem? The banks' claim is: nonsense! Why? Because many financial statement numbers, like: oil and gas reserves, actuarial liabilities, depreciation or bad debt allowances, are: drumroll please, estimates. So? A bank could say take a sample of 2,500 to 10,000 loans, make an estimate and record it. Why not?

"If the banks had no risk in sponsoring the SIVs, why are they trying to keep them off their balance sheets today? ... The SIV crisis shows what 'structured finance' is, i.e., creating vehicles which substance and form differ", my 16 October 2007 post. "Meanwhile you might think the existence of the put would make it impossible for Citi to get those CDOs entirely off its balance sheet. ... But remarkably, Nov. 5 was the first time that Citi mentioned liquidity puts to the world", my 20 November 2007 post. What are the facts? If, as a result of loan modification, the holders can "put" the assets back to the sponsoring bank, record the liability. I conclude this too, is an issue of contract law, not accounting. "Citigroup's sponsored SIV accounting is nonsense and always was. ... Citigroup created a blizzard of paperwork to obscure the SIVs economic realities. I say: Citigroup and KPMG fess up. Cut the nonsense", my 27 November post. Citigroup subsequently recorded $49 billion in assets. "It is obvious the new position of the SEC is to accomodate the Wall Street insiders and their creation of financial products", my 9 December 2007 post.

Now we approach the real issue in this US Treasury, not SEC fiasco. "Under accounting rule FAS 140, lenders must make a 'true sale' to the trust, so that it, and not the lender, is the actual owner of the loan proceeds. ... But critics say another important reason banks and policy makers are straining accounting rules to preserve the QSPE structure is that the legal and accounting structure of the 'true sale' is designed to shield banks from investor lawsuits", emphasis not in original, my 11 December 2007 post.

The big issue is not accounting, but trying to "Stoneridge" QSPE asset holders and stop them from suing the banks. That banks supposedly relied on SFAS 140 not to record the QSPE assets shows me bank accounting's lack of substance from day one. Read SFAS 140 paragraph 47, "An agreement that ... obligated the transferor to repurchase or redeem transferred assets from the transferee ... is therefore to be accounted for as a secured borrowing". If the assets had put options, they should always have been on the banks balance sheets, or at least disclosed. Whether or not there was a "reconsideration' event is irrelevant to me.

In law, the banks may have shot themselves in their collective feet in "relying" on SFAS 140 not to consolidate their QSPEs, they put SFAS 140 accounting in issue and now beg the SEC to protect them from their cupidity! It seems they are trying to "whipsaw a court" and argue against their previously adopted position. Many judges would hold they should be "estopped" from doing this. In my experience, the longer a SFAS is, the more it strays from economic substance. SFAS 140 is 101 pages, phew. I read paragraphs 9 and 33-55. CH ignores paragraph 32, "Some rights or obligations to reaquire transferred assets both constrain the transferee and provide more than a trivial benefit to the transferor, thus precluding sale accounting under paragraph 9(b)". Maybe CH never read this because he's using KPMG's "incomplete" copy of the applicable accounting rules.

Now I went to to read CH's 8 January letter, dated one day after Robert Steel's (RS), Undersecretary of the Treasury, letter to CH. RS writes, "We look forward to your perspective regarding the consistency of the ASF Framework with [FASB] Statement No. 140. ... We are pleased that mortgage investors and servicers worked through the ASF to develop this streamlined process for fast-tracking refinancings and loan modifications where doing so is in the interest of both homeowners and investors". Very interesting. CH was a partner at E&Y, a Big Four CPA firm. It is inconceivable to me he wrote his four-page letter in one day. That's not how these guys who deliver "carefully considered opinions" work. I find RS's letter threatening, as if he's saying: untermench, don't get in my way, do as you're told. "We" reads like the "royal we". My guess: RS had a firm of attorneys write "CH's" letter and told him sign it. Why now? Because banks' 2007 audits are in progress and the auditors wanted "SEC cover" to ignore the problems with QSPE accounting.

Who is RS? Have we, dear reader, seen that name before? Yes, he's another, no, no, no, Goldman Sachs (GS) guy. GS runs everything! See my 14 October 2007 post. RS is one of the architects of now deceased MLEC! Is his 7 January letter to CH "Son of MLEC"? MLEC died on or about 21 December 2007, 17 days earlier. You have to hand it to RS, he keeps on pitching!

CH's letter does not read like a CPA wrote it, but like an amicus curiae brief the SEC will file on behalf of financial institutions when they get sued. CPAs rarely write things like, "This letter expresses only the view of the OCA on this accounting issue, and its limited application should not be extended by analogy or relied upon for any mortgage modification other than one occurring pursuant to the ... This letter does not express any view or opinion regarding whether servicers are legally permitted to modify the terms of subprime ARM loans pursuant to the recommendations in the ASF Framework. This ability, is determined by the contractual provisions set forth in the governing documents for the securitzation trust. ... OCA indicated that it believed mortgage modifications that occur when default is 'reasonably foreseeable' would not invalidate the status of a trust as a QSPE provided the nature of the modification activities are consistent with those when a mortgage becomes delinquent or default has occurred", my emphasis. Why is CH rendering what reads like a legal opinion? Is it because a "former" GS guy told him to?

This reminds me of an early 1960s flap over investment credit accounting. "He believes this Opinion [APB 4] illustrates the accounting profession's complete failure in its responsibility to establish accounting principles that are comparable among companies and industries, for the use of the public in making personal investment decisions. He states there is no justification for sanctioning two contradictory policies to accommodate SEC and other regulatory bodies". Who wrote that? Leonard Spacek, of Arthur Andersen in dissenting to APB 4, March 1964.

My bottom like: Tanta missed the boat. This fiasco is worse than YS thought it was. The banks' QSPE accounting was wrong from day one. Having "relied" on SFAS 140 to keep the assets off their balance sheets, the banks are now stuck with having to apply other SFAS 140 provisions not to their liking, tough. Worse, they may be getting set up for some very nasty lawsuits. Insha Allah.

As for "former" GS guy Robert Steel, 18 USC 1505 reads in part, "Whoever corruptly, or by threats of force, or by any threatening letter or communication influences, obstructs, or impedes or endeavors to influence, obstruct, or impede the due and proper administration of the law under which any pending proceeding is being had before any department or agency of the United States, or the due and proper exercise of the power of inquiry under which any inquiry or investigation is being had by either House, or any committee of either House or any joint committee of the Congress--Shall be fined under this title or imprisoned not more than five years, or both". Jeffrey Taylor, get going. You have some work here. Ladies and gentlemen of the blogosphere, you've heard both sides evidence. Now I ask you to return a verdict of guilty against all parties, RS, CH and the banks.


Junior said...

'Grandpop' -

Funny you should mention 6 year olds since I've maintained since I woke up to financial crisis that my own nearly 6 yr old boy could have handled much of this better than those entrusted to do so on the American people's behalf.

The kid is smart (naturally) but it doesn't take a genius to figure the deficiencies out.

I agree with you. This is certainly an epic Skeptical CPA post.

But how exactly do we go about repairing this mess??

Independent Accountant said...

Your 6-year-old probably could. At the very least, he would never have given Citigroup $350 billion and AIG $170 billion.
Thanks. It took long enough to put together.
As to repairing this mess, the first thing is to send the financiers to alcoholics anonymous to learn the 12 steps. There's something about rigorous honesty in there. Next, tell everyone, Uncle Sam is broke. Defaults will come. Treasury bonds, social security, medicare, you name it. Next, repeal the Federal Reserve Act and reverse the gold clause cases of the 1930s. Repeal the drug laws. Now, we can rest for a year and begin dealing with the fallout.