In today's rapidly shifting market, financial institutions, investors, and legal and financial advisers need to be aware of the financial issues related to subprime lending and mortgage-backed securities.
The recent subprime mortgage meltdown and ensuing credit crunch have created extraordinary challenges—including the risks of litigation and bankruptcy—for companies in the mortgage and financial services industries. They also have caused unprecedented write-downs of mortgage-backed and related securities and the recording of robust provisions for loan losses for many financial institutions. This crisis has raised numerous financial issues for these companies, their investors, and their attorneys.
Mortgage companies, retail banks, commercial banks, loan servicers, mortgage brokers, special-purpose entity trusts, investment banks, ratings agencies, bond insurers, and investors in mortgage-backed securities such as banks, mutual funds, hedge funds, pension funds, private-equity firms, and the attorneys representing them.
The subprime crisis has entangled nearly every participant along its path, from those originating, packaging, and securitizing mortgages to those investing in a variety of mortgage-backed securities. It has ensnared those who underwrote, insured, and rated these securities as well as the financial advisers and auditors of those who invested in them. So pervasive was reporting in the news media on the subprime mortgage crisis that the American Dialect Society selected the word subprime as the 2007 word of the year!1
This article provides a synopsis of the basic subprime mortgage lending and securitization process and identifies some of the accounting and disclosure issues that have arisen from the expansion—and now contraction—of investments in mortgage-backed securities. In this rapidly shifting market, it is important for financial institutions, investors, and legal and financial advisers to be aware of some of the financial issues related to subprime lending and mortgage-backed securities.
The Subprime Crisis
In general, subprime mortgage loans are loans to borrowers with weak or impaired credit histories. Among the factors considered in placing a borrower in a particular risk category are his or her credit rating (perhaps based on the borrower's FICO score), history of payment delinquencies or defaults, and any prior bankruptcy filings. Definitions of subprime, however, can vary from lender to lender and, in addition to credit ratings, are influenced by factors such as the mortgage-loan-to-value ratio and the extent of loan documentation.
Because of their higher risk of delinquency and default, subprime loans often carry higher interest rates and different terms than do loans to customers with higher credit ratings. Many subprime loans are interest-only loans or adjustable-rate-mortgage (ARM) loans, some of which are negative amortization loans (in which the outstanding balance grows in the amount of each month's unpaid accrued interest).
Federal Reserve Chairman Ben S. Bernanke recently commented:
The problems [in the housing and house financing industries] have been most severe for subprime mortgages with adjustable rates: the proportion of those loans with serious delinquencies rose to about 13½ percent in June, more than double the recent low seen in mid-2005. The adjustable-rate subprime mortgages originated in late 2005 and in 2006 have performed the worst, in part because of slippage in underwriting standards. . . . With many of these borrowers facing their first interest rate resets in coming quarters, and with softness in house prices expected to continue to impede refinancing, delinquencies among this class of mortgages are likely to rise further.2
According to research by the Securities Industry and Financial Markets Association, 2006 was the first year in which more than half of issued securities were backed by subprime and other nonconforming loans.3 About 80 percent of subprime loans originated in 2005 were adjustable-rate mortgages, many of which did not begin to reset until early 2007.4
Once the low introductory teaser rates expire, the adjusted rates, which are typically linked to an index rate such as a one-year constant-maturity Treasury (CMT) security or the London Interbank Offered Rate (LIBOR), will be significantly higher. The result will be higher monthly interest payments for borrowers that, in turn, will contribute to increased borrower delinquencies and defaults.
The current subprime crisis is the result of many factors, including the dramatic increase in the volume of subprime mortgages and their securitization into a variety of mortgage-backed securities when interest rates were low. Exhibit 1 illustrates the growth of subprime originations during the 2001 – 2006 period.
To appreciate the different roles of the securitization participants, it is helpful to understand the basic mortgage lending and securitization process.
Securitization refers to the process of pooling mortgages with similar characteristics, packaging them into bonds, and selling these bonds to investors. In the basic securitization process, the mortgage loans are sold to a special-purpose entity (SPE), which in turn repackages the loans and sells these assets, in the form of bonds, to investors. Exhibit 2 illustrates the basic mortgage lending and securitization process. Actual securitization structures can involve many additional participants and transactions.
As home prices and mortgage lending accelerated during the first half of the decade, investment banks found many ways to repackage—that is, securitize—billions of dollars in mortgage loans, selling them off in slices to investors around the world. Financiers and regulators supported securitization, anticipating that it would disperse risk and strengthen markets.
The rapid growth in securitization was, in itself, an indication of the considerable value that market participants perceived in mortgage-backed securities. These credit instruments increased the supply of credit to prospective homeowners, provided risk diversification for investors, and, for lenders, freed up capital for other uses.
Mortgage-backed securities (MBS) – the product of the securitization process - are debt instruments such as bonds that are collateralized by pools of mortgages. They are typically issued to institutional investors. The payments made by the homeowner/borrower provide funds for the principal and interest payments on the securities. Investors in mortgage-backed securities comprise many types of entities, including commercial and retail banks, investment banks, and insurance companies. Mortgage-backed securities can also be held indirectly through investment companies such as mutual funds, hedge funds, pension funds, and private equity firms.
There are two general categories of MBS: a) those composed of loans sponsored by the government entities Fannie Mae (Federal National Mortgage Association), Ginnie Mae (Government National Mortgage Association), and Freddie Mac (Federal National Mortgage Corporation), which require conformity to strict lending guidelines regarding borrower credit limits, credit ratings, and loan documentation and thus are often identified as "prime" loans; and b) "private-label" issuances, which are backed by loans that are not required to conform to the government-sponsored restrictions. While the government-sponsored entities were the primary issuers of MBS for the latter half of the 20th century, by 2006 the private-label issues accounted for a greater share of the total MBS market.
Collateralized Debt Obligations
Collateralized debt obligations (CDOs) are investment vehicles that pool mortgage-backed securities and segregate them into tranches of varying risk (senior, mezzanine, and equity, for example). Bonds are then issued related to these tranches. For a variety of reasons, ratings agencies recently have downgraded many CDOs, causing price declines and considerable anxiety among investors that more losses could result if prices for these securities fall further. Questions about the magnitude and timing of write-downs in the value of CDO holdings have been raised by many participants, including investors and regulators. In the past few months, the three major rating companies—Moody's Investor Services, Standard & Poor's, and Fitch Ratings—have downgraded ratings on tens of billions of dollars of CDOs, including many previously from higher credit tranches.5 Since many pension funds and other institutional investors are obligated to hold only investment-grade debt, downgrades can require rapid changes to portfolios and investing strategies.
The Credit Crunch
By summer 2007, interest rates had increased, real estate markets had stagnated (or declined), underwriting standards had tightened, and default rates on the underlying mortgages had increased, revealing the inherent risks in these structured credit products.
Because of the pooling of many mortgages that is integral to the securitization process, mortgage-backed securities can sometimes camouflage the risk and performance characteristics of the underlying mortgage collateral. For example, the underwriting standards followed for a particular loan or collection of loans in a given security may be different from the standards used for another set of loans in that security. This feature of securitization can mask the delinquency and default risks of the combined mortgages within a given security. And, as the markets for subprime mortgage-backed securities became increasingly illiquid in mid-2007, market prices for establishing benchmarks to value the different tranches of these securities all but disappeared.
The lack of transparency and price clarity coupled with extensive press coverage of the growing number of cases involving mortgage fraud has made investors and lenders increasingly risk averse, further contributing to the credit crunch. For these reasons, it is anticipated that losses on subprime portfolios will continue to affect participants in the subprime mortgage securitization process throughout 2008 and perhaps longer. In addition, the underwriting practices followed by subprime lenders are, and will be, the focus of numerous investigations in the months to come.
The many participants, transactions, and agreements involved in the structured financing of mortgagebacked securities create a complex arrangement, particularly in contrast to previous lending practices where originating banks retained mortgage loans on their balance sheets instead of selling them into securitization vehicles. These structured credit facilities are complex, and accounting for these transactions can be equally complex.
As is frequently the case, accounting for complex financial transactions often lags behind the creation and execution of these transactions.6 A number of accounting issues have surfaced and are drawing increased scrutiny by those involved in the mortgage securitization process. Many of these issues are at the heart of allegations set forth in recently filed lawsuits against originators (mortgage companies and banks), issuers (special-purpose entity trusts, often established by originating banks), investment banks, ratings agencies, and investors (such as hedge funds and pension funds). These accounting issues include, for example, the provision for loan losses, the valuation of mortgage-backed and other securities, and the adequacy and timing of disclosures regarding credit risks.
One area of valuation that can challenge mortgage originators, as well as investors in these entities, involves determining an appropriate allowance for loan losses for portfolios of mortgages. Financial institutions are required to record an allowance for that portion of their mortgage portfolio that is impaired. The allowance is established by a charge to the income statement, referred to as bad-debt expense or provision for loan losses.
Prior to the subprime mortgage crisis and ensuing credit crunch, many banks had an allowance for loan losses of less than 1 percent of net loans, but this allowance grew significantly for many banks in 2007, as mounting delinquencies and defaults became apparent.7
Financial Accounting Standards Board (FASB) Statement No. 5, "Accounting for Contingencies," sets forth two conditions for accruing an estimated loss: "a) information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability incurred at the date of the financial statements"; and "b) the amount of loss can be reasonably estimated."8 Disclosure of a loss contingency must be made if there is "at least a reasonable possibility that a loss or an additional loss may have occurred."9
The Securities and Exchange Commission (SEC) has provided guidance in its Staff Accounting Bulletin No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues,"10 on how registrants are to account for the provision. The methodology for estimating loan-loss provisions must:
- Include a detailed analysis of the loan portfolio, performed on a regular basis;
- Consider all loans (whether on an individual or group basis);
- Identify loans to be evaluated for impairment on an individual basis under Statement of Financial Accounting Standards (SFAS) No. 114 and segment the remainder of the portfolio into groups of loans with similar risk characteristics for evaluation and analysis under SFAS No. 5;
- Consider all known relevant internal and external factors that may affect loan collectibility;
- Be applied consistently but, when appropriate, be modified for new factors affecting collectibility;
- Consider the particular risks inherent in different kinds of lending;
- Consider current collateral values (less costs to sell), where applicable;
- Require that analyses, estimates, reviews, and other loan-loss allowance methodology functions be performed by competent and well-trained personnel;
- Be based on current and reliable data;
- Be well documented, in writing, with clear explanations of the supporting analyses and rationale; and
- Include a systematic and logical method to consolidate the loss estimates and ensure the loan-loss allowance balance is recorded in accordance with generally accepted accounting principles (GAAP).
As this guidance makes clear, because accounting for the impairment of a loan portfolio is based, in part, on estimates, with all the uncertainties implied in making an estimate, it is important that a financial institution develop and adhere to a systematic methodology when making those estimates. This practice includes making adjustments to the provisions, either upward or downward, as changes in the portfolio or external market affect it.
During this period of rising interest rates, resetting ARMs, and falling home values, many subprime borrowers found making their mortgage payments increasingly difficult. This difficulty put some of them into delinquency status and, in some cases, caused them to default.
As might be expected, this changing dynamic prompted lenders to analyze and adjust (that is, increase) their provisions for loan losses. But since recording a provision for a loan loss is an estimate influenced by a number of variables, making an accurate estimate can be a challenge. And, as the size of mortgage loan portfolios increased dramatically at many lenders, estimating loan losses for the entire portfolio became even more hazardous.
Loan Repurchase Obligations
A valuation issue in the mortgage securitization process arises for originators regarding the repurchase obligations they incur for loans sold to issuers of mortgage-backed securities. When originators enter into agreements with mortgage-backed security issuers (often investment banks) or wholesalers, the agreements typically set forth conditions whereby the originator must "repurchase" loans from the issuer for loans experiencing early payment defaults. These are referred to as recourse obligations and are reflected as a liability on the originator's balance sheet.
Guidance on accounting for recourse obligations is provided in FASB Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." Statement 140 requires the recognition of recourse obligations in transfers of financial assets qualifying for sale treatment and that they are measured at fair value. FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," requires additional disclosures.11 The disclosure requirements for recourse obligations can be extensive and include information such as:
- The nature of the guarantee, including its approximate term, how the guarantee arose, and the events and circumstances that would require the guarantor to perform under the guarantee;
- The maximum potential amount of future payments under the guarantee;
- The carrying amount of the liability, if any, for the guarantor's obligation under the guarantee; and
- The nature and extent of any recourse provisions or available collateral that would enable the guarantor to recover the amounts paid under guarantee.12
The issue of loan repurchases has been the recent focus of a number of lawsuits in which plaintiffs, often a class of shareholders of an originator, allege that the originator improperly accounted for loan repurchase losses when it knew of, or recklessly disregarded, a surge in payment defaults on the part of borrowers.
These complaints allege that the defendant originator's improper accounting of loan repurchases violated GAAP regarding the company's assessment of the size of loan repurchase losses.
As can be seen from this guidance, accounting for loan repurchase obligations is based, in part, on estimates. Accurately estimating amounts and determining the fair value in an unsettled economic environment has proved to be challenging for some financial institutions.
As previously noted, the structured credit market, primarily in the form of CDOs, expanded dramatically during the 2004 – 2007 period. The variety and volume of issuances increased, and the transaction size for individual CDOs grew. The inherent complexity of CDOs, coupled with their expanding size and diversity, has made pricing them all the more difficult.
When the markets for mortgage-backed securities, including CDOs and structured investment vehicles (another form of short-term structured security backed by pools of mortgage-backed securities and CDO bonds), began decelerating in 2007, obtaining information on prices for these securities became even more difficult. With little or no trading in securities in a particular market, there are no price points on which to anchor valuations. This creates a lack of price transparency, which in turn has exacerbated the credit crisis and reduced trading in these securities.
Lacking an active market but nevertheless facing a need for current valuations, institutions resorted to valuing these securities either by using as a yardstick prices for comparable but more actively traded securities or by relying on mathematical models that consider the various risk characteristics of a portfolio (default, interest, and early redemption risks) to estimate a security's value. As with any financial model, however, inputs are often based on assumptions and subjective estimates that, if erroneous, can erode the accuracy of the end results.
Retained Interests in Securitized Loans
Originators that sell mortgage loans to an SPE trust process sometimes retain an interest in these loans. The trust typically uses the cash proceeds from the sale of the mortgage-backed securities to pay the originator the cash portion of the purchase price for the mortgage loans. The trust also issues a certificate to the seller/originator representing a retained beneficial interest in the payments on the securitized loans as a result of the over-collateralization established at the creation of the structured vehicle.
Retained interests represent the right to receive cash collected from borrowers that is greater than the obligation the SPE trust has to the investors in the issued securities. For example, excess interest can be generated from the difference between the coupon rate on the loan collateral and the average interest rate on the securities backed by the loan. The amount that the originator expects to receive for these payments must be accounted for on the originator's balance sheet. Like the above-mentioned issues associated with CDO valuation, determining the value of retained interests is based on estimates and these estimates are influenced by the payment and default experience of the mortgage portfolio.
Retained interests are exposed to credit and interest rate risks that can make their valuation quite sensitive to changes in the underlying assumptions. For example, changes in the marketplace can affect the discount rate or performance of the underlying mortgages supporting these interests, which, in turn, can affect their value. And, retained interests must be regularly evaluated for impairment pursuant to EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets."13
Timing of Valuation Adjustments
A relevant consideration affecting each of the valuation estimates is the question of when these adjustments are recognized and disclosed. For example, at what point should an originator's obligation for loan repurchases reflect an increasing delinquency or default rate in the mortgage portfolio? Or when should portfolio managers make adjustments in light of deteriorating market conditions? In general, when the entity recognizes that a loan or a portion of loan portfolio is impaired, then an adjustment should be recorded in the current reporting cycle.
Fair Value Measurement in the Absence of Liquidity
As a result of the increased credit risk and reduced liquidity in the secondary marketplace for mortgagebacked securities, these products have experienced extreme price volatility and reduced trading activity. When there is little or no trading in a security, however, determining an appropriate fair value can be challenging. This situation has raised questions (and litigation) about just how to value these securities.
Fair value is a fundamental concept within GAAP that forms the foundation of accounting and financial reporting. While fair value has been applied in accounting for many years, the definitions were dispersed throughout the literature. In an effort to define fair value in one location, the FASB issued FASB Statement No. 157, "Fair Value Measurements." This statement takes effect for fiscal years beginning after Nov. 15, 2007, with early application encouraged.14
Although this statement was not effective during the period of growth in subprime mortgage securitizations, the valuation techniques enumerated in Statement 157, including the market, income, and cost approaches to determining fair value, are consistent with those that have evolved in the valuation community over many years. Of course, the selection of approach or approaches for valuing a given asset or liability should be appropriate for the circumstances and should be applied consistently.
A useful source for those interested in gaining an understanding of Statement 157 can be found on the FASB's Web site.15 Questions about how to measure the fair value of subprime mortgage assets in accordance with Statement 157 and previous guidance have also been addressed by the Center for Audit Quality (CAQ), a nonprofit organization created to serve investors, public company auditors, and the markets (see www.thecaq.org). In its white paper, "Measurements of Fair Value in Illiquid (or Less Liquid) Markets," the CAQ provides further guidance on applying fair value principles set forth in FAS 157 to mortgage-backed securities.16
In managing the many issues associated with the subprime mortgage crisis, it is important that financial institutions, their investors, and counsel closely examine their procedures regarding accounting for, valuing, and reporting on these securities and related mortgage portfolios. By proactively identifying the nature and scope of potential problems such as those associated with loan documentation, valuations, and disclosures, management will be in a much stronger position to take corrective action and, when necessary, either pursue or respond to claims or investigations.
1 In its 18th annual vote, the American Dialect Society named subprime the word of the year. Subprime was also a winner in a brand-new category, real estate words, a category that reflects the preoccupation of the press and public for the past year with a deepening mortgage crisis. See www.americandialect.org.
2 Chairman Ben S. Bernanke at the Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole, Wyo., Aug. 31, 2007.
3 "The Subprime Sinkhole," Bloomberg Markets, July 2007.
4 "Explaining the Higher Default Rates of the 2005 Origination Year," The MarketPulse, June 2006.
5 According to a recent Wall Street Journal article, 58 percent of collateralized debt obligations backed by subprime collateral issued during 2005 to 2007 have been downgraded or are being reviewed for downgrades (Wall Street Journal, "Nearly 20,000 Downgrades — and Counting," Dec. 5, 2007).
6 In June 2007, the SEC established an advisory committee to make the U.S. financial reporting system more user-friendly for investors. See the first report of this advisory committee at www.sec.gov/about/offices/oca/acifr/acifr-sc1-report.pdf.
7 For statistics on depository institutions, see the FDIC's Web site at: www2.fdic.gov/sdi/main.asp.
8 FASB Statement No. 5, "Accounting for Contingencies," paragraph 10.
9 Ibid., paragraph 10.
10 Staff Accounting Bulletin: No. 102, "Selected Loan Loss Allowance Methodology and Documentation Issues," 17 CFR Part 211, July 6, 2001. Additional guidance regarding recognition of loan losses is provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan." Guidance on the recognition, measurement, and disclosure of loan losses is also provided in Emerging Issues Task Force (EITF) Topic No. D-80, "Application of FASB Statements No. 5 and No. 114 to a Loan Portfolio"; FASB Interpretation No. 14, "Reasonable Estimation of the Amount of a Loss" (FIN 14); and American Institute of Certified Public Accountants, "Audit and Accounting Guide, Banks and Savings Institutions."
11 FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," paragraph 13.
12 Ibid., FIN 45 summary.
14 As of this writing, the FASB has issued a proposed deferral of implementation of SFAS 157 for non-financial assets and non-financial liabilities except those that are recognized or disclosed at fair value on a recurring basis (at least annually). At http://www.fasb.org/pdf/abs99-20.pdf.
16 CAQ Alert #2007-51, Oct. 3, 2007 ()http://www.aicpa.org/caq/download/CAQAlert2007_51_10032007.pdf).
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