The Subprime Meltdown: Understanding Accounting-Related Allegations (Part II of A NERA Insights Series)

By Dr. Thomas L. Porter, CPA and Dr. Airat Chanyshev

Forthcoming topics in this subprime lending series will include:

Anatomy of a Fraudulent Conveyance

De-Mystifying the Economics of Complex Mortgage Transactions

The Domino Effect: Economic Impact of When Exotic Mortgages Reset

INTRODUCTION

In the

first article in this series, NERA Economic Consulting provided a primer on "The Subprime Meltdown."1 That article described the players and their roles in the subprime securitization process. This article focuses on mortgage originators and the accounting-related allegations made against them in recent subprime lawsuits. A sampling of those allegations, with the accounting-related topic in bold, includes the following:

the Company lacked sufficient internal controls to determine loan loss provisions; the Company mischaracterized its Low Documentation Loans as prime loans, and as a result of the deteriorating market conditions, it needed to take on more risky loans in order to maintain its growth.2

The Company lacked requisite internal controls, and as a result, the Company's projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts;

The Company's financial statements were materially misstated due to its failure to properly account for its allowance for loan repurchase losses;

The Company's financial statements were materially misstated due to its failure to properly account for its residual interests in securitizations by failing to timely write down the impaired assets.3

The Prospectus further failed to detail that the failure to sell these packages of sub-prime loans would necessitate that the Company keep them as investments and have to weather the full weight of the risk of default.4

What is a "loan loss provision?" What is an "allowance for loan repurchase losses?" What is a "residual interest in securitization?" How does one know if a residual interest in securitization is impaired or not? What are the financial reporting implications of weathering "the full weight of the risk of default?" This article will answer each of those questions and provide some suggestions for how to analyze the pertinent accounting issues in subprime lending cases.

ACCOUNTING FOR MORTGAGE BANKING ACTIVITIES

A mortgage originator's business involves originating or purchasing mortgage loans, holding some of those loans as a long-term investment, and selling the rest to be securitized. Holding loans as a long-term investment ties up capital until the loan is repaid, whereas selling loans to be securitized provides immediate funding so the mortgage originator can continue to make new loans.

While the accounting for the origination or purchase is relatively straightforward, the same cannot be said for what happens afterwards. As will be discussed below, some mortgages that are actually "sold," in a legal sense, remain on the originator's books because they are not considered "sold" from an accounting perspective. Further, the accounting makes a distinction between market factors that affect the current fair value of a mortgage and credit factors that affect the amount of principal that will ultimately be collected.

Mortgage Loans Held for Investment

Mortgage loans that a mortgage originator intends to hold until maturity as an investment are categorized as "held for investment"5 on the mortgage originator's books and reflected as an asset on the balance sheet at amortized cost.6 As principal is repaid over time, the original cost is reduced and the resulting amount is referred to as the "carrying amount." At any time until maturity, if it becomes doubtful that the carrying amount will not be recovered and the impairment is considered to be other than temporary, the carrying amount is reduced and a loss is included in income in the period in which the impairment occurs.

In addition to impairments, which affect individual loans in a portfolio, originators are required to estimate and record an allowance for credit losses inherent in a portfolio of loans. That allowance is referred to as the "loan loss reserve." A loan loss reserve is netted against loans held as an investment, in the asset section of the balance sheet. The resulting amount is a reflection of the principal that is expected to be collected from borrowers. The loan loss reserve is increased by recording a loss that appears on the income statement.

Loan Loss Reserve

An analysis of the loan loss reserve may provide an...