Another one for the hyperbole files: Bloomberg’s Jonathan Weil
the subprime mess not on ratings agencies, this time, but rather on accounting
standards. Or, to quote his headline, "crack cocaine accounting".
Weil seems to be objecting, in the strongest possible manner, to the whole
concept of securitization. He’s saying that when lenders packaged up their mortgages
and sold them to outside investors, they didn’t really sell them, and
that therefore they shouldn’t have been able to book a profit when the sale
But isn’t it precisely those outside investors who are suffering large losses
now that the mortgages are underperforming? Try telling Bear Stearns that it
didn’t really buy subprime mortgages, and that the big problem here
is that the lenders still have control of the loans. I’m sorry, that just doesn’t
Besides, I think that Weil is wrong when he writes this:
Adding to the complexity, gain-on-sale calculations are based on lots of
estimates and guesswork about future events, such as customer defaults, prepayments
and interest rates. Things like these normally are impossible for mere mortals
to predict consistently. Yet the absence of any right answers also makes it
difficult for outsiders to challenge the numbers. Armed with that insight,
practitioners of gain-on-sale accounting can create profits through sheer
As far as I understand it, gain-on-sale calculations are based not on estimates
and guesswork at all, but rather on the price received when the bonds are
sold. Now it’s true that the person buying the bonds does have an option
to put mortgages back to the originator if they default more or less immediately,
or if they were fraudulently underwritten. For that reason, the originator should
make some kind of provision against future losses, even if it’s sold all the
loans. But the gain on sale is based on a real price, and the future path of
prepayments and interest rates affects the value of the sold bonds, and not
the amount of money which the originator can book as profit.
Weil seems to think that everything would be much better if originators had
no control over their loans – if they essentially had their hands tied
when it came to things like renegotiating mortgage payments for borrowers who
find themselves in financial difficulties. But that’s precisely what originators
should be doing. A homeowner shouldn’t be unable to negotiate his loan
just because his mortgage got bundled and tranched and sold to a hedge fund.
A good negotiation benefits everybody: the bondholders, the originator, and
the homeowner. In contrast, a stubborn originator who refuses to negotiate is
much more likely to end up foreclosing on the property, which benefits no one.
There are many reasons why the mortgage market is looking ugly right now. But
accounting rules in general, and FAS 140 in particular, are not among them.