Though much of the debate over loan modifications has centered on smoothing conflicts with investors in securitizations, modifications of mortgages are starting to cause headaches for lenders holding loans in portfolio as well.
Lenders are required to account for losses stemming from changes to the terms of loans they hold on their balance sheets. The view on whether or not that represents an onerous burden is not unanimous but the Mortgage Bankers Association has been among those lobbying rulemakers for relief, on the grounds that lenders lack the systems to apply the requirement to the huge volume of loans that could end up being reworked.
Clearly modifications are beginning to have a financial impact on some balance sheets: On Monday, Downey Financial Corp. said that it had to restate nonperforming asset ratios to account for mortgages it had modified.
Under Downey’s revised calculations, nonperforming assets as a share of total assets jumped more than fivefold from June 30, to 7.8% at yearend. Modified loans’ share of nonperformers surged from zero to 40% over the same period.
Downey said it has not yet determined the effect of the reclassification on previously issued financial statements. Its shares fell 12.9% Monday on the disclosures.
Downey did the modifications under a program it launched in the beginning of the third quarter where it offered to convert option adjustable-rate mortgages that have not defaulted into five-year hybrid ARMs and annually-adjusting ARMs that do not allow negative amortization.
Because the new loans were offered at interest rates that “were the same or no less than” those offered to new borrowers, and because they were offered to borrowers who were current, Downey said, it had initially classified the modified loans as performing. But after further assessment in light of “the current interpretation of GAAP, especially in the current housing market,” Downey determined that the modifications should be treated as “troubled debt restructurings.”
The Newport Beach, Calif., thrift company said it had not performed new underwriting for the modifications — “including an updated property valuation, credit report and income analysis” — that would prove that the revised terms reflected a “market rate of interest.”
It said it skipped those steps because the original loans were current and because it wanted to get the modifications done quickly. Downey did not return a phone call by press time.
Financial Accounting Statement 114 requires that impairment charges be recognized when it becomes probable that all amounts due under original contractual terms will not be collected.
According to the standard, written in 1993, “large groups of smaller-balance homogenous loans that are collectively evaluated for impairment,” such as mortgages and credit card loans, are typically excluded — unless the loans are restructured.
Impairments are to be measured each reporting period as the difference between the recorded investment in the loan and the present value of the cash flows anticipated at the end of the period. Companies can also use market prices and collateral values to gauge impairment.
The MBA wrote a letter to the Financial Accounting Standards Board in early December asking for relief from FAS 114, arguing that “MBA members report that they do not have the systems capability, and are unlikely to be able to obtain the capability, to evaluate huge volumes of modified loans under” the standard.
Portfolio loans “have increased in recent months as the secondary market for many ‘subprime’ and other loans has diminished dramatically,” the trade group wrote.
“MBA is very concerned that without relief mortgage lenders on an industry-wide basis could be forced to issue qualified financial statements.”
The MBA did not respond to calls on Monday.
HSBC Finance Corp., which in October 2006 launched a program to modify ARMs approaching their first interest rate reset, said it is accounting for the loans under FAS 114 in its most recent quarterly filing with the Securities and Exchange Commission.
The U.S. consumer finance unit of the $2.15 trillion-asset HSBC Holdings PLC of London said that it had “modified more than 8,000 loans with an aggregate balance of $1.2 billion.”
In an interview last month, William Longbrake, the vice chairman of Washington Mutual Inc., said the approach required by FAS 114 “sounded very black and white” and not “all that complicated.”
Mr. Longbrake, a policy adviser to the Financial Services Roundtable who has worked on the federally backed initiative to streamline modifications of loans in securitizations, said lenders need to create filters to identify loans “in imminent danger of default” by, for example, examining “various measures like loan-to-value and payment history.”
“Then, if you do modify the loan, you do have to … calculate the change in value, and that becomes the charge against current earnings,” he said.
The filter would be similar to what is called for by the modification framework for loans in securitizations.
“Once you’ve got the measures to find” possible defaults “and you’ve got your auditors’ blessing” of the methodologies used, “it’s just a matter of running it against your servicing system and doing a loan sort,” he said.
Christine L. Klimek, a spokeswoman for the standards board, said the organization had just received a second letter from the MBA on the issue last week, and is still reviewing the December request.
The December letter “is being treated like a formal agenda request, and the staff is going to research the issues and present it to the board and see if they’d like to add a project in the future,” she said.
She said the timetable by which the standards board typically decides to add a project “varies widely.”
Sachit Kumar, a managing director with Mortgage Industry Advisory Corp. of New York, said modifications of portfolio loans are far less complicated than modifications of loans in bonds, because of the absence of complicated ownership structures and other issues.
The rigors of FAS 114 notwithstanding, the decision to modify loans is principally an economic one for lenders, he said.
“If the borrower has a good amount of equity, then foreclosure may work out better for the lender,” Mr. Kumar said. “But if the homeowner doesn’t have much equity, then certainly the lender would like to do the modification, in which case there will be impairment that needs to be recorded under FAS 114.”
