Mortgage Mess: It's Not the Fault of Accounting Rules

Another one for the hyperbole files: Bloomberg's Jonathan Weil is blaming 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 took place.

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 wash.

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 optimism.

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.