- Accounting Is King
- March 17, 2005 | Author: Ellen R. Marshall
- Law Firm: Manatt, Phelps & Phillips, LLP - Costa Mesa Office
When the Enron scandal broke in late 2001, the mortgage banking industry braced for a problem. Enron, it seemed, had used special-purpose vehicles to achieve off-balance sheet treatment. So do many mortgage companies. Would the regulators rush in to stop the use of SPVs by honest companies for legitimate purposes, or would they understand the difference between legitimate and abusive SPVs? Would the mortgage industry's honorable participants lose this valuable tool of risk management, because of what the Enron gang did?
To their credit, the SEC and the FASB took the time to evaluate the SPV terrain before treading in with revised rules. And the revisions that have been promulgated and proposed to date do not run roughshod over this terrain. FASB Interpretation No. 46R (dealing with which entities must be consolidated for financial reporting) and the proposed revisions to FASB Statement 140 (tinkering with the requirements for treatment as a qualified special-purpose entity), both issued in 2003, reflect a nuanced understanding that there are legitimate transactions that use SPVs and that should be accounted for as sales, moving assets off balance sheet. If FIN 46R and the FAS 140 proposal move the goalposts, it is as much a response to changes in market practice as it is to changed sensibilities post-Enron.
Yet there are now two other phenomena -- also accounting-related, and also an outgrowth of the Enron aftermath -- that have the potential to be more insidious for financial managers at mortgage companies.
You're On Your Own
The first problem derives from the Sarbanes-Oxley legislation of mid-2002, and the resulting changes in the accounting firms' view of their own roles. That is an unwillingness, or inability, on the part of the accounting firm that audits a company to provide advisory services about structuring transactions. Where audit firms used to seek out opportunities to serve as consultants, helping to design transactions for intended accounting treatment, those firms now are wary of being too close to the company during the planning stages of a transaction.
At a December 1, 2004 meeting of the Financial Accounting Standards Board's Small Business Advisory Committee, the CEO of a top accounting firm himself is reported to have complained about auditors' "inability to give answers." He blamed pressure from the Securities and Exchange Commission and the Public Accounting Oversight Board, and recognized that there's now a sort of "Catch 22" situation, in which the fallout is the ability to conduct complicated transactions at all. Some audit firms are going so far as to say, in effect, please go to our competitors for your planning advice, as we need to be completely independent when we come in, after the end of the fiscal year, to perform your audit. But of course no other accounting firm can provide the same level of assurance about how a transaction will be viewed by the auditor.
The schoolbook notion that a company goes about its business, and the accountants simply follow behind and record what happened, is naïve in the extreme. It is simply unrealistic to think that companies will evaluate potential transactions purely on their economic merits, without being mindful of the accounting considerations. Too much is at stake. Warehouse lines of credit and other financial transactions include covenants about GAAP net worth and other accounting measures. Wall Street is obsessed with short-term financial results, invariably couched in GAAP terms.
Take the commonplace example of a mortgage portfolio seller considering two structured transactions, one at 98% that will be accounted for as a sale, and the other at 103% that will be accounted for as a financing. This seller might well choose the first transaction, if the latter will increase leverage beyond levels permitted by its other contracts or, in the case of regulated banking institutions, regulatory limits. So it is important to know in advance how a transaction will be treated for accounting purposes. Yet more than one friendly accountant has said in recent months, my national office has laid down new rules that prevent me from telling you how we will look at this transaction when audit time comes. Thus a pendulum has swung from what may have been too much coziness -- surely one of the vices that afflicted Arthur Andersen's Houston office in its dealing with Enron -- to an entirely unhelpful and stultifying distance.
Don't Annoy Your Auditor
The second problem is the accounting firms' newfound belligerence toward those of their clients who are not in the top tier (however that is perceived). The "Big Shrinking-Number" -- is it now Four? when will it be Three? -- firms are certainly feeling their oats. Since late summer of 2004 we've heard more and more accounts of abrupt resignations at the most inconvenient times, within days of the due date of an 8-K or 10-Q, by reputable accounting firms who would not have considered such rude behavior in the past. The flimsiest of reasons are given. The company is left in the lurch.
For mortgage companies the treatment of SPVs is one of the hot buttons over which an audit resignation could easily turn. In conversations about transactions that were previously blessed as successfully moving assets off balance sheet, accountants are now citing the revised accounting standards, or changed internal positions, to challenge the same treatment. They are making management very uncomfortable about disagreeing.
Over time the inclination of leading audit firms to pare their customer base will doubtless bolster the standing of smaller regional accounting firms. Over time the balance of power will shift back, and the accountants will not hold all the cards. Maybe this is healthy. For now, though, some upstanding companies, feeling themselves at risk of being abandoned, are being pressured to accept unintended and infelicitous accounting treatment, or lose their accounting relationships entirely.
The Market Marches On
Yet the financial landscape is not static. What made sense in the falling-rate environment of the last ten or so years may make no sense at all in the coming rising-rate environment. What made sense for balance sheet management of an ordinary corporation may not make sense for one that has, say, converted to a real estate investment trust. Some mortgage companies are now seeing reasons for intentionally retaining assets on balance sheet, even where those assets are financed through SPVs. Sellers of mortgage portfolios may, for example, wish to retain the upside potential associated with slower prepayment rates. Purchasers of these portfolios may still seek the isolation of the asset pool from the seller's credit risk, and may therefore ask that an SPV be interposed, even though the accounting treatment is as a borrowing, not a sale. Similarly, a mortgage company that is taxed as a REIT, and as such needs to retain substantial mortgage loan assets, has reason for retaining the assets on balance sheet, even if its lender sees added protection for its loan if an SPV is used.
In this context, on-balance sheet accounting may actually be perceived as less conservative than sale accounting. Will the recent positions of the accounting profession make it easier for companies in this new environment to structure the desired transactions? Or will intended on-balance sheet treatment be as elusive in this new environment as off-balance sheet treatment was becoming before it? Unfortunately, the reluctance of accounting firms to dispense advisory assistance at the time of structuring remains a problem. Whether the goal is on- or off-balance sheet accounting, there's nothing that beats certainty of the outcome.
It is incumbent on the leaders of the accounting profession to find their way back to a stance that enables the honest and honorable members of their profession to provide useful and timely planning advice to honest and honorable companies who are their clients. Anything short of that means less efficient use of capital, as companies operate under the specter that transactions undertaken will not have the intended accounting treatment. The mortgage banking industry is not the only constituency that's worried about this. As a heavy user of structured transactions, it probably runs into these problems more than most. Restoring the balance of power with the accounting profession must be high on the industry's agenda.