Feb. 6 (Bloomberg) -- First the Securities and Exchange Commission's chief accountant gave the subprime-lending industry a valentine that wasn't in his power to bestow. Now some of the accounting rule-makers are starting to push back.

The SEC's Conrad Hewitt got things rolling with a Jan. 8 letter, blessing an industry plan to keep problem subprime mortgages off lenders' balance sheets while freezing their interest rates. Hewitt's letter came in response to requests by the Treasury Department and a group called the American Securitization Forum, whose accounting committee is led by a Morgan Stanley managing director, Esther Mills.

By any objective reading, Hewitt's letter offered an accounting exemption that would let banks avoid unwelcome hits to their capital ratios. Yet at the time, nobody at the Financial Accounting Standards Board would say so publicly.

Now three FASB members have gone on record characterizing Hewitt's letter as an exemption to the standard known as FASB Statement 140. This highlights another problem. Unlike the SEC, Hewitt, as chief accountant, has no authority to issue exemptions from the FASB's standards.

That leaves lenders and their auditors with a decision to make: They can follow generally accepted accounting principles, as set by the FASB. Or they can use accounting principles acceptable to Hewitt, the validity of which is doubtful.

``Con has completely undermined the FASB due process,'' FASB member Donald Young says. The worst part, Young says, is that Hewitt appeared to suggest the FASB agreed with his position. ``The technical call on that should have been made by the FASB board. And what I think is wrong in Hewitt's letter is representing it as a FASB position, when it is not.''

Avoiding Losses

Two other FASB members spoke out at a Jan. 30 meeting, when the board rejected a separate banking-industry request for another exemption from a different standard, called Statement 114. This one would have let lenders avoid losses on modified loans now on their balance sheets.

``In some respects, this industry has already received some exemptions from accounting of Statement 140,'' FASB member Tom Linsmeier said, in a reference to Hewitt's Jan. 8 letter. ``I don't have any sympathy for another exemption in this circumstance.'' The FASB's chairman, Robert Herz, spoke immediately after Linsmeier. ``I don't support the project either, for all the reasons stated,'' Herz said.

Hewitt declined to comment, as did Mills and Morgan Stanley spokesman Mark Lake. ``Con's letter speaks for itself,'' SEC spokesman John Heine says.

Upfront Profits

Many lenders recorded upfront profits by selling pools of loans to off-balance-sheet trusts known as qualified special purpose entities, or QSPEs, which then repackaged the loan pools into mortgage-backed securities. Under Statement 140, the trusts can remain off-balance-sheet only if their activities are ``significantly limited'' and ``entirely specified'' in the legal documents that created the entities. The purpose of those rules was to ensure the trusts were beyond a lender's control, by minimizing their ability to exercise discretion.

The ASF on Dec. 6 unveiled new guidelines under which mortgage servicers would have wide latitude to freeze interest rates on securitized adjustable-rate mortgages issued from 2005 to mid-2007 if default is deemed ``reasonably foreseeable.'' Hewitt said he believed the approach wouldn't jeopardize the banks' ability to keep the trusts off-balance-sheet.

One reason that's an exemption, and not merely an accounting interpretation: There's no way the activities described in the ASF's proposal could have been fully specified in the trust documents in question, because the ASF document didn't exist until two months ago. While the ASF's executive director, George Miller, says he doesn't agree that it's an exemption, it's hard to see how this is anything other than a retroactive fix.

Stacked Deck

This was Hewitt's second memo on subprime-loan modifications since July. Both times he cited a June 22 FASB ``educational forum'' as support for his position, a meeting the SEC's staff requested. Hewitt said there was a ``general agreement among participants'' that mortgage modifications wouldn't invalidate a trust's off-balance-sheet status if they occur when default is ``reasonably foreseeable.''

What Hewitt didn't mention: Just two of the FASB's seven board members attended the forum. The FASB took no position on the ideas presented there. And the meeting was stacked with banking-industry representatives, including executives from Morgan Stanley, Countrywide Financial Corp., Washington Mutual Inc. and Wells Fargo & Co.

Young, who wasn't invited to the forum, called Hewitt's letter an exemption, too, though he says he'd like to see a full FASB staff analysis before deciding conclusively.

Legal Shield

He says he's worried the letter also may help shield banks from legal liability. A QSPE is supposed to be ``bankruptcy- remote,'' meaning neither the bank nor its creditors can reach the trust's assets. Bringing those assets back onto a bank's balance sheet might indicate the bank controlled them all along, making it easier potentially for investors to sue the bank for losses on mortgage-backed securities.

Young says he's tried, unsuccessfully, to get the FASB to address Hewitt's letter through a board vote or public statement. Meanwhile, the FASB has a project to overhaul Statement 140.

Freezing subprime mortgage rates as a way to limit foreclosures may be a wonderful idea. Yet lenders shouldn't need the promise of accounting freebies to do this. If the SEC is going to dangle exemptions anyway, it should at least say so. Its mission is to protect investors, not the banking industry.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in Boulder, Colorado, at jweil6@bloomberg.net

Last Updated: February 6, 2008 00:11 EST