July 25 (Bloomberg) -- Back in 1998, as the subprime- lending industry imploded, critics blasted the loose rules that allowed profits to be booked under ``gain-on-sale'' accounting - - the financial world's equivalent of crack cocaine. While the rules got a few patches, they stayed largely intact, and most investors forgot the whole mess.

Nine years later, the subprime world is imploding again. One difference now: The folks who write U.S. accounting standards say they want to redo the rules, insisting that their desire predates the current debacle. Whatever the impetus, it's about time.

If you had to list the culprits for the subprime-mortgage mess, the Financial Accounting Standards Board would be a good place to start. Under its rules, lenders that sell blocks of loans to certain types of off-balance-sheet trusts are allowed to take the loans off their books and record immediate profits. Often, the gains are permitted even if the lenders still bear risks of losses on the loans, and even if they still hold influence over the trusts' activities.

That's not how it was supposed to work. In principle, under the Byzantine standard known as FASB Statement No. 140, lenders are supposed to surrender control of the loans before recognizing gains, and the lenders' interests in the trusts are supposed to be passive. In practice, however, the rules are so full of exceptions that the broad principles have little meaning.

``Our experience indicates that Statement 140 is broken,'' says Tom Linsmeier, who joined the Norwalk, Connecticut, board last year. ``What we need to do is take a fresh approach.''

Big Fix Needed

For now, the FASB is seeking another short-term fix by amending Statement 140. It could be a big one, though, aimed squarely at the securitization industry, which packages pools of loans into asset-backed securities and repackages them into exotica like collateralized debt obligations.

On May 30, the board said it will look hard at eliminating the concept of off-balance-sheet trusts -- called qualifying special purpose entities, or QSPEs -- from Statement 140 entirely. The likely effect: Lenders no longer could record sales on transfers of loans or other financial assets to securitization trusts in which they have continuing involvement.

Instead, the transactions would be treated as secured borrowings, and the assets would stay on the lender's balance sheet, though possibly in a way that would show the specific liabilities to which they're linked.

Different Look

While that wouldn't get rid of gain-on-sale, it would be much more difficult for lenders to record immediate profits, unless they sold their loans to independent third parties lock, stock and barrel. Such a change would affect any company that securitizes loans or accounts receivable, including credit-card companies and many manufacturers.

If it weren't for QSPEs, the securitization industry might look very different today. That's partly because mortgage lenders might not have lent so much money to people with poor credit, if the rules hadn't let them front-load their profits and show smaller balance sheets to investors.

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.

Crashes Past, Present

Time and again, gain-on-sale has proved its power to addict, from the crashes at FirstPlus Financial Group Inc. and Mercury Finance Co. back in 1998, to the 2007 wave of collapses led by New Century Financial Corp. Take one puff, and it feels euphoric. To keep getting the same high, however, you must take bigger and bigger hits. Before long, you may end up in Chapter 11 rehab.

Statement 140 had envisioned QSPEs as ``brain-dead'' entities akin to wind-up toys, meaning they aren't supposed to exercise judgment or discretion. Any actions they take -- such as responding to a customer's default -- are supposed to be automatic responses to circumstances clearly spelled out in the documents that created the trusts. If lenders remain involved in servicing a QSPE's mortgages, they're supposed to take limited roles, like collecting borrowers' payments or executing foreclosures if needed.

In practice, servicing has taken a much broader role, and FASB officials say the QSPE concept has proven unworkable. At a June 22 meeting with FASB members, the Mortgage Bankers Association presented a paper taking the position that Statement 140 permits QSPEs to grant ``concessions to debtors experiencing financial difficulty'' on the grounds that this, too, is part of servicing activities. The FASB didn't issue a response.

Reset Time

When I asked Stephen Ryan, an accounting professor at New York University, if this is correct, he said the question boils down to whether the contemplated restructuring activities are entirely specified in the legal documents that established a given trust.

``If yes, then QSPE status seems unaffected,'' he says. ``If no, then QSPE bye-bye.''

About $900 billion of subprime adjustable-rate mortgages will reset at higher interest rates by the end of 2008, according to Bank of America Corp. analysts. Ryan says he suspects some lenders may be trying to head off foreclosures on loans held by QSPEs that lack the right documentation.

If all this looks needlessly complex, that's the point. A sale should be a sale, not an accounting fiction. Linsmeier is right: The FASB should rewrite its standard. Just don't wait for the next blowup.

(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: July 25, 2007 00:04 EDT