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Accounting Rules May Hamper Servicers

Accounting standards that stringently define the scope of servicer discretion in dealing with properties backing securitized loans could clash with the proposal to modernize the real estate mortgage investment conduit structure to provide more discretion for servicers of securitized mortgage loans.

In connection with the accounting questions, which have been an issue for a few years now, the Financial Accounting Standards Board has set up a special project looking into what sort of discretion a servicer is allowed to exercise within the scope of FAS 140 and continue to meet qualifying special purpose entity guidelines.

This project would help define what sort of activities a servicer could undertake without needing to consolidate loans that back a securitized transaction on their balance sheets, in other words, without losing their QSPE status.

Lenders and servicers would like to qualify for QSPE status so as to get assets off their balance sheets, which would give them more financial flexibility.

Among the activities that the accounting body is deliberating are:

* A special purpose entity's ability to waive a due-on-sale provision.

* Situations involving substitution of collateral underlying a commercial mortgage-backed securities pool.

* A servicer's duties in connection with the sale of real estate owned property in accordance with the pooling and servicing agreement.

Input on this subject from representatives of the commercial and residential mortgage securitization sectors, accounting firms, the Public Company Accounting Oversight Board (an entity set up by the Sarbanes-Oxley Act to oversee the auditors of public companies), banking authorities, and the Securities and Exchange Commission is also being considered.

In the meantime, concern has arisen about a potential conflict between the accounting body's restrictive outlook on a servicer's permitted activities under FAS 140 and the REMIC modernization legislation that the commercial mortgage-backed securities industry is lobbying for.

Currently, a major knock against the CMBS industry is that borrowers find servicers unresponsive to changes after a transaction closes. The REMIC modernization act would give servicers more flexibility to deal with distressed properties and allow them to be more flexible with borrower requests after a transaction closes.

Susan Merrick, a managing director with Fitch's CMBS group, said, of the FASB restrictions, "It is one of those things that everybody in the CMBS industry

sees can be so detrimental, but FASB has a different view."

Anytime a special servicer has flexibility to workout loans and maximize proceeds, they are required to consolidate the whole transaction on their balance sheet. This "doesn't make sense from our perspective," she said.

Ms. Merrick added, "On the one hand, we want servicers to be able to work out loans to the best advantage to the trust, but on the other hand, having them consolidate the entire asset on their balance sheet doesn't do anything for the investor to understand the balance sheet any better because their risk is really the bonds that they have."

She believes that "it's important for the CMBS market the way it is currently structured to have that flexibility."

About the potential clash of the FASB's restrictive outlook on permitted servicer discretion with the REMIC legislation, another rating agency analyst source, who requested anonymity, said, "It would seem that one approach that asks for greater discretion and one approach that asks for less discretion would seem to be not on the surface compatible."

This source believes that the issues will have to be worked out, noting, "I think the industry will simply have to address the contradictions between one approach demanding less discretion and one demanding greater discretion. From a credit point of view, we've always been of the view that commercial real estate is a living, breathing asset and that commercial real estate in distress needs expertise to properly deal with it."

Jason Jacobs, a practice fellow with the Norwalk, Conn.-based FASB, told Commercial Servicer that the FASB special project is looking into what discretion is appropriate within the boundaries of statement 140 requirements.

The project was initiated last December as a result of technical inquiries about the interpretation of FAS 140 that the board received from "constituents."

About the potential clash, he said, "Changes to REMICs wouldn't have a direct impact on the requirements of Statement 140. We will consider all the information as it becomes available. Statement 140 has specific requirements that need to be met."

Mr. Jacobs expects that the additional guidance on FAS 140 will be initially available for public comment during the second quarter, and in its final version by the end of the second quarter.

George Miller, executive director, American Securitization Forum, an adjunct forum of The Bond Market Association, said that the FASB special project came about as a result of inquiries from some accounting firms that raised it as an issue that required guidance from the accounting authority.

According to Mr. Miller, "The basic issue has always been there - what is the boundary line between a permissible and impermissible degree of servicer discretion in the context of this vehicle that is supposed to be passive."

He believes that if an entity that transfers assets into a QSPE were required to consolidate the assets on their balance sheet, it would prove to be a liability.

"CMBS transactions are historically structured as sales that have the appropriate effect of removing assets from the transferor's balance sheet. If that changes in some way, it disrupts the intended accounting treatment in other ways that could have a market impact in terms of the attractiveness of this as a financing vehicle. At the end of the day, it could have a significant, adverse impact on the availability and cost of financing to commercial and residential borrowers."

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