In the wake of the subprime meltdown, many investors in struggling mortgage banking companies have been asking themselves how these companies could have been recording such huge profits on the sales of bad loans. The answer is simple. These companies were required by existing accounting guidance to record a gain or loss on the sales of these loans based upon future estimates of economic conditions, interest rates and borrower default rates.

To appreciate gain on sale accounting fully, you need to understand the basic definition of a securitization. Asset backed finance expert, Richard A. Graff, defines securitization as “the process by which loans, consumer installment contracts, leases, receivables and other relatively illiquid assets with common features are packaged into interest-bearing securities with marketable investment characteristics.”

Securitizations in the mortgage industry are collateralized with home or commercial mortgage loans and are packaged into mortgage-backed securities (MBS). MBS are sold to various institutional investors that seek to realize higher returns on an investment-grade debt instrument compared with other securities with similar credit quality.

Now, here’s where it gets complicated.

This article has been excerpted from the Journal of Accountancy. Read the full article here.