Downey Financial — perhaps the best known of the option-ARM specialists, although there are others — put out a press release today that said the bank’s auditors, KPMG, are forcing them to book loan modifications as part of reported non-performing assets. It turns out that Downey has been running after a good chunk of its option ARM-holding borrowers, trying (desperately?) to modify their loans into an adjustable-rate mortgage that doesn’t permit negative amortization. Not that you could blame them, although I get the sense this is exactly the sort of thing Downey wishes hadn’t been made public. The problem here is that there’s a meddlesome accounting rule known as SFAS 114 that governs just this sort of thing — you know, just in case a financial institution wanted to, say, start modifying loans for current borrowers that it obviously thinks are at high risk of defaulting. The result is a press release that reads like a kindergartener complaining about the teacher. Witness the verbosity of Rick McGill, Downey’s president:

“During December 2007, KPMG advised us that upon further review of the modification program, it was likely the loan modifications should be recorded as troubled debt restructurings. After reassessing our initial analysis, we determined these modified loans should be accounted for as troubled debt restructurings. This conclusion was reached because in the current interpretation of GAAP, especially in the current housing market, there is a rebuttable presumption that if the interest rate is lowered in a loan modification, the modification is deemed to be a troubled debt restructuring unless the modified loan can be proved to be at a market rate of interest based upon new underwriting, including an updated property valuation, credit report and income analysis. We did not perform these additional steps since borrowers who qualified for our retention program were current and we were trying to streamline the process for qualified borrowers to modify their loans at interest rates no less than that being offered to new borrowers.”

In other words, Downey has been modifying option ARMs as fast as it can, and isn’t bothering to wait for things like a new appraisal, running credit or even determining whether the borrower can afford the restructured loan. Sure sounds like loss mitigation to me. The result of forcing these modifications onto the books is a pretty significant spike in non-performing assets — expected now to be 7.8 percent of total assets at year’s end, when Downey had previously reported 3.65 percent worth of NPAs one month earlier, in November. Reported NPAs jumped for previous periods as well. The originally-reported 3.65 percent for November 2007 was restated to 5.77 percent — note that even with the restatement, NPAs are skyrocketing at Downey. If the numbers hold when Q4 results are released, that means non-performing assets will have jumped 35 percent in just one month between November and December of last year. The rest of the restated numbers:

(HT: Tanta, who wonders who else was using Downey’s interpretation of “troubled debt restructurings.” Disclosure: At the time this post was published, the author held no positions in DSL.