Anyone who really understands the mortgage markets understands one very important thing: securitization largely provides the critical liquidity that makes modern mortgage lending possible, something that holds true even in the agency market. Which means that anything that fiddles with securitization has the potential to fundamentally alter mortgage lending as we know it; and while we were freaking out over the fate of American International Group (AIG) and Lehman Brothers Holdings Inc. (LEH), the Federal Accounting Standards Board served notice that it was moving forward with a project that may end up meaning more to the financial markets than either firm's particular fate. (See sidenote at the bottom of this story as well: the proposed changes could affect mortgage modifications now as well.) In a press statement Tuesday, the FASB announced the release of three exposure drafts that would amend the accounting and related disclosures for transfers of assets including securitizations, and consolidation of certain off-balance sheet entities -- what one market participant has called the "securitization killer." In particular, the proposed changes seek to amend two key accounting standards critical to modern securitization: FAS 140, which establishes the concept of a qualifying special-purpose entity, commonly called the Q; and FIN 46(R), which currently provides an exception for QSPEs. Both proposed changes would effectively kill the mechanism for off-balance sheet securitization. Analysts have suggested that as much as $5 trillion would need to come back on the balance sheets of various financial institutions as a result of the proposed changes, tentatively "effective at the beginning of each reporting entity’s first fiscal year that begins after November 15, 2009," according to the FASB's statement. Which would force massive core capital needs at a time when liquidity is, at best, an endangered species; at the very least, regulatory capital ratios would come under severe stress. The Federal Reserve said in a brief statement that "federal banking agencies are evaluating the amendments," but said little more, beyond alluding to the proposal's effect on securitization. A key HW source suggested that FASB's proposal provided the smoking gun for the Fannie/Freddie conservatorship, despite no imminent threat of failure at either GSE. "This may be the gun that put the bullet into FNM/FRE, but at this point, focus is going to be marginal at best," said the source, an ABS/MBS analyst that asked her name not be used. "Presuming regulated financial institutions would have to increase capital, in current markets the outcome of that exercise is dubious. "My bet is still that the only institutions with a walloping increase in assets on balance sheet are Fannie and Freddie. Most credit cards but less private MBS than anyone expects will be 'repatriated.'" The primary exposure drafts surrounding FAS 140 and FIN 46(R) are now subject to a 60 day comment period; and you can bet comments will be flowing in from market participants looking to quash the maneuver. Sidenotes: The FEI blog has a strong take on the exposure drafts and is worth looking at ... one on the money musing from the site: An interesting question now that the proposed changes to FAS 140 and FIN 46R are out, is whether they will encourage, discourage, or have no effect on the desire of financial institutions and servicers of their loans to modify the terms of mortgages for those at risk of default, particularly subprime mortgages. Disclosure: The author held no relevant positions when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.