The House Financial Services Committee heard testimony from lenders and regulators Friday on a proposed bill that would allow banks to count recently modified mortgages as accrual loans on their balance sheets – meaning the loan can be counted on to be repaid. The emerging concern is twofold, however, where modified mortgages could be counted as an asset and not a liability. This may create a false assumption of capital requirements, especially for lenders with large amounts of modified mortgages on the books. Secondly, put simply, modified mortgages are at a higher risk of re-default than other, similar loans. Rep. Bill Posey (R-Fla.) introduced H.R. 1723, the Common Sense Economic Recovery Act of 2011 in May. The bill would change how banks and regulators count a loan as accrual when determining whether or not these institutions meet safe capital requirements. According to the bill, modified mortgages can be considered accrual for accounting purposes as long as it is current and the borrower did not miss a monthly payment in the previous six months. James McKillop, CEO of the Independent Banker's Bank of Florida and a representative of the Independent Community Bankers of America, said the current "oppressive exam environment" constrains lending at a time when the economic recovery needs it. "There is an unmistakable trend toward arbitrary, micromanaged, and unreasonably harsh examinations," McKillop said. He pointed out that examiners require write-downs of performing loans based on the value of the collateral and force banks to place loans in nonaccrual status even if the borrower is current. George French, the deputy director for the risk management division at the Federal Deposit Insurance Corp. said the bill is duplicative of what the regulator already does. It is a misconception, French said, that a modified loan remains in nonaccrual status even if the borrower demonstrates an ability to repay. A loan can be, in fact, be counted as accrual as long as the borrower stays current for a period of more than six months. But the bill goes too far, he said. "Under the proposed legislation, as long as an amortizing loan is current and has performed as agreed in the recent past, institutions could disregard currently available borrower financial information indicating that the borrower lacks the ability to fully repay the principal and interest on the loan going forward," French said. "This, in turn, would enable institutions to include accrued but uncollected interest income in regulatory capital when its collection in full is not expected." Simon Johnson, a professor of entrepreneurship at the Massachusetts Institute of Technology and a member of the Congressional Budget Office panel of economic advisers, said the bill would effectively lower capital requirements for banks saddled with impaired assets. "In some ways, the bill duplicates what the FDIC already does," Johnson said in testimony before the committee. "But classifying loans as 'accrual' when they are either not receiving the full interest due or when the institution knows there will be a problem is not a good idea." This is especially a concern because of the redefault rate on modified mortgages. According to the Treasury Department, mortgages modified through HAMP beyond eight months delinquent redefaulted at a rate of 28%, compared to a 16% redefault rate for loans modified before five months delinquency. "In addition, modified loans are treated the same way as other loans in the bill – so that if a borrower comes to the bank knowing that he or she will not be able to make the next payment, those loans could still be treated as accrual loans because – under the bill – they are still technically current even though the bank knows that future payments are uncertain," Johnson said. Write to Jon Prior. Follow him on Twitter @JonAPrior.