Readers
of financial statements are confused by the inconsistent,
complex and incomplete disclosures of mortgage banks’ implementations
of mortgage servicing rights (MSRs) Financial Accounting
Standards (FAS) 133 accounting procedures. The Mortgage
Bankers Association and the Financial Accounting Standards
Board (FASB) response to this financial transparency problem
is to allow mortgage bankers to elect fair value, or mark-to-market,
accounting for their MSRs.
This step will do some good, do some bad, and ultimately do little
to improve the situation for readers of financial statements
and simply obfuscate the real problem.
On Aug. 11, FASB issued an exposure draft of a proposed statement
of financial accounting standard that will amend the current
FAS 140. Under the proposed FASB elect to maintain all separately
recognized mortgage servicing rights at fair value.
Once a mortgage bank has capitalized its servicing rights, the
company would be
________________________________
Sachit R. Kumar is the managing director of the
capital markets group at Mortgage Industry Advisory
Company (MIAC). He over sees the monthly valuation
and hedging, FAS 140 accounting, FAS 133 accounting,
MSR loan-level tax accounting and pipeline FAS 133
accounting of over $2 trillion of MSRs, whole loans
and residuals.
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permitted
to elect either the current lower of cost or market (LOCOM)
accounting or the proposed fair value accounting for each
class of separately recognized servicing asset . This election
would be permanent: Once a company decides that it will use
fair value accounting, it cannot go back to LOCOM.
KUMAR |
Industry
participants have had differing views from the beginning
of the FASB fair value initiative. The proposed statement
accommodates all participants by allowing them to switch
to fair value accounting on an elective basis . Most mortgage
banks that elect not to hedge their MSRs will continue
to use the less volatile LOCOM accounting for MSRs. Only
the active MSR hedgers are likely to elect to switch to
fair value.
Fair value accounting, while eliminating hedge accounting, could
significantly increase the volatility of the income statement if
the service Mortgage
banks that are not hedging their servicing asset |
would
prefer to keep their LOCOM accounting for their servicing
asset.
The
good
Proponents of the movement to fair value assert that
by having both sides of the equation - MSR assets and
derivative hedges marked-to market - the financial statements
of the institutions will become easier to understand
. Furthermore , the principle motivation for moving to
fair value accounting is to eliminate the complex hedge
effectiveness testing and implementation requirements
for FAS 133 and MSRs.
Mortgage banks that had wished to hedge their MSRs but were intimidated
by the complexity of implementing FAS 133 will certainly be more
inclined to initiate MSR hedging programs. This will reduce earnings
volatility and risk management practices.
Of the large mortgage banks that hedge their MSRs, nearly all have
business procedures in place to hedge the economic risk at the
MSR portfolio level or at a very aggregated product-level basis,
such as all fixed-rate conventional MSRs.
However, FAS 133 requires that measurement of hedge effectiveness
be done at a similar-asset level, although procedures for creating
similar assets and the statistical methods
for measuring price sensitivity and
hedge effectiveness are certainly
highly complex and very difficult
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Motivated To Hedge
Institutions electing to use fair value, or mark-to-market,
accounting
will be motivated to hedge their mortgage servicing
rights while they
are still in their pipelines because the loans are
subject to lower-of-costs-or-market accounting rules.
An example illustrates the situation. |
At Close |
At Settlement (Rates Fall) |
Basis Change At Settlement |
Loan MTM: 100 |
Loan LOCOM: 100 |
MBS Component: 99 |
MSR Component: 1 |
Hedge Position: -99 |
|
Loan MTM: 100.75 |
Loan LOCOM: 100 |
MBS
Component: 100 |
MSR Component: 0.75 |
Hedge
Position: -100 |
|
. |
. |
MBS
and Hedge Change: 0 |
MSR
Change: -0.25 |
. |
|
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| SOURCE:
Mortgage Industry Advisory Co. |
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As a result, the embedded value of the MSR booked
at close will have declined at settlement. At settlement, the
initially booked embedded value of the MSR will have to be
written down to fair value. Because the mortgage-backed securities
portion of the loan is effectively hedged while in the pipeline,
the change in the fair value of the MSR during this period
will impact earnings and increase its volatility. Unless the
fair value electors begin to hedge their MSRs while they are
in the pipeline, they will increase their earnings volatility.
The ugly
Heretofore, auditors, regulators
and equity analysts have faced some
serious issues on how to accurately
measure the fair value of MSRs. The
procedures for GAAP fair value accounting are well established;
however, readers of financial statements
usually believe that fair value is a
close proxy for estimated market value. For illiquid and
complex assets
such as MSRs, this is often not the
case.
Previously, this issue has been
most pronounced in periods of declining interest rates when
the MSR
values are impaired. However, in a
world of fair value of MSRs, the fair
value of the MSRs on the market value will become apparent
in all rate
environments.
The issue isn’t whether the company
properly implements fair value accounting procedures, but whether
the fair value properly reflects a value of the MSRs that the
readers of
the financial statements believe it is
telling them.
The current lack of transparency or understanding of the
financial statements is not the result of the complex FAS
133 procedures
and their particular implementations. The lack of transparency
in the financial statements is the result of highly complex
and difficult -to -validate methods for determining the fair
value of MSRs, not complex hedge effectiveness measurement
techniques.
Ticking time bomb
The most difficult and obfuscated issue for readers of MSR
balance sheets is the methodology and accu
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for non-MSR
hedgers to understand. By electing to use fair value accounting
of the MSRs, the hedging at the highly-aggregated level
will be accurately reflected in accounting statements.
With fair value accounting,
mortgage banks could start hedging their risk exposure
at the enterprise level, where they could look at the mortgage
pipeline and the MSR portfolio
together
and hedge their net risk exposure. Effectively integrating
these symmeterical risk profiles doesn't work currently because
the
MSR cannot be written up beyond the amortized book basis. Mortgage
banks could take advantage of the fair value accounting and
could use analytics that facilitate hedging their net risk
exposure
of the mortgage pipeline and the MSR portfolio.
The bad
Under the current MSR hedging practice, mortgage banks focus
primarily on hedging their impairment risk. Acoounting risk
strata that has a higher market value than the amortized book
basis of mortgage servicing asset will have no affect on the
income statement. And, as a result mortgage banks don't hedge
the market value change above the amortized book basis. |
If a mortgage
bank switches to fair value accounting, the whole market
value change on its entire servicing portfolio will go into
the income statement. This will likely force mortgage banks
to hedge 100% of their servicing portfolio market value risk.
As a result, mortgage banks will likely incur higher hedging
costs.
Over the last few years,
under current accounting, mortgage banks have built in
huge impairment reserves that they still plan to recover.
If interest
rates start rising, mortgage banks will recover these reserves
and start building a book cushion at the accounting risk
strata level. With a cushion established, they will hedge
only to the extent that they havfe the impairment risk
exposure at the accounting risk strata level and therefore
incure
lower MSR hedging costs than hedging 100% of fair value
change. Institutions electing to move
to fair value will be increasingly motivated to hedge their
MSRs while they are still in the pipeline. Loands in the
pipeline that have closed and not yet settled are subject
to LOCOM accounting. This mea ns that if rates fall during
the closed-to-settlement period, the value of the loans will
appreciate; however, LOCOM will not permit upward adjustment
in their book basis. Nevertheless, the value of the MSRs
will decline during this period. |
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racy
of the MSRs’ fair values. GAAP fair value methods
allow considerable latitude in the methodologies for price discovery
of illiquid assets. Without a liquid marketplace, which valuation
method permissible under GAAP fair value accounting can be used
to most accurately replicate market values ? This ongoing de
bate within the industry is often characterized and simplified
as the “option adjusted spread vs. static” debate.
Another contributing factor to the confusion surrounding reading MSR balance
sheets is the widely divergent set of equity analysts that cover mortgage banking
that read the GAAP financial statements. Currently, mortgage banking companies
are covered by analysts in the auto, lodging industry, thrift , money center
bank, European bank and mortgage banking sectors.
Can
this diverse set of analysts acquire the expertise needed
to understand this complex financial asset?
Surely this widespread confusion represents an opportunity
for some equity analysts to do their homework and fully understand these
MSR valuation issues.
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Ultimately,
if a company’s GAAP fair value differs greatly from a reasonable
market value, someone is going to be held accountable. Most likely, eliminating
the analyst’s focus on understanding the complexities of FAS 133 implementations
will make his job slightly easier, but it won’t address the fundamental
problem with GAAP statements.
Are the recorded book values on these balance sheets approximately
equal to the estimated market value of these assets,
which is the objective of
fair value
reporting? This is a very serious question and will emerge as the most
significant debate in the mortgage banking industry
in coming years.
The proposed amendment to initially measure all separately
recognized servicing rights at fair value will be effective
for transactions occurring in the
earlier of the first fiscal year that begins after Dec . 1 5 or fiscal
years beginning
during the fiscal quarter in which the final statement is issued. |
The amendment would require the subsequent measurement at fair
value, if elected, to be applied to existing classes of servicing
rights as of the beginning of a fiscal year or to initial recognition
for new classes of servicing rights. The statement would enable
entities to make a permanent election to subsequently measure
a class of separately recognized servicing rights at fair value
after the earlier of fiscal years beginning after Dec. 15 or
the fiscal year that begins during the quarter in which the final
statement is issued.
The subsequent measurement of a class of separately recognized
servicing rights at fair value would be applied prospectively
to all new and existing separately
recognized servicing rights within that class. The adjustment to reflect
the carrying amount of separately recognized servicing
rights existing at the date
of initial application of fair value measurement would be reported as a cumulative
effect adjustment to beginning retained earnings. Early or retrospective
application of this proposed statement would not be
permitted.
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