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.

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.

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.