FAS 159 Is Finally Here
Presenting New Issues, New Solutions



Tina Reid, CFA
SVP Secondary Solutions Group

Those of us who have been Secondary Marketing professionals for a long time have vivid (and sometimes disturbing) memories of the time when FAS 133 was released. Suddenly we would be forced to undergo a grueling daily exercise of bucketing and re-bucketing our closed loan pipeline, which changed literally daily (nay, dare I say hourly?), and reallocating hedges to every bucket. Constantly adjusting for changes caused by new activity, new pools, pairoffs … entire departments were hired in some companies just to accomplish this bookkeeping task.

Sadly, all this activity didn’t do much to help us gain useful information for improving risk management. Because the correlation measurement and analysis process applied only to loans that were closed but not sold, and not to that great big pipeline of locks, it was only a partial measurement of hedge effectiveness.

Well, for all of the war-torn risk managers and their beleaguered accounting departments, the release of FAS 159, “The Fair Value Option for Financial Assets and Liabilities”, comes like a ray of sunshine. But hold on to your hats … while this new standard is definitely a move in the right direction, there will be new challenges to face in the “Fair Value” world.

Let me give you a little background to justify my opinion. When I got my CPA license way back in 1995, the issue of Fair Value Accounting was being hotly debated. It took a long time for the FASB to reach a consensus on this issue, because of a very long history of conservatism and the principle of Historical Cost Accounting. When I, and millions of other potential bean counters like me, took our first Intermediate Accounting course, we were trained in the wisdom of Historical Cost Accounting.

Historical Cost was considered to be the only real, genuine, and documentable proof of the value of an asset. The transaction price paid for an asset, in an unbiased, arms-length transaction between unrelated parties, was by its very nature an actual market price. Yes, assets often did appreciate in value, but without a true sale, one could never be certain that valuation methods would not produce an inflated value.

So most of the CPA’s out practicing in the world today were brought up believing that Historical Cost was absolute and all other methods were suspect. Every accountant has been trained that any departure from historical cost provides potential for overstating earnings and inflating balance sheets.

What’s my point? With this change, accountants will have an even greater sensitivity to the possibility that you will use the Fair Value Option on your pipeline as a means to overstate your mark-to-market values and therefore inflate your earnings. Accountants, even when they are nice people, are trained to be suspicious of you, even if your motives are pure. The important thing is to understand what the new rules are and be prepared for the audit that is surely coming.

Now from a pipeline management standpoint, the change we have been granted in FAS 159 is very simple. You can now mark your closed loans to market. No more hedge accounting or bucketing or correlation analysis. Whew! That was easy.

The sticking point will come from another recently released standard, FAS 157. FAS 157 is devoted entirely to the question “What exactly is Fair Value”? There are three types of “Inputs” defined that determine how you can calculate fair value. Here is a short summary, in a mortgage pipeline context:

Level 1 Inputs:

Assets that can be priced directly to active, exchange-traded market pricing are Level 1 Inputs. This would be your conventional and government loans. To document your pricing on these will be a cakewalk, assuming you have an agency master agreement, price them out to FNMA, FHLMC or GNMA securities pulled directly from Bloomberg or Telerate closing prices. Your servicing values associated with these loans, however, are not exchange-traded and you will need solid Level 2 inputs to justify your MSR values.

Level 2 Inputs:

Level 2 inputs are called “observable inputs”. These inputs are required for your loans you would not price to an actively traded security, and that you can’t price DIRECTLY to a quoted exchange price. This is all of your non-agency pipeline and MSR values. For Level 2 inputs, you must be able to document, clearly and concisely, your exact valuation methodology, including all of your adjustments for risk in the underlying loans. All of your pricing and adjustments must be “observable”, meaning you must be able to point to third-party sources to justify your pricing decisions. This part is complicated, but achievable with thorough price discovery, the right software technology and a disciplined business control process.

Level 3 Inputs:

Level 3 Inputs are called “unobservable inputs”. These inputs are required if you produce a product that nobody buys and you are trying to justify a value, or more commonly, you want to justify a great payup you get for aggregating in bulk or for your company’s stellar reputation. My advice is to avoid using Level 3 Inputs whenever you can. Your audit will be less enjoyable than a visit to the dentist. But where you must use them, be prepared to provide as much documentation as possible. For example, if you are trying to justify a bulk payup, you should maintain a very clear history of previous trades and how much additional payup you received compared to an easily validated benchmark. If you can create a documented history, you can transform a vague, subjective Level 3 Input into a more objective Level 2 Input.

MIAC can help you prepare for the Fair Value world ahead, with superior technology and pipeline valuation and hedge advisory services.

Our MarketShield™ pipeline management system can provide the robust technology needed to precisely price your pipeline, with documented inputs and audit-friendly outputs.

• Price loans to documented third party sources in a simple, user-friendly interface with unparalleled accuracy.

• Print in seconds the precise, to-the-basis-point detail of the price calculation for any loan selected in an audit.

• Price your bulk trades against dealer quoted pricing, conduit rate sheets, or other benchmarks with complete accuracy, allowing you a true and documented measure of your bulk trading performance.

In addition, our MIAC Secondary Solutions Group offers third-party, independent pipeline valuations. As the leader in valuation analytics in the mortgage industry, MIAC can lend credibility to your mark-to-market process by providing an independent assessment of value. MIAC is fully SAS-70 compliant and its models have been validated by the largest firms in the mortgage industry, and was named a leading pricing source by the Bond Market Association.

The effective date of FAS 159 is for fiscal years beginning after November 15th, 2007, however, you can implement early provided you adopt the new standard within 120 days of the beginning of your fiscal year. If your last fiscal year ended December 31, 2006, you will need to act quickly to document your decision to adopt Fair Value Accounting for your pipeline in 2007.