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Finding a financial yardstick.

Finding a Financial Yardstick

Mortgage bankers have long posed a unique challenge for credit and investment analysts. This stems from the fact that mortgage bankers often produce only limited financial information. Furthermore, there exists no well-established methodology for analyzing the data available.

These obstacles have caused analysts to make the mistake of resorting to traditional bank and thrift analysis techniques for assessing mortgage bankers. But because mortgage banking operations differ significantly from banks and thrifts, common techniques that work well for analyzing those institutions simply cannot be applied to mortgage bankers.

To fill this void, this article offers a new methodology to help those trying to analyze mortgage banker financial data for credit and investment purposes. It provides analysts with a framework for reviewing the financial health of clients. This system evolved from a review of several thousand mortgage banker financial statements. The approach is convenient because it can be performed quickly by an experienced analyst, and relies on financial data that can be obtained readily from the mortgage banker client.

A "traditional" mortgage banker originates, markets and services long-term mortgage loans. The primary sources of income are origination fees, servicing fees, gains on mortgages sold and interest on mortgages held in inventory. Most expenses are either for personnel or interest on warehouse advances and other short-term debt used to fund inventory. While large mortgage bankers are typically owned by either a bank or a thrift, it is common for small institutions to be independent.

During the past few years, many mortgage bankers began to specialize in one or more of the traditional functions that previously had made up a part of the mortgage banker's whole operation. Some firms now specialize in mortgage origination and sell loans on a servicing-released basis. Other specialists perform a wholesaler function, purchasing large amounts of loans originated by other institutions. However, in spite of the trend towards specialization, this article focuses on analysis of traditional mortgage bankers in order to address the diversity of problems they face. However, the proposed system can be adapted to analyze the many types of industry specialists.

The unique structure of mortgage bankers makes it difficult to rely on ratio and financial analysis used to evaluate banks and thrifts. Since the mortgage lender's largest asset, mortgage inventory, represents as much as 70 to 90 percent of total assets, the process of selling large blocks of inventory can result in a wildly fluctuating asset base. The potential volatility of assets suggest that total assets should not be used as the denominator in any ratio. Therefore, return-on-assets, equity-to-assets and net-interest margin ratios are often not reliable indicators of financial health for mortgage bankers. Similarly, debt-to-equity and other leverage ratios are also not good benchmarks because warehouse lines and other borrowings are directly tied to assets in inventory.

General approach to analysis

The system we suggest ultimately requires obtaining the most recent three years of financial statement information. Many mortgage bankers will not provide their financials to the public but will release them for credit and investment purposes. The audit opinion should be unqualified and given by a certified public accountant. While qualified opinions should always be studied carefully, our experience has found that the audit opinion almost never reveals significant risk issues. Parent financials often provide information (parent/subsidiary relations, etc.) even if the analysis is performed independent of affiliates.

The analysis can be performed with only one or two years of financials, but less information makes a high rating more difficult to achieve. The general rule regarding analysis of mortgage banking subsidiaries is that they should be evaluated independently of affiliates, unless the affiliate provides a formal credit support agreement (a capital maintenance agreement, for example). If an affiliate provides formal support, then the affiliate is analyzed along with the mortgage banking operation. Affiliate strength may also be considered if one or more affiliates is severely distressed, in which case, a concern may arise that the distressed affiliate may look to the mortgage banking operation for support or embroil it in bankruptcy problems.

The analysis proceeds by completing the checklist shown in Table 1. As many attributes as possible should be checked as either superior, acceptable or unacceptable. Some of a firm's attributes will fall into only one of the three categories, whereas others may lie in a gray area between two categories and require two checks. A few attributes cannot be given a superior rating because only their "down-side" risk can be evaluated. An attribute may be left blank if there is either not enough information or if the attribute does not relate to the mortgage banking operation's structure. A final evaluation is possible if information exists for most attributes on the checklist.

Table 1 is convenient because an analyst simply checks as many attributes as possible, then looks to see if the institution is, on average, unacceptable, acceptable or superior. Greater weight can be assigned to either the capital, assets, earnings or liquidity categories depending on the purpose of the analysis. For example, capital might be emphasized for credit purposes because it provides a cushion against potential losses. Firms of any size can achieve a superior, acceptable or unacceptable rating.

Table 1 has an added advantage in that it avoids reliance on industry averages as a basis for analysis or comparisons. Industry average data has been a problem for analysts because it tends to be outdated when published, and fails to provide detail on the characteristics of strong versus weak firms.

The remainder of this article examines Table 1 in detail. Each section includes an overview followed by a detailed discussion of specific problems and concerns for all line items in the section. [Tabular Data Omitted]


There are two reasons why capital is important. First, capital provides a cushion against losses and ensures that owners have a strong financial interest in protecting the firm's health. Second, because inventory and servicing assets distort mortgage banker balance sheets, capital is the only benchmark against which asset and earnings quality can be measured. That is, book equity is a basic starting point for most useful financial ratios.

Book equity (BE) - The minimum acceptable level of capital is $5 million, and preferably $10 million, of book equity (retained earnings and common stock). Firms with book equity falling below this range are especially exposed to severe reductions in equity if earnings deteriorate. We have found that variations between firms in the capital-appreciation rates is very high for firms with less than $5 million book equity. Firms with larger capital commitments, especially those exceeding the $20 to $50 million range, tend to have more stable capital appreciation characteristics.

Servicing value - A large servicing portfolio is an important element in the viability of a mortgage banking company. It can be sold to increase earnings in less productive times, or sold to generate cash if liquidity problems arise. In many cases, a large portion of the value of a mortgage servicing portfolio constitutes "hidden protection" for creditors and investors because it is not reflected on the balance sheet in accordance with generally accepted accounting principles (GAAP). Servicing value on the balance sheet appears as "purchased" and/or "excess" servicing. This "on-book" servicing value is already recognized in book equity. However, because a portion of servicing value often does not appear on the balance sheet, an estimate must be made of the hidden "off-book" value. Statement of Financial Accounting Standards (SFAS) No. 65 requires that firms capitalize and book future servicing revenue in excess of normal servicing fees. As outlined in Financial Accounting Standards Board Technical Bulletin 87-3, the general procedure for implementing SFAS No. 65 is to capitalize servicing income in excess of the minimum fee set by government-sponsored or federally-related mortgage market agencies. In cases where loans are typically sold to private investors, the normal servicing fee rate is defined by Technical Bulletin 87-3 as a servicing fee rate that is representative of servicing fee rates most commonly used in comparable servicing fee agreements covering similar types of mortgage loans.

One way to estimate off-book servicing value is to first establish a reasonable estimate of the total value of all servicing. The value of off-book servicing is found by subtracting on-book servicing from the estimated total servicing value.

We employ a conservative estimate of off-book servicing value that assumes servicing can be sold for 1 percent of the unpaid principal balance of loans serviced. That is, off-book servicing value equals: ([unpaid principal balance serviced] [0.01]) - (on-book servicing value), where unpaid principal serviced can usually be found in a footnote and on-book servicing value is shown on the balance sheet (purchased servicing plus excess servicing). If on-book servicing value exceeds 1 percent of total unpaid principal balance serviced, off-book servicing value is assumed to be zero.

The estimated off-book value of servicing may be added to book equity to form adjusted book equity. Adjusted book equity in this instance reflects a reasonable estimate of the amount of equity that would be shown on the balance sheet if the value of the entire servicing portfolio were on-book.

Capital management - Most mortgage bankers retain either all or most of their earnings. Any large capital inflow or outflow is, therefore, significant. A large capital infusion from an affiliate is an exceptionally positive sign, especially if the affiliate is healthy. Conversely, declining capital caused by large dividend is a danger signal.

Asset quality

The key to evaluating asset quality lies in determining whether or not there is substantial risk of credit-related loss in any of the firm's assets. While mortgage bankers regularly manage problem assets as a part of servicing, they generally do not have the capital to support substantial credit risk. This implies that even modest amounts of risk exposure are cause for concern.

REO/BE ratio - Real estate owned (REO) may arise through default of loans previously sold for at least three reasons: 1) repurchase is required due the documentation or other problems, 2) loans guaranteed by the Veterans Administration (VA) are not purchased by the VA at foreclosure (no-bids) or 3) the loan was sold with "recourse." While it is often not possible to identify the reason for the REO, it is safe to assume that REO has the highest risk of loss of any asset and that only very low, steady inventory levels can be safely held. An REO/BE ratio in the 15 percent range is acceptable, whereas a ratio below 5 percent is superior and more than 25 percent is unacceptable.

ADC loans/BE ratio - Acquisition, development and construction (ADC) loans are very risky investment because their performance is very sensitive to deteriorating local real estate markets and they are difficult to foreclose and sell. Moreover, ADC projects may require more funds than anticipated to complete the project, thereby forcing a firm to unexpectedly provide additional funds. An acceptable ratio is set at 25 percent, which is only slightly higher than the 15 percent acceptable level for REO.

Assets from related parties - These assets are a concern because they may be associated with the use of corporate funds for non-corporate purposes. Notes or receivables from officers, managers or stockholders signal potential for abuse. Therefore, even small amounts may justify an unacceptable rating.

Off-book risk/BE ratio - While off-book liabilities are often undisclosed, it is important to watch for any sign that they exist. Usually found in a footnote, the most common items are loans sold with recourse, coinsurance obligations, potential losses on lawsuits and other contingencies. A modest amount of loans sold with recourse (below five times BE) is acceptable, but larger amounts (more than ten times BE) are unacceptable. The risk of coinsurance and other types of contingencies must be assessed on a case-by-case basis.

Mortgages for investment/BE - Mortgages may be held as investments because a firm has been forced to repurchase a significant amount of loans or is simply holding mortgages in an effort to earn interest income above its cost-of-funds. Investment mortgages usually do not represent as high a credit risk as ADC loans or REO, but may nevertheless expose the firm to interest-rate risk. An acceptable level is set somewhat higher than the level set for REO and ADC loans.

Servicing - Servicing can either enhance or detract from asset quality. If it appears that most of the value of a servicing portfolio (more than two-thirds) has been booked, then servicing reduces asset quality because there is a risk that a drop in interest rates will erode on-book servicing value. Similarly, there is little risk of a decline in value if only a small amount of the portfolio has been booked (below one-third).


Earnings provide information on a firm's future viability by representing a source of capital accumulation. An earnings analysis focuses on the trend and stability of "core" earnings in an effort to gauge future operating strength. Because core earnings are derived from origination and servicing fee income, stability or increases in these factors provides comfort that strong earnings will continue. By contrast, declining trends and instability in these areas signal problems.

An important earnings issue to monitor is transfer pricing problems between mortgage banking units and their affiliated institutions. We have encountered a number of cases where income or expenses between affiliates were not transferred on a market basis. For example, fees paid from a parent might be less than those typically paid in the market or funding costs for affiliate warehouse advances might be unusually high. If there is evidence of transactions with affiliates on a non-market basis, the analyst may wish to forego the earnings analysis, and instead, focus on the health of the parent and/or affiliate. However, as previously noted, a formal support agreement is needed before parents and/or affiliates can be counted on for financial support.

A second earnings problem is that accounting changes during the past several years, especially changes related to SFAS 91, have reduced the degree to which reported earnings can be interpreted. In particular, loan origination fees, and certain direct loan origination costs, are now deferred and recognized as adjustments to yield (interest income). Commitment fees may also be reported as service fee income. These changes have complicated the earnings analysis by making it difficult to identify core earnings.

In practice, however, the accounting changes may not present a significant problem. Because the amount of interest income that represents amortization of deferred fees and costs is small for most companies, it is generally not difficult to estimate true interest income. However, we recommend that the analyst confirm this fact with the chief financial officer before proceeding further with the analysis. If the percentage is large, then only the first ratio may be used for earnings analysis. However, if the percentage is small, then all of the following ratios (ratios 2 through 6 in Table 1) may be used.

Net income less extraordinary and nonrecurring items/average BE - This ratio attempts to measure core earnings by eliminating any unusual income or expense from net income. The analyst should deduct any income that has not consistently appeared during the last several years (gains from the sale of real estate, servicing, mortgages or other assets). A notable item is income from the sale of servicing. Income from the sale of servicing and other unusual income may not appear in the income statement because it has been consolidated with another line item. However, the information may still appear in a cash flow statement.

While some firms regularly sell servicing as a business strategy, servicing sales can also be used to boost earnings. A simple rule is to permit income from the sale of servicing as long as the sale does not cause the servicing unpaid principal balance to decline from year to year. If portfolio size declines, income from servicing sales should be considered a nonrecurring item.

A second caveat to keep in mind is that returns may appear high if the firm is paying little or no taxes. This is especially likely for subsidiaries of institutions with large tax shields or losses. If the firm paid no taxes, then it is useful to recompute the net-income ratio under the assumption that the firm paid taxes. Reducing the net income of a no-tax firm by one-third permits a more objective comparison of the firm's financial health with firms that are fully taxed. In addition, an adjustment must be made for taxes associated with extraordinary gains or losses.

A net-income ratio in the range of 10 to 15 percent in all the past three years indicates good financial health. Returns consistently exceeding 20 percent are clearly superior whereas losses in any of the past three years are a danger signal. Losses in two of the last three years is a red flag that should override almost all other factors as a signal of severe problems.

As a reminder, the remaining earnings ratios should be used only if it is determined that a small portion of interest and service fee income is comprised of deferred fees. If the percentage of income applicable to amortization of fees is either large or cannot be ascertained, then the following earnings ratios should not be used.

Servicing fees/origination fees - This is calculated as servicing fee income divided by origination fee income. While servicing fee income is usually reported as a separate line item, it may also include gains on servicing sold. Gains on servicing sold should be subtracted from servicing fees to maintain a conservative analysis.

Because the mortgage market is highly sensitive to interest rates, mortgage banker originations and fee income tend to be highly cyclical. It is, therefore, unusual, but a very positive sign, to see stable origination fee income over a three-year period. Relatively volatile origination fee income is much more common, but not necessarily problematic. If volatile origination income is observed, greater emphasis may be placed on the presence of a large servicing portfolio. Servicing fees help to offset cyclical origination fees by providing stable income when interest rates rise and originations fall.

Interest income/interest expense - This is calculated as gross interest income divided by gross interest expense. This ratio is an alternative to the net interest margin ratio (net interest income/average assets) commonly used in bank and thrift analysis. Mortgage bankers can often earn an interest spread between 1 and 2 percent (100-200 basis points) on inventory. Consistent with this assumption, we have found that an interest income/interest expense ratio of 115 percent is average, while a ratio exceeding 140 percent is superior, and a ratio below 90 percent is considered poor. A low ratio is usually a strong indicator of problems because it may be caused by a decline in origination volume, inventory pricing problems or high funding costs.

Non-interest operating income/non-interest operating expense - This ratio provides a measure of operating efficiency. It is also helpful in monitoring trends in salaries or personnel expense. Growth in salaries should either lag or be about equal to total income growth. Salary growth that exceeds total income growth is a warning flag. The ratio depicts the fraction of overhead covered by non-interest operating income. Items that do not arise from normal operations, such as gains from the sale of servicing, gains from securities sold and extraordinary and nonrecurrent items, should be excluded from the ratio. A ratio of 100 is average, whereas ratios that exceed 120, or fall below 80, percent are considered superior and poor, respectively.

Gains on mortgages sold/origination income - Gains or losses on mortgages sold are sometimes booked as "marketing gains" or "marketing losses." Some firms are able to earn a modest, steady gain as a result of their marketing strength, operating efficiency or other reasons. The ratio for these firms tends to be relatively stable and in the range of 20 percent or less. Firms that have much larger gains, and/or wide yearly fluctuations in gains, may be exposed to significant risk. A ratio higher than 40 percent may be viewed as unacceptable.


Liquidity is the most difficult area to evaluate. The problem is that liquidity primarily depends on access to funding. The accessibility of funds, however, may have little relation to information from the financial statements. While the balance sheet shows short-term assets and liabilities, these amounts say nothing about the firm's ability to contract additional short-term assets or liabilities. Footnotes often mention the size of lines of credit, but provide little detail regarding the structure of the lines or their restrictions. Analysts should assess whether or not the mortgage banker has adequate liquid assets to meet short-term obligations.

Mortgage banker's balance sheets do not generally classify short-term versus long-term assets and liabilities. Our approach calculates short-term assets by adding mortgages held for sale (inventory), marketable securities, reverse repurchase agreements and any other clearly identifiable short-term assets. Short-term liabilities include warehouse advances, repurchase agreements and short-term payables. An acceptable level for the short-term asset/liability ratio is in the 80 to 100 percent range. A superior rating cannot be given for the ratio because there is little reason for firms to exceed the 100 percent ratio level.

While some mortgage bankers are able to maintain independence from affiliates, many are closely integrated with the operating structure of related institutions. Affiliates often provide funding or purchase mortgages to such an extent that it is difficult to separate the mortgage banker from the affiliate. If a mortgage banking unit is run independently from its affiliates, the health of affiliates should not impact the mortgage banker. However, if affiliates are closely tied through funding or other relationships, then it may be necessary to consider their financial health.

Other information

Information from outside the financial statements is often an important complement to published financial data. This data can be readily available also. A good example is the location and demographic trends of the market area. The health of a mortgage banker's market area should be noted, along with the company's diversification throughout the region. The length of time in business should also be considered, as mortgage bankers with long track records (more than 10 years) tend to have a stronger customer base and greater experience surviving slow periods.

A single phone call to a top operating officer can often supply valuable additional information. The following are some types of data that may be requested to complete an analysis. * What is the annual origination volume

by loan type? What is the

annual volume of loans purchased

by loan type? * If "other" assets represents more

than 20 percent of total assets,

more detail about the category

should be requested. * If "other" income or expense exceeds

20 percent of total income or

expense, more detail about the category

should be requested. * If servicing fees are combined with

gains on servicing sold, a breakdown

on these items should be

requested. * If the unpaid principal balance of

loans serviced for non-affiliates is

not disclosed, this information

should be obtained for at least the

most recent two years. * Any information on relations with affiliates

is useful. Is there any type of

credit support agreement from an

affiliate? Do the published financials

accurately account for all

activities with affiliates? (For example,

do all activities reflect market


There are limitations to any analysis that is solely dependent on quantitative data. However, the authors have found that applying the methodology presented will yield an effective and consistent analysis of the published financials.

Peter J. Elmer is a financial economist for the Resolution Trust Corporation. Eileen Siegel is a credit analyst with the Federal National Mortgage Association. The authors would like to thank Allison Utermohlen, the Accounting Committee of the Mortgage Bankers Association of America, Dave Olsen and Dave Borowski for helpful comments. The views expressed are those of the authors and not necessarily those of the Resolution Trust Corporation or the Federal National Mortgage Association.
COPYRIGHT 1990 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage company accounting
Author:Elmer, Peter J.; Siegel, Eileen
Publication:Mortgage Banking
Date:Sep 1, 1990
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