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Stretching out servicing's write-off period.

The recently vetoed tax bill would have hiked the tax burden on mortgage servicers by lengthening the amortization period for purchased servicing. Consumers, servicers and the RTC would be among the losers if such a measure is resurrected.

It came close to happening--actually, only President Bush prevented the enactment of a tax provision that would have hiked the taxes on mortgage servicers dramatically by changing the way purchased servicing is amortized.

The tax bill recently vetoed by the president would have stretched out the amortization period for purchased mortgage servicing from the current 7 to 10 years to 14 years. The bill would also have taken away the accelerated amortization schedules that are now widely used by servicers--which have enjoyed the blessing of the IRS and the U.S. Tax Court since the early 1970s.

The president jettisoned the bill in the final hour because it did not contain other key provisions he wanted to see in an economic stimulus package. What the vetoed bill did include was an entire section devoted to standardizing the tax treatment of intangible assets in general. This title of the legislation included purchased mortgage servicing rights (PMSR) as one of the covered intangible assets.

The policy goal of standardizing the tax treatment of intangible assets has strong support from both the Treasury Department and the powerful chairman of the House Ways and Means Committee. That combined support favors simplification of the code in an area where, currently, many intangibles are measured in rather haphazard ways. Because of the influence of the parties backing a new title in tax legislation that would clarify and standardize the treatment of all intangible assets, this issue is likely to be revisited by Congress. Industry lobbyists note that because the Ways and Means Committee chairman is so convinced on policy grounds of the need for new tax legislation dealing with intangibles, there is a good chance it could get tacked onto an "extender" bill. Such a bill is widely expected to be acted on this session if it can remain free from other more controversial items of tax legislation. The so-called "extended" bill would extend the authority for mortgage revenue bonds, the low-income housing tax credit and a few other noncontroversial items due to expire soon.

A unique intangible

A key determination that must be made by lawmakers is whether purchased mortgage servicing is sufficiently different from the other intangible assets, such as goodwill. Ways and Means Committee Chairman Dan Rostenkowski (D-IL) asked the General Accounting Office (GAO) to attempt to determine the assets that should be contained in a new intangible asset section of a tax bill. The GAO prepared a study that had three categories of intangible assets: short-term intangibles, medium-term intangibles and long-term intangibles. However, Chairman Rostenkowski favored a much more simplified approach of using a single amortization period for all assets classified as intangibles.

The mortgage servicing industry made a strong case on Capitol Hill that PMSR should not be lumped in with other intangible assets because PMSR has unique attributes that make it less intangible than other types of assets falling in this category. Financial institution regulators now view PMSR as something more along the lines of a "quasi-tangible" intangible--or a hybrid--and not a true intangible.

The argument revolves around the fact that PMSR is marketable, severable and quantifiable. The notion that PMSR is marketable is evident from the fact that roughly $200 billion to $300 billion of such assets are traded each year. The evidence that it is severable comes from the fact that PMSR is traded apart from the underlying mortgages and there are companies that are set up to simply do servicing and buy servicing on the open market to pursue this strategic niche. Finally, testifying to the quantifiable nature of PMSR is the fact that because these assets are a component of the secondary market, mortgage servicing is quantified and tracked by both those purchasing these assets and the large secondary market players-- GNMA, Fannie Mae and Freddie Mac.

Official estimates of the cost of carving out PMSR from the intangibles section of the tax bill have started to climb. That is important because that cost must be made up in other areas to produce a tax bill that is totally revenue neutral to be in accordance with the budget accord that is still binding. One industry representative who has closely watched the progress of the recent tax bill noted that the estimate from the Joint Tax Committee of carving out PMSR from the intangibles section of the tax bill started at $150 million, went to $300 million, then climbed to $500 million and then climbed to $1 billion at the time the bill reached the conference committee. Such a figure represents a significant hurdle for lawmakers. This, coupled with the fervor of the Ways and Means Committee chairman in simplifying the tax treatment of intangibles, means that this is an area of legislation that the servicing industry must monitor closely over the coming year.

To examine the specific legislative provisions that may be under consideration it is helpful to go back and look at the initial legislation introduced by Chairman Rostenkowski and estimate its potential impact on the servicing industry. That bill would establish an across-the-board 14-year amortization period, straightline method, for all intangible assets, including goodwill. Under Rostenkowski's bill the proposed change in tax law could apply prospectively; any intangible assets on a firm's books prior to the effective date and would continue to be treated as under current law.

If enacted, this legislation would have significant impact on the real estate finance industry, on the federal government and on consumers. First, PMSR, which under current law tends to be amortized over 7 to 10 years using an accelerated method, would be amortized over 14 years using a straight-line method. Simulations using a servicing portfolio valuation model suggest that the resulting increase in the tax burden on PMSR would reduce the value of servicing assets by about 6 percent. The value of the asset falls by an amount equal to the present value of the increase in tax burden.

By eroding the value of existing assets, this legislation would weaken the capital positions of financial intermdediaries with purchased mortgage servicing on their balance sheets. Moreover, it would erode the value of all servicing assets currently held by the Resolution Trust Corporation (RTC), increasing the ultimate cost of the thrift bailout. The RTC has about $40 billion of servicing remaining to sell, with a market value estimated at about $600 million. This legislation would reduce that market value by about $36 million.

In addition to reducing the value of all existing servicing assets, this legislation would increase the tax burden on all newly created PMSR relative to current law. Had this amortization period and method been in effect during 1990, the mortgage banking industry's tax burden would have been about $150 million higher than under current law. This increase in tax burden would have been partially offset by the ability to amortize goodwill.

Because the mortgage lending industry is very competitive, characterized by thousands of individual firms and by the relatively easy entry of new firms, this increase in tax burden is very likely to be passed onto consumers in the form of higher mortgage interest rates or points. Estimates suggest that mortgage lenders would have to charge about 50 basis points upfront to offset this increase in tax burden.

Impact on value of servicing assets

The current market value of an asset is derived by calculating the present value of the future, after-tax, net income yielded by that asset over its expected life. A change in tax law that reduces that future after-tax net income, or that postpones it further out into the future, will reduce the current value of an asset. When there is risk that a future after-tax net income flow expected from an asset may not be received, the discount rate the market uses to evaluate that asset is higher than if there is certainty that the after-tax net income will be received. Therefore, holding all other relevant parameters equal, a given change in tax law is likely to have a greater impact on the current value of a risky asset than on the current value of a riskless asset.

Under current law, PMSR tends to be amortized over 7 to 10 years using an accelerated method, such as sum of the years digits, double declining balance, and the FASB income method. In contrast, under the proposed legislation, PMSR placed on a firm's books after the effective date of the legislation would be amortized over 14 years using the straight-line method. This change in amortization would have a significant effect on the after-tax net income flow provided by PMSR and, therefore, on its market value.

It is helpful to review the amortization patterns for the four most commonly used amortization methods for PMSR under current law: double or 200 percent declining balance over 10 years; sum of the years digits over 10 years; the FASB income method over 10 years (liberal interpretation); and the FASB income method over the full 30-year life of the mortgage (strict interpretation). Clearly, all of the methods currently in use are considerably more accelerated than 14-year straight-line amortization. Moreover, it should be noted that the income from the servicing asset is actually received in an accelerated pattern.

Switching from the sum of the years digits over 10 years approach to the straight-line over 14 years method means that through about year 7, amortization would be lower, and so taxable income and the resulting tax burden would be higher. Beyond year 7, amortization would be higher, and so tax-able income would be lower. One way to assess the net impact of this change in the level and timing of the tax burden is to evaluate the present values of these alternative amortization methods. Figure 1 presents the present value per $1,000 amortized over these alternative methods, assuming a 14 percent discount rate. This relatively high discount rate reflects the fact that PMSR is a relatively risky asset. The sum of the years digits method has the highest present value at $708 while the proposed 14-year straight-line method has the lowest present value at $489. The fact that the present value of the 14 year straight-line amortization schedule is less than the amortization schedules currently in use means that the present value of the tax burden on PMSR would be higher.
Discounted Present Value Per $1,000
Amortized Under Various Methods(1)
Method Value
Sum of the Digits (10 years) $708
Income Method (FASB), as Practiced
 (10 years)(2) $663
Declining Balance (10 years) $651
Income Method (FASB), in Theory
 (30 years)(3) $547
Straight-line (14 years, as proposed) $489
(1)Assumes a discount rate of 14 percent.
(2)Amortized over 10 years instead of the full tail of the income
stream over 30 years.
(3)Amortized over the full income stream over 30 years.

This fact is confirmed by simulations done using an actual servicing portfolio that was recently traded. This simulation, conducted by John S. Hopkins, Inc. of Bethesda, Maryland, was performed on a portfolio of conventional, fixed-rate mortgages with an average coupon rate of about 10 percent. The loans in the portfolio were widely distributed across roughly 20 states. In the base case, this asset is amortized using the FASB income method over 10 years. In the alternative case, the amortization is changed to the 14-year straight-line method. Determining the ultimate change in market value of the portfolio required several iterations, since the initial change in amortization schedule reduced value and so reduced the amount to amortize. Ultimately the servicing valuation model converged on a new equilibrium value for the portfolio that was 6 percent less than the value in the base case.

This decline in the value of PMSR would cause a decline in the equity of all firms with PMSR on their balance sheets. For the typical mortgage banking firm, where PMSR represents about 13 percent of assets, while equity represents about 12 percent of assets, equity would decline by about 6 1/2 percent. For firms where PMSR represents a higher percentage of total assets, the percentage decline in equity is potentially much larger.

Impact on the industry's tax burden

Because the Rostenkowski legislative proposal is prospective, the tax burden on the real estate finance industry would not rise immediately upon enactment of this legislation. Rather, the tax burden would rise above what it would be under current law gradually over time as the firms in the industry acquired new purchased servicing on their balance sheets. Clearly, the rate at which the tax burden rises depends on the rate at which these assets are acquired.

To gain some insight into the potential magnitude of the increase in the tax burden, simulations using a sample of firms from the fourth quarter 1990 Mortgage Bankers Financial Reporting Form (MBFRF) database were conducted. In these simulations, amortization of PMSR was changed to approximate what it would be under the Rostenkowski bill. Then, taxable income and tax were computed again and compared with tax under current law.

Figure 2 presents the results of this simulation, broken out by size of servicing portfolio. For the average firm in this sample, the 1990 tax burden would have been $338,125 greater than under current law due to the change in amortization of PMSR. The impact on individual mortgage banking companies increases as the size of the firm's servicing portfolio increases, due to the fact that purchased servicing tends to increase as a percentage of the servicing portfolio as the portfolio increases. For the entire mortgage banking industry, the next tax burden, assuming enactment of this proposal, would have been about $150 million higher. [Tabular Data 2 Omitted]

Of course, some of this increase in tax burden would be offset by the ability to amortize goodwill in the determination of taxable income, which is not allowed under current law. Using an identical approach as for PMSR, Figure 3 presents estimates of the change in the tax burden for this sample of 102 firms resulting from the amortization of goodwill. For the average firm in the sample, the tax burden would decline by $27,800, less than 10 percent of the increase resulting from the change in amortization of PMSR. The net effect of the entire proposal--in terms of both amortizing goodwill and stretching out the amortization of PMSR--on the industry is an increase in tax burden of about $135 million per year. [Tabular Data 3 Omitted]

Impact on mortgage interest rates

The real estates finance industry is very competitive, with thousands of individual firms providing a relatively homogeneous product to consumers and relatively modest barriers to entry for new firms. Economic theory suggests that a firm of average efficiency in such an industry will earn only normal profits, or a return to capital equal to the return available in the next most productive alternative use. Under such circumstances, an increase in taxes on the industry will cause the return to capital in the industry to fall, marginal firms to exit and the equilibrium price in the industry to rise. The rise in price for mortgages restores the return to capital to a level sufficient to keep the remaining capital employed in that industry.

Based on that theoretical model of the workings of a market economy, it is reasonable to assume that mortgage interest rates would rise to offset the increase in taxes imposed on the real estate finance industry. To gauge the order of magnitude of the potential increase in the cost of mortgage credit, a servicing valuation model was again used. The average coupon rate of the pool of mortgages was increased such that the present value of the portfolio increased to equal its value under current law but with the 14-year straight-line amortization schedule. The resulting increase in average coupon rate was 1/8 percentage point, or 12.5 basis points. Rather than increasing the servicing fee, the market would most likely pass this increase in tax onto the consumer in the form of about a 50 basis point increase in up-front points and/or fees.

The tax legislation addressing the need to establish uniform treatment for intangible assets, therefore, represents a significant concern for those in the mortgage servicing business. The proposed legislation--as it relates to purchased servicing--is the equivalent of establishing a depreciation schedule for a building or piece of machinery considerably longer than its true economic life. The net effect of doing that to the servicing industry holds some significantly negative consequences for consumers and the industry alike. Richard W. Peach is deputy chief economist for the Mortgage Bankers Association of America (MBA), Thomas M. Holloway is a former senior staff economist for the MBA and Lawrence Parks is director, associate legislative counsel at MBA.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage servicing
Author:Peach, Richard W.; Parks, Lawrence; Holloway, Thomas M.
Publication:Mortgage Banking
Article Type:Cover Story
Date:May 1, 1992
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