The world according to GAAP.
If mortgage bankers could conjure up Aladdin, their "wish list" of accounting rule changes probably wouldn't stop at three--and would likely run counter to much of the current thinking at FASB.
When it comes to accounting, it's a tough time to be a mortgage banker. No fewer than seven projects underway at the Connecticut-based Financial Accounting Standards Board (FASB) have the potential to change the way the mortgage banking industry conducts business. FASB is the nation's official accounting standard-setter.
With so much accounting scrutiny focused on the industry, one would think the single issue nearest and dearest to the heart of Mr. and Ms. Everybanker--capitalizing servicing from retail originations--would be under discussion up in Norwalk, Connecticut. It isn't.
There probably isn't a mortgage banker in America who would hesitate to kill accounting-motivated servicing transfers by allowing originators to capitalize some value for retail-produced servicing. But FASB just doesn't see it that way.
That's why so many of the skirmishes being fought in the trenches of mortgage banking accounting today have arisen from the issue.
Facing rising net-worth requirements and earnings pressures, mortgage bankers have turned to experimental transactions designed to allow them to record a value for their originated servicing to help reduce any losses on the sale of underlying loans.
"As long as the accounting prohibits companies from recording a value for originated servicing, people will keep trying to find ways to capitalize that asset," says KPMG Peat Marwick Partner Geoffrey Oliver, of the firm's Washington, D.C. office.
By not allowing mortgage bankers to record a value for originated servicing, the accounting "literature," that is, the guidance set out for the accounting profession to follow, is at odds with the economics of the typical mortgage banking transaction.
In response, some mortgage bankers have turned to "table funding" in an attempt to record servicing values and to avoid the prohibitions on capitalizing originated mortgage servicing. In table funding, a wholesaler funds a loan originated by another firm. The loan, sold by the originator to the wholesaler immediately after closing, may be closed in the wholesaler's name or the originator's name.
The current rules inspire all kinds of accounting-motivated transactions, such as three-way servicing transfers. "People would like to have their own servicing on the books instead of others' servicing," says Oliver.
He gives another example of an accounting-based business maneuver. A mortgage banking firm allows a branch office to become an independent contractor without changing anything else. The mortgage banker table funds the loans for the old branch, buying both loans and servicing, then records the servicing rights--which have now been "purchased" rather than originated.
The trend toward reducing origination costs will continue to lead to new transactions followed by new accounting issues, Oliver predicts. "Table funding is just a skirmish of the main war. The real war is over recording the value of originated servicing on the books," he says.
Mortgage bankers are in a situation where accounting practices are driving economic and business decisions, agrees David Frank, president of Margaretten & Company, Inc. in Perth Amboy, New Jersey. Working as a member of the Mortgage Bankers Association of America's (MBA's) Accounting Issues Task Force, Frank is reviewing the relative advantages and disadvantages of amending the accounting rules for the purpose of, among other things, allowing the capitalization of originated and retained servicing.
"We're reviewing the fact that these accounting issues have not been addressed. We want to study what that impact is and what means there are to change [the servicing capitalization rules]. We've been talking to different participants in the industry to see what they're doing and why," he says.
By fall, the task force hopes to be able to make a recommendation to the full MBA Board of Governors on whether the trade group should push FASB to change the rules.
The subservicing sidestep
Accounting has also driven the actions of mortgage bankers concerned about how servicing does or does not appear on their balance sheet. Institutions concerned about the size of their balance sheets sometimes attempt to reduce their servicing holdings through subservicing arrangements.
In a subservicing deal, a mortgage banker can sell originated servicing to a buyer but continue to service the mortgages for the buyer for a fee.
FASB's Emerging Issues Task Force recently looked at the circumstances surrounding subservicing sales. In July, the task force reached a partial consensus that these transactions shall be accounted for as sales only if all the risks and rewards of the servicing rights have been transferred to the buyer.
"In July, [the FASB task force] reached a consensus that it's a sale only if substantially all the risks and rewards of having the servicing rights are transferred to the buyer. That's a pretty narrow door," says FASB Practice Fellow John Lawton.
Mortgage bankers can still use sale treatment even if they continue to service the loans they sell, as long as they're doing only simple administrative duties. "If you're only collecting the principal and interest and passing it along, it may be a true sale," says Lawton. "The task force doesn't see assuming credit risk as an administrative function."
While the sale treatment still won't allow servicers to book the gain upfront, it will remove the servicing from their balance sheet.
The controversy that remains revolves around judging when a mortgage banker has truly transferred the significant risks and rewards. For instance, is the subservicing contract cancellable by both parties? If the servicing buyer can't cancel the seller's contract to service the loans, it may not actually be a sale, Lawton suggests.
He expects the task force to meet this fall to clear up the facts-and-circumstances questions. If the task force can reach a consensus on the issues, it would publish an abstract on subservicing arrangements this fall, says Lawton.
What your accountant won't see, the IRS will take
The Internal Revenue Service (IRS) has fired a few salvos of its own in the servicing accounting war. At issue was the IRS's treatment of loan sales where the originator retains the servicing.
"Taxpayers were taking the position that the origination of a mortgage followed by the sale of the mortgage and retention of the servicing rights did not generate income. The IRS originally disputed this," explains Coopers & Lybrand Tax Partner Bernie Kent of the Detroit, Michigan office.
The IRS modified its position to say that originated, excess servicing income results in immediate income, while regular servicing does not result in immediate income.
"There is potential for abuse with excess servicing, where you can create a loss currently on your sale of a mortgage and make it up through getting more than you need for the serving rights in the future," Kent says.
For example, if a lender takes 100 basis points for a servicing fee on a group of mortgages, the yield on a pool backed by those mortgages will decline. When the lender sells the pool, it creates an artificial loss that gets made up as the excessively high servicing fee is earned over the life of the servicing.
Because excess servicing differs between servicers and loan products, the IRS defined it as anything above the standard agency fee. "It's a terrific ruling," says Kent. "It will be good for the industry."
Looking in your closets
Turning from the back end to the front end of the business, FASB is also working on disclosures about the market value of whole loans and mortgage-backed securities.
How well a financial institution's mortgage-backed securities investments are doing may soon be captured in annual reports, thanks to FASB's simple, yet far-reaching Disclosures About Market Values Project.
One of FASB's less-popular proposals, the market-value disclosure project calls for footnote disclosures of the market value of all financial instruments. The final definition of a financial instrument could include assets, liabilities, MBS, whole loans, options, swaps and guarantees.
This project is only one part of FASB's broad-based Financial Instruments Project umbrella, which includes two other projects as well (see sidebar). The market-value disclosure project is a very comprehensive proposal, yet FASB's approach is general.
"We're basically saying: |Give us your best estimate [of market value] and use whatever methods and assumptions are most cost-efficient'," says Project Manager Jeannot Blanchet.
FASB hopes to complete a final statement for the project by the end of the year but has some unresolved issues to settle first, according to Blanchet. The most important of the unsettled issues is defining the scope of the project. "We're including assets, liabilities, on- and off-balance-sheet instruments, and we have very few exclusions from the [project's] scope," says Blanchet.
But many of those who wrote to FASB after it issued the market-value disclosure exposure draft last December said they should not have to provide disclosures for all financial instruments. "They all have their list of financial instruments that they would gladly see excluded," he says.
Others want certain types of entities excluded, such as nonfinancial companies or smaller commercial banks. "The spokesmen for the community banks are telling us: |We don't need that because nobody uses our financial statements'," Blanchet explains.
Also at issue within this project: the level of guidance from FASB on how to measure market value. Not outlining specific methods for estimating market value makes it easier for firms to comply with the proposal. But it may also make it tough to compare results when firms comparing similar assets use different valuation methods, Blanchet says.
Once FASB solves these conflicts, it will issue a final statement. Its ruling could become effective as early as 1992 for financial instruments with easily determined market values and perhaps as much as a year later for tougher-to-estimate instruments, according to Blanchet.
FASB also plans to take one step beyond disclosing market information in footnotes. By the end of this year, the board may issue an exposure draft suggesting companies include in their balance-sheets market values for some financial instruments.
This project, also a part of the larger Financial Instruments Project, originally focused only on debt securities held as assets but has now been widened far enough to be renamed the Marketable Securities Project.
"Basic financial statements are what people pay attention to. It's more the management report card than footnotes are," explains Project Manager Robert Wilkins. After all, companies often base compensation on information in the basic financial statements and not on footnotes, he adds.
The project focuses on how assets are recognized and measured. In June, FASB tentatively agreed that marketable debt securities should be marked to market. And it also agreed to consider giving preparers the option of marking to market some liabilities as well.
The ability to include liabilities to offset market-value changes in assets is important to mortgage lenders who carefully match the two. If a mortgage lender marks both sides to market, then a change in interest rates will not have a significant effect on its capital, Wilkins notes.
"If the market value of the assets went up, the value of the liability would go up. But if you measure only half of that equation, and mark just the assets to market and do nothing with liability, then the adjustment of capital could give information that people might misunderstand," he adds.
However, FASB decided that, at a minimum, assets should be marked to market. It agreed to consider allowing the optional valuation of liabilities--if it can find a reasonable process for doing it. FASB still must decide which assets to include in the market valuations--perhaps Treasury-bills, mortgage-backed securities (MBSs), government securities or even conforming loans.
Independent mortgage bankers won't be greatly affected by any change, as long as FASB sticks with its plans not to include conforming whole loans in the mark-to-market proposal, says Thomas J. Murray, president of T.J. Murray Company, Englewood, Colorado.
Warehouse loans are often a mortgage banker's largest asset. If the FASB proposal had included loans held for sale, mortgage bankers may have had to report market swings that create a large volatility in earnings.
"If their loans held in inventory are marked to market every month and every year, the ups and downs could be significant," says Murray. "Unpredictability and volatility in earnings is bad for banks. It scares the investors."
If FASB adopts mark-to-market accounting, mortgage bankers will probably use more hedges, he predicts. "They may stay away from those [assets] that are subject to the greatest volatility or where they have no control over the asset," says Murray.
But, like Wilkins, he suggests that any swings in asset values could be offset by swings in the value of corresponding liabilities.
Another important area FASB must discuss before it issues an exposure draft on the Marketable Securities Project is where the unrealized gain or loss will get reported. There are two choices: run it through the income statement, or allow it to be a separate component of equity, says Wilkins.
The FASB staff would prefer to keep the market-value adjustment for securities out of the income statement, but as in all cases, the board has the final say, said Wilkins.
Market-value accounting may have great potential benefit for mortgage lenders--when the value of their assets are rising. But, it may also create a burden if implementing the proposal proves costly, points out George Benston, the John H. Harland Professor of Finance, Accounting and Economics at Emory University in Atlanta.
"Marking your loans to market should not be a problem, but it's not free," Benston says. So, FASB should have a good reason before it asks mortgage lenders to bear the costs of mark-to-market accounting.
"If it's simply to inform stockholders, I think stockholders can look out for themselves. If it's a matter of forcing the regulators to admit that we've got some insolvent or close-to-insolvent institutions out there, that's important," says Benston.
The Marketable Securities Project could also spur further change in today's mortgage banking strategies, says J. Clarke Smith, executive vice president of corporate administration at Sears Mortgage Corporation in Riverwoods, Illinois.
If mortgage lenders are required to mark their portfolios to market and can include both assets and liabilities, they'll be more inclined to protect those assets.
"If they adopt something that allows you to mark both sides, then you're going to see people willing to spend money on hedges," Smith predicts.
The prepayment crystal ball
FASB has been searching for a way to estimate an important future occurrence--one every mortgage banker would like to have a crystal ball to predict--prepayments.
By the end of August, FASB was expected to have completed an exposure draft setting more uniform guidance in the accounting for investments with prepayments, according to Jane Adams, manager of FASB's Accounting for Investments with Prepayment Risk Project.
"The issues involve when we estimate prepayments and how we recognize changes in those estimates," Adams explains.
FASB has tentatively reached several conclusions. First, it agreed to modify its Statement 91 regarding when prepayments may be considered in the valuation of an asset.
"Right now, Statement 91 requires contract life to be applied, but it provides an exception. If you have a large, homogenous portfolio, estimates of prepayments may be factored into your calculation," she says.
The exposure draft suggests eliminating the large-portfolio requirement and concludes that there are other situations in which prepayments may be estimated.
"In cases where prepayments are probable, and they can be reasonably estimated, the exposure draft would permit an investor or originator to estimate prepayments," says Adams.
FASB also tentatively concluded that in some circumstances, prepayments must be estimated. Situations may include those when prepayments are probable; when it's possible to estimate the prepayments; and also where the anticipated prepayments would have a significant effect on yield.
"Generally, that would encompass, from a mortgage banker's perspective, investments with high premiums or discounts, say, an interest-only strip. But you can't say it absolutely would encompass an interest-only strip, because if that strip prepaid in year 19 instead of year 20, it probably wouldn't have a significant effect on the yield," says Adams.
How does FASB intend to recognize changes in future cash flows due to prepayments? Currently, depending on the investments held, mortgage lenders may apply one of three interest methods to recognize changes in cash flows due to prepayments: the retrospective approach, the prospective approach or a composite approach that combines aspects of the retrospective and prospective approaches.
"The board has tentatively concluded it would prescribe the retrospective method," says Adams. "It would affect mortgage bankers that have excess servicing fees and have changes in their anticipated prepayments that are recognized currently by a composite approach," she says.
Institutions with interests in collateralized mortgage obligation (CMO) residuals would be forced to change from the prospective method to the retrospective method of accounting for prepayment changes.
FASB also said the changes in the retrospective method will not apply retroactively. Only transactions entered into in fiscal years beginning after 1992 will be covered.
It's who you are
When it's time to account for loans going bad, the type of financial institution can make a difference.
That is because the current regulatory audit guides for banks and savings and loans disagree on how to account for bad loans. The savings and loan guide published by the American Institute of Certified Public Accountants (AICPA) says you must take into account the time value of money--the AICPA bank guide doesn't.
Last winter, FASB decided to address the time-value issue by accelerating part of its Financial Instruments Project. Their decision will likely affect commercial lenders most.
"But if mortgage bankers assess collectibility on individual loans or loan relationships, then they, likewise, will be affected," explains Danita Ostling, manager of the Accounting by Creditors for Impairment of a Loan Project.
The issue seems simple: FASB has tentatively decided that impairment of a loan should be recognized when it's probable that a creditor will not be able to collect all the principal and interest due, or when a bank modifies a loan's original terms because of concerns about its ability to collect payments.
FASB also tentatively said that impaired loans should be recorded at the present value of the loan's expected future cash flows. But next, FASB must decide how to measure that value: which interest rate should be used in that present-value calculation?
Further, once the loan is recognized as impaired, how should the lender report any future payments or changes in its original estimate of future payments? "The board has to discuss how to recognize income in the future from these impaired loans," Ostling says.
Also, FASB must identify a threshold for recognizing loan impairments. Current accounting literature states that impairment is recognized when a loss is "probable." But a recent government report on failed banks by the GAO suggested "probable" was too loose of a term, and decided "more likely than not" was a better choice.
"Everybody recognizes there's significant judgment involved in deciding at what point a loan is impaired. However, because there is apparently some confusion in this area, the board will address the interpretation of |probable' as it applies to the recognition of loan impairment," Ostling says.
FASB is shooting for a fourth-quarter exposure draft on the accounting for impairment project, with a final statement in 1992, says Ostling. Until then, mortgage lenders will continue to accrue losses for impaired loans under the current standards--generally on an undiscounted basis--when their information says it is probable the loan is impaired and the loss can be estimated.
Son of FASB-96
The way mortgage bankers report losses and other tax events on their year-end balance sheets and income statement may also be changed by the issues raised in an exposure draft nicknamed "Son of 96"--so named for the statement it will delay and eventually supercede.
Under the mantle of the project, officially called the Accounting for Income Taxes Project, mortgage bankers may see changes in the way they report deferred income-tax assets such as loan fees.
In simple terms, the current accounting rules say that if a firm has a tax deduction that cannot be realized until the firm earns offsetting income in the future, it has to wait until the income is earned to recognize the tax deduction as an asset.
The difference in timing between the book and tax basis of an asset, called a "temporary difference," is the core of one of the issues raised in the income tax accounting project.
Take loan fees, for instance. "For tax purposes, you'll recognize them all at once, for book purposes you'll recognize them when they're earned," explains Project Manager John Gribble.
Companies would like to immediately recognize the tax benefits for which they believe they will have the future income to cover. But the old FASB Statement 96 prevents them from doing that.
"The board had a theory that if you had a deductible temporary difference-- a future tax deduction that hasn't hit a tax return yet--if it takes future income to earn that benefit, you can't recognize it yet," says Gribble.
In June, the Accounting for Income Taxes Exposure Draft suggested changing that rule to allow firms to consider future income. "You could go ahead and recognize a deferred tax asset, but you would have a responsibility to record a valuation allowance to reduce that asset if you believe some portion or all of the tax asset will not be received in the future," Gribble says.
FASB plans to hold a public hearing on the issue in mid-October. With final debate on the issue scheduled for late 1991 or early 1992, a final statement on the income tax accounting project could come as soon as next year.
Dona DeZube is a freelance financial writer based in Columbia, Maryland.
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|Title Annotation:||includes related article; general accepted accounting principles|
|Article Type:||Cover Story|
|Date:||Sep 1, 1991|
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