Pipeline: Accounting Changes Could Bring About Some Bad Surprises

Many mortgage executives have eagerly awaited the accounting profession's gift to the home loan business: a new treatment of servicing rights that could bolster reported earnings per share.

But along the way, the gift also became a burden that could cause earnings volatility. Simply put, mortgage companies can now put onto their books the value of any servicing on loans they originate, but they must also mark to market any portion of their portfolio, regardless of source, that has declined in market value.

The timing of the amendments to Financial Accounting Standard 65 made Countrywide Credit Industries, Pasadena, Calif., the first major company to report a significant writedown because of portfolio impairment.

The company reported a charge of more than $100 million in the quarter ended May 31, something that would ordinarily have been a heavy blow. But it also reported a hedging profit of more than $100 million that completely offset the writedown.

So the hedge - holding options to buy long-term Treasuries - helped Countrywide help itself to a profit of about 10 cents a share from the other new accounting provisions. The reason: The value of the Treasury options rose as interest rates fell and pushed down the value of a portion of its servicing.

With second-quarter reports due in a few weeks from most of the still independent mortgage companies, we could be seeing further impairment writedowns. While the biggest servicers appear to be fully hedged, some midsize and smaller companies could take it on the chin.

Companies without impairment problems, however, could benefit.

Fleet Mortgage Group, No. 3 in servicing at the beginning of this year, says it started hedging its servicing portfolio two years ago. "We and Countrywide were two of the first companies to hedge our servicing," said Kevin Race, chief financial officer.

"Since we're now 100% owned by Fleet, we don't report our results separately. But qualitatively, we've had very positive results from our hedging, offsetting any impairment that may have arisen."

He said the company used Treasury issues of various maturities in its hedging strategy.

Prudential Home Mortgage also has had a very successful hedge, according to a source close to the company.

At GE Capital Mortgage Corp., a spokesman declined to provide information about the company's operations, but industry sources said the company's servicing portfolio was fully hedged.

North American Mortgage Co., Santa Rosa, Calif., No. 2 among independent mortgage banks and in the top 30 in servicing, has taken a foolproof approach the impairment problem. "We've sold all the rights we originated in 1994 and so far this year," said Terrance Hodel, president.

North American delayed its first-quarter report in order to be able to report a profit based on other provisions of the new accounting rules.

The company's portfolio of about $15 billion appears to have little vulnerability to impairment charges at present, he said..

Standard Federal Bank of Troy, Mich., announced this week that it had restated its second-quarter earnings to reflect a gain from application of the new rules. The change enabled it to raise profits by 10 cents a share. The announcement of the restatement did not mention an impairment of its rights portfolio.

Joseph Krul, chief financial officer, said Standard's servicing portfolio was not hedged because the company believes it has a natural hedge between the mortgage company and the bank. "We do better in a declining-rate environment, just the opposite of the bank," he said.

Experts on hedging strategies are quick to point out that hedges are often imperfect and may not always deliver the expected results. The so- called natural hedge between servicing rights and loan originations is certainly an example, breaking down under the extreme boom-and-bust cycle of 1993 and 1994.

So far, there have been no disaster stories. But second-quarter reports may provide some.

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