The financial statements of mortgage businesses will have a new look in coming quarters, and the impact of the changes should cause executives to take a hard look at some of the traditional beliefs about servicing rights.
The new accounting requirements introduced by the Financial Accounting Standards Board's statement 122 are the reason for the new look. That statement amends FAS 65 by putting originated mortgage servicing rights on the same basis as purchased rights and also establishes standards for measuring impairment of their value.
Some resulting changes in the mortgage business have been much discussed, including fewer sales of servicing rights and higher subsidies for loan originations. But most mortgage executives will have no trouble identifying their own internal reasons to look at the changes that might result from this accounting shift.
The following list includes those issues that are made more urgent by FAS 122 but also need to be addressed because the industry is fundamentally changing in the way it looks at servicing.
Issues of profitability include:
*The cost of acquiring servicing (originations or bulk purchases).
*The cost of servicing loans.
*Revenues available (i.e., float income and other ancillary income).
*The cost of funding servicing that is retained.
Issues of how to calculate the return include a choice of yardsticks:
*Return on equity.
*Return on assets.
*Return on investment.
Other issues include whether or not to outsource some part of the business, whether to sell or retain servicing, the long-term prospects for your company to make significant improvements in performance, and how your company will manage the volatility of earnings.
These are questions that we are addressing every day with clients, because the new accounting change has focused key executives on this new asset on the balance sheet. Many of the concerns have always been there.
However, the fact that the mortgage servicing asset has been off balance sheet has allowed it to be less scrutinized. Many of the traditional performance measurements have not been applied because there has not been an accounting basis for the asset.
A focus on profitability and returns from the servicing asset to its owners will shed new light on the dynamics of servicing loans and will cause businesses to change the way they currently approach loan servicing.
The industry has often heard that servicing returns exceed 20% unleveraged and are more than 30% on a leveraged basis. Little is known about these calculations because companies have different costs for both servicing and leverage. Furthermore, there are questions whether any cost basis was included for servicing rights that were off the balance sheet (before FAS 122).
Hence, the comparability and the methods of measuring the returns have not been analyzed to determine what the industry truly achieves on average. Clearly, the profitability itself is often measured differently by various companies.
Another major impact on profitability is managing the prepayment risk associated with mortgage servicing. Prepayments have recently had a severe impact on profitability of servicing because of low rates, the efficiency of mortgage borrowers in refinancing, the development of products that potentially increase prepayment risk (such as low-cost refinance loans), and the number of brokers soliciting previous clients.
One major reason for the increased interest in protecting against prepayments is that the accounting changes clearly increase the volatility of the financial statements of mortgage entities. The write-offs of mortgage servicing assets have become more defined, and as a result a prepayment wave like that of 1993 will have a direct impact on net income.
Managing this risk effectively is a growing concern to many mortgage executives. Historically, this risk hasn't been given the same degree of attention because the asset was never on the balance sheet. Companies are looking at hedging servicing rights as a way to offset the volatility.
The cost of the hedge is a new cost to consider when evaluating the profitability of the servicing.
Hedge accounting, which would allow a matching of impairment losses of the portfolio and gains on the hedge, involves some very complicated issues.
The impairment test for mortgage servicing rights, as spelled out in the new accounting rules, has companies focusing on the other risks of servicing rights also. Expanding this risk focus to foreclosures, repurchase risk, regulatory risk, and other risk areas requires management to obtain more detailed and timely information about the risks inherent in mortgage servicing.
These risks manifest themselves generically as portfolio, operational, and business risks that can individually or collectively have devastating implications for servicing returns.
The challenge for mortgage servicers is to be able to identify and protect the servicing asset more aggressively than ever before as the lack of action will now have a more immediate impact on the returns achieved and the reported financial results, as required under FAS 122.
At the portfolio level, mortgage servicers are generally aware of the major risks inherent in their servicing portfolio's characteristics - geographic concentration, loan types, investor mix, delinquency rates, and so on. However, having integrated systems, management reporting, and analyses to identify increases in these risks and their potential implications for the profitability and return calculations for the business is not common in the industry.
For example, few mortgage servicers have the ability to identify deteriorating loan-to-value ratios by geographic area and extrapolate the potential implications for servicing performance. Quantifying the dollar implication of this risk and determining an appropriate strategy to mitigate the negative impact will greatly enhance management of the asset.
Recent examples of the impact of geographic concentrations and regional economics on portfolio performance are evident from the Southwest and New England real estate collapses during the last decade and the current problems experienced by some servicers in Southern California.
Geographic exposure is one of many portfolio risks that mortgage servicers will need to assess in detail and plan for any potential negative consequences on cash flows from servicing and the fair market values of such portfolios.
Next: How management reporting requirements will change.
Mr. Oliver, a partner at KPMG Peat Marwick, is co-director of its mortgage and structured finance group. Mr. Fitzsimmons is senior manager of the group.
