Comment: New Accounting Standard Highlights Servicing Risks

If you think chief executives don't care about financial accounting standards, FAS 122 will prove you wrong. The release of the accounting rule is changing the way the mortgage banking industry views its mortgage servicing asset investment. The new standard is having a significant impact on a mortgage company's balance sheet, income statement, operations, and servicing strategies (buying, selling, holding, and hedging).

Although some of the risks associated with mortgage servicing rights have always existed, they are highlighted by FAS 122, as an increase in risk will have a more immediate impact on reported financial results and returns.

In addition, regardless of whether the asset has been on-balance-sheet or off-balance-sheet, many mortgage banks were not forced to closely manage this asset in the past.

However, now that financial statement issues exist, the economic risks associated with this asset have become more significant. Mismanagement of the servicing asset that may have gone unnoticed in the past will now be the focus of CEOs, chief financial officers, and stockholders.

Even for smaller companies, FAS 122 may have a material impact on financial statements. For example, $100 million in production could have an impact of $1 million or more to a company's bottom line. The mortgage banking industry must address and effectively manage these new issues and risks.

Among the financial ramifications, the standard puts an asset on the balance sheet that is highly sensitive to interest rates. This asset is required to be carried at the lower of unamortized cost or fair-market value on an ongoing basis, which inherently creates earnings volatility. The volatility and risks associated with this asset will cause (and has already caused) companies to scrutinize their buy, sell, and hold decisions on servicing rights.

Many companies that have retained servicing in the past may find that it is more economical to sell servicing than retain it as a balance-sheet asset.

In fact, many companies may not be able to justify retaining the asset in periods of high servicing values. In addition, for those companies that retain servicing, the associated volatility will increase their focus on hedging, which introduces additional issues and risks to manage.

Many chief financial officers and servicing managers are now struggling with the appropriate method of managing this new asset financially as well as operationally.

From an operational perspective, mortgage companies must consider and plan for systems, organizational structure, disaster recovery, and FAS 122 monitoring procedures. Items that affect profitability and cost to service will affect a company's overall bottom line and therefore will require additional scrutiny.

Managing the on-balance-sheet asset will undoubtedly add to a servicer's cost, which will affect profitability and performance results. Therefore, the process and operational issues associated with implementing the new standard are significant to senior management.

The increased risk of earnings volatility because of servicing assets has mandated the need for more comprehensive and flexible systems to analyze and track servicing assets and excess servicing assets for management purposes, as well as both generally accepted accounting principles and tax purposes.

To appropriately manage these assets, companies, regardless of size, must procure the right technology or set of tools. Although most mortgage operations understand the major risks inherent in mortgage servicing, the appropriate systems to manage these assets have not existed in the past.

Having an integrated servicing asset management system to analyze risk, profitability - for accounting and tax issues - portfolio valuation and analysis, hedge analytics, and management reporting, is critical for effective evaluation and results.

A system that meets one or more but less than all of these needs will put the company at a disadvantage in bidding on and maintaining servicing portfolios. The system should have the capability to perform all of the following at the loan level:

*Calculate fair-market value of mortgage servicing rights.

*Calculate amortization of loan servicing rights based on the cash flow method of amortization.

*Stratify the portfolio of loans under a multitude of scenarios based on unique loan-level attributes.

*Calculate impairment based on company-defined risk parameters.

*Calculate excess servicing rights.

*Calculate amortization of excess servicing for accounting principles and tax purposes.

*Calculate amortization for bulk purchases for tax purposes (straight line).

*Calculate cash flow of various hedge instruments and their impact on cash flow and overall return.

*Calculate duration, convexity, and risk associated with given groups of loans based on underlying loan characteristics.

*Perform interest simulations and rate shock analysis.

*Either perform or integrate with option-adjusted spread models.

A servicing asset management system must give a company comfort in analyzing its portfolio of loans and assist in developing a risk management strategy. The strategy should identify the specific risks associated with a given servicing portfolio and identify which solutions are best available to minimize risk.

Many of the traditional performance measures, such as ROI, ROA, and ROE, have not been used to measure servicing portfolios in the past because there has never been a consistent accounting basis.

Now that this basis exits, a first step in establishing a risk management strategy, is establishing appropriate hurdles (ROI and ROE) to monitor the asset's performance over time. It will be interesting to monitor the assets' performance in relation to what was predicted, particularly as they relate to prepayments or foreclosure costs/losses.

In the past, many organizations were unable to track prepayments or foreclosures by loan attributes over time. However, tracking prepayments or foreclosures over time gives a company insight as to how a given portfolio, or segment of a portfolio, may prepay or foreclose in relation to the national averages or consensus averages.

Analysis of this type may shed new light on the dynamics of servicing loans and may cause mortgage banks to change the way they approach the servicing investment.

Next: A further look at designing a servicing management system.

Mr. Oliver is a partner of KPMG Peat Marwick and co-director of its mortgage and structured finance group in Washington. Ms. Kogler is senior manager of the group.

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