The mortgage industry has a Y2K problem of its own.
Executives and accountants say a derivatives-accounting rule set to take effect next Jan. 1 will raise costs and create wild swings in earnings for mortgage companies, which often rely on the complex financial instruments to hedge the risks of loan servicing.
The Financial Accounting Standards Board has indicated that it may delay enforcement of the rule, known as FAS 133, for as long as 18 months. Even so, mortgage bankers would sooner or later have to come to grips with the rule-which, some say, could intensify an industry shakeout that has been going on for several years.
"There are going to be mortgage bankers getting out of the business because of FAS 133," said William B. Naryka, chief financial officer of Fleet Mortgage Group in Columbia, S.C.
Mortgage lenders are hardly the only companies affected by FAS 133, which would require firms to report derivatives at fair market value on their quarterly earnings reports. Indeed, the rule has come under fire from banks and trade groups, largely because of its complexity.
But FAS 133 is particularly problematic for mortgage companies, because it would make the hedging of servicing portfolios-already a tricky exercise-even more precarious.
When interest rates fall and homeowners refinance their mortgages, the fees that companies collect for processing payments on those loans disappear, and the market value of servicing drops. If book value exceeds market value, the company has to write down its servicing and take an impairment charge.
Many mortgage companies use derivatives whose value increases when rates fall-such as interest rate floors or Treasury options-to offset depreciation of their servicing. But hedges do not always work perfectly.
Last year, as falling interest rates spurred a refinance boom, companies such as Bank of America Corp., BankAtlantic Bancorp, and Capstead Mortgage Corp. took substantial writedowns on their servicing portfolios. BankAtlantic and Capstead subsequently got out of the servicing business altogether.
Under current accounting rules, a company whose hedge is deemed "effective" can defer any gain or loss in the hedge over the life of the servicing asset.
But under FAS 133, the gain or loss on hedge would be applied directly to the income statement. If the hedge were deemed effective, the gain or loss on the asset being hedged would also be recorded there.
For example, suppose a company had a $100 billion servicing portfolio that it valued on the books at $1 billion, the same as market value. Suppose interest rates rose, and the market value of the asset increased $200 million, but the hedge lost $180 million.
Under current accounting rules, because the hedge is considered effective, the company would "credit" the liability side of its balance sheet the $180 million loss and "debit," or write up, the servicing asset by $180 million. When the company tested for impairment, it would have a $20 million cushion.
Under FAS 133, the company would have to record the $180 million loss in its profit and loss statement. Because the hedge was deemed effective, the company could then write up the asset by $200 million, more than offsetting the loss. But the $20 million net gain would go directly to the bottom line-and would not be there to cushion the company from potential impairment the next time around.
It gets more complicated-and potentially even worse for mortgage servicers. Though there is no written rule, if the ratio of the change in the hedge to the change in the asset is between 80% and 120%, the hedge is usually deemed effective.
Currently, many mortgage companies use a 12-month average to gauge how much the behavior of the hedge has correlated to changes in value of the servicing. "The longer the period of time, the greater your opportunity to correlate," Mr. Naryka said.
There is now fear that under the new rule the period for measuring a hedge's effectiveness would be limited to three months. As a result, many hedges would no longer be "effective."
"Under 133, it's unclear as to how strictly you have to measure effectiveness," said Timothy F. Ryan, a partner in the mortgage banking group at PricewaterhouseCoopers in Boston.
The Derivatives Implementation Group, a committee of accountants that makes recommendations to the FASB, is expected in its June meeting to address the matter of how long a period hedgers may use to measure effectiveness.
Under both the current rules and FAS 133, if a hedge is deemed ineffective, the gain or loss in the hedge is directly applied to earnings.
Suppose in the example above that the hedge lost $200 million during the measurement period but the asset gained only $150 million. The ratio would be 130%-outside the band of effectiveness.
Therefore, the company would not have the privilege of writing up the book value of its asset, and would take the full $200 million loss on its earnings statement.
The upshot of all this: more earnings volatility, something the stock market does not take well to.
The damage caused by FAS 133 would be less severe in a falling rate environment, Mr. Ryan said, because the hedge would gain in value whether or not it correlated within the band of effectiveness. "Either way you get a (profit and loss) answer that reflects reality."
Another problem: FAS 133 would require mortgage companies to stratify their servicing rights for measurement of hedge effectiveness. Dividing the portfolio into smaller strata increases the chance that a hedge will not correlate, said Mr. Naryka of Fleet.
Moreover, stratification would require companies to develop new computer systems. That is hard to do, because so many issues still need to be settled by the Derivatives Implementation Group, and many companies are devoting their technology resources to making sure their existing systems are ready for 2000, noted Donald E. Lange, president of the Mortgage Bankers Association of America, in a letter to the FASB.
Indeed, many companies have imposed moratoriums on changes to their systems until next year, Mr. Lange noted. In his letter, he requested that enforcement of FAS 133 be delayed until Jan. 1, 2001.
Some see a silver lining to FAS 133, arguing that it would bring more discipline to hedging. Robert N. Husted, principal at Mortgage Industry Advisory Corp. in New York, said the rule would force servicers to check on the values of their hedges and their servicing more frequently, to pass the hedge effectiveness test.
"The more often people do the evaluation, the better their chance to average out the aberrations, or at least identify adverse trends while there's still time to correct them," Mr. Husted said. "You're playing Russian roulette if you use a wide range for valuation dates."
However, he added, "not everybody is geared up to getting accurate values daily," and derivatives dealers might get bogged down if servicers started calling them for frequent live quotes.
Indeed, FAS 133 might lead some mortgage bankers not to use derivatives at all to hedge their servicing, but instead to use Treasury bonds or other securities, Mr. Husted suggested.
