Before Financial Accounting Standard 122 was adopted, the principal reason given in its support was that it would make the accounting treatment for originated mortgage servicing the same as that for purchased servicing. The oft-heard refrain was, it will only change the accounting, not the economics.
Under this rule, we are required to capitalize servicing rights for originated loans and recognize changes in their value caused by fluctuating interest rates. The "relative fair value" of the servicing must flow through the income statement onto the balance sheet and be amortized over the "expected life of the asset." Neither relative fair value nor expected life of the asset are defined numerically, allowing substantial latitude for application.
In considering FAS 122, there was little public discussion of how companies might use or abuse this latitude and what might result. The Mortgage Bankers Association of America, in its position paper, considered some of the business risks, but determined that they were minimal and would ultimately make us stronger. It looks like things are not turning out that way.
One unintended and unhealthy business effect of this rule has been increased price competition in the primary market. This competition is driven by those seeking market share at the expense of cash flow. Why is this happening? Who would want to record noncash revenue as income?
People operating publicly traded companies, that's who. Managers of these companies get bonuses and stock options based on book earnings, not the cash generated. When applied aggressively, FAS 122 permits the creation of book earnings without the cash flow to go with it.
Who does this hurt? Shareholders.
I recently had a conversation with a friend who is the secondary-market manager for a bank-owned mortgage company. I asked what he was quoting on a particular note rate, and he replied "par." After considering the price of the mortgage-backed security and the impact of the agency guarantee fee, etc., I concluded that he should have been at 99, or one discount point.
I asked how he got to par, and he said, "The financial guys in the bank give us 1.75% credit for servicing. Since we collect a 1% origination fee on the note rate in question, we can give one point back to the borrower and still earn 1.75%."
The financial guys in this bank may be able to show good volume and "revenue" of 1.75%, but they aren't making money the old-fashioned way.
At certain points in each cycle, many lenders subsidize the price by giving part of the servicing value, or servicing-released premium, to the borrower in the form of lower rates or fees. FAS 122 has exacerbated this practice and caused lenders who don't have long-term objectives to quote rates recklessly.
Although servicing rights are relatively liquid, they represent the present value of future cash flow, not current cash. While accrual accounting is well accepted in our industry, I believe FAS 122 allows the envelope to be pushed too far.
For instance, what happens when rates fall dramatically and homeowners refinance in droves? It's time to pay the piper - in the form of writedowns on originated servicing. When a loan pays off, the lender must take a charge to earnings in the amount of the unamortized balance of the asset.
In the aggregate, when rates fall, lenders are required to write down the value of the asset even if payoffs have not accelerated. Since the valuation is the lower of cost or market, no writeups are permitted when rates rise.
Some of the brightest mortgage bankers I know believe that a rate drop of 200 basis points will most likely cause losses greater than the net worth of more than one major institution in our industry. Consider the impact of the coming time when rates drop 25 basis points, and the borrower can refinance by clicking the refinance icon on his home computer.
Do we as an industry really want all these assets to be that vulnerable?
One partial solution is the use of a reserve instead of a writedown. If rates rise, a reserve can be reduced creating book income and increased net worth, whereas a writedown cannot be written up. When rates rise, the remaining servicing is worth slightly more since escrow balances were earned at the higher rate of return. However, this is a limited value since falling rates result in payoffs and a reduction in the outstanding balance of servicing to be written up.
We should all encourage increased competition from improved business practices, advancing technology, and a more informed consumer. But this accounting rule provides a short-term consumer benefit at the cost of dangerous volatility.
Indeed, this rule allows the potential for a financial meltdown for those who aggressively apply this voodoo accounting.
Now the Financial Accounting Standards Board is considering hedge accounting for servicing hedges. This means that if rates rise, a mortgage banker who puts on a servicing hedge would face a cash loss, and the servicing would be worth more. Therefore, the servicing may be "written up."
Although there is no additional cash in the mortgage company, the theory is that if rates stay the same for a long time (which of course never happens), then the cash flow from the servicing will be worth more over time, at present value. Go figure!
The principal justification for FAS 122 was that accounting for purchased and originated servicing rights would be consistent - but that's not always the case. Originated servicing created before the effective date of FAS 122 is off the balance sheet, and servicing originated more recently is on.
The new accounting convention was supposed to be an aid for the readers of mortgage company financial statements such as investment bankers, securities analysts, and warehouse lenders. According to the credit analysts and warehouse bankers I know, they already know to look past the balance sheet for servicing that might have value; they have been doing this for years.
One warehouse banker recently expressed frustration with FAS 122 because, she said, it has actually increased the work she must do to approve a credit line for a mortgage company. She has to back out originated rights from the reported servicing portfolio to develop a true value. Newly originated and newly purchased servicing is treated consistently on the balance sheet, but the older originated servicing is still not on the balance sheet.
Maybe that would be one good (or bad) result of a 300-basis-point reduction in yields. Most servicing would then be on the balance sheet and accounted for consistently.
FAS 122 is looking like it will have nothing but bad effects on my company, which is small and privately held. What are we doing about it? We value originated servicing as low as our auditors will allow and write it off as fast as possible. The result is that our pricing cannot be as aggressive as many competitors'.
Mr. Eustis is president of New Orleans-based Eustis Mortgage.