Last month the Financial Accounting Standards Board passed the long- awaited Financial Accounting Standard 122. The key changes brought about by this new standard are the required capitalization of originated mortgage servicing rights and the creation of more conservative guidelines for measuring "impairment" on all mortgage servicing.
This new standard will change the reported financial results of virtually every U.S. mortgage banking operation. Thus, it is important to understand not just the financial reporting aspects, but the business ramifications of this new standard.
FAS 122 was supported and closely monitored by the Mortgage Bankers Association of America. In fact, the MBA began the process that resulted in this new standard by asking the FASB to undertake the project in December 1992. Although there were some dissenters, the project was supported within the mortgage banking industry.
There has been much talk and ample reporting on the benefits of the new standard, focusing on a more level playing field for wholesale and retail production, a reduction in accounting-motivated servicing sales, and more flexible impairment rules.
Though those benefits are noteworthy, there are also potential pitfalls. These include:
*Adverse impact on reported servicing income.
*Increased balance sheet volatility.
*The potential for increased hedging of mortgage servicing rights.
Basically, FAS 122 requires mortgage bankers to capitalize certain of the costs of originating or acquiring a loan and the related servicing rights.
As a result, these costs, which used to be recognized as a component of the gain or loss when the loan was sold, are now capitalized and amortized over the estimated life of the servicing rights.
Under the new standard, mortgage bankers will realize higher loan sale gains today and lower servicing income in future years, as a result of the expense associated with amortizing the servicing rights.
Commercial banks that have grown accustomed to expected levels of fee- based income from loan servicing activities need to be aware that FAS 122 will result in reduction in servicing income unless their servicing portfolio grows.
In addition to a lower level of future servicing income, bankers need to be aware that capitalizing income today means that their servicing business will be less equipped to offset future reductions in loan production volume.
To illustrate this, you need to look no further than the first three months of the year. Virtually all mortgage banking operations lost money in the origination business as volumes dipped and margins narrowed, but maintained overall profitability due to high levels of servicing income. FAS 122 reduces management's ability to weather downturns in the origination cycle.
Alternatively, under the new standard, the first six months of 1995 production losses might have been lower due to the capitalization of costs. FAS 122, however, permits the capitalization of costs on closed loans only, so the ability to capitalize costs on originated loans is little consolation when there are no loans.
In the end, the standard that the mortgage banking industry worked so hard to have passed produces favorable financial reporting results only as long as originations are stable or increasing at reasonable rates.
Originations that increase too quickly would, in all likelihood, translate into a high-refinance period, and potentially an impairment of the newly capitalized servicing rights. As the old saying goes, the higher you go, the further you have to fall.
FAS 122 and its requirement to capitalize mortgage servicing rights will result in higher levels of servicing for most companies. More servicing rights, however, mean larger impairment charges in refinance periods.
The new standard does not impact the cash flows underlying originated mortgage servicing rights. Under the old accounting model, however, a mortgage banker would recognize the costs associated with the retail origination of a loan and the related servicing rights in income in the period the loan was sold.
Servicing income on the rights originated through retail channels was often viewed as an annuity in which the entity had no financial accounting basis. Though the mortgage bank did not relish the thought of high prepayments, it was not exposed to a financial statement charge if the loan prepaid as the costs of the servicing rights had already been expensed when the loan was sold.
Mortgage bankers, though concerned, did not generally lose sleep worrying about prepayment risk associated with their originated mortgage servicing rights' annuity stream, because there was no financial statement risk associated with that stream.
Under FAS 122, however, servicing rights associated with retail production will be capitalized. Though nothing has changed economically, higher-than-anticipated prepayments could result in financial statement charges and increased volatility in reported earnings. In periods of high prepayments such as late 1992 and 1993, impairment charges could be significant.
An optimist might argue that though impairment charges will grow during a period of high prepayments, financial statement income will remain unaffected due to the capturing of additional loan production volume and the capitalization of some of the related costs of this production. This view has little merit, as it fails to recognize that economic loss has occurred.
Though purchased mortgage servicing rights have always caused balance sheet volatility, hedging that risk has never been widespread, even in 1993.
Most mortgage bankers managed interest rate risk by selling servicing rights associated with retail loans at gains to offset impairment losses in wholesale and bulk servicing. With FAS 122 requiring the capitalization of all servicing rights, however, the ability to use the sale of servicing as a risk management tool will be significantly diminished.
Within the industry, there is wide recognition of the "new" volatility discussed earlier and the elimination of the servicing sale as a hedge.
Wall Street firms and mortgage bankers alike are working feverishly to find better hedges, which while becoming more common, remain imperfect, difficult to track and, in several cases, costly.
In addition, the level of sophistication needed to monitor and properly execute today's hedges is better suited to larger organizations that put smaller banks and stand-alone mortgage banks at a distinct disadvantage.
Until a more effective and simpler hedge is developed, the industry is not fully equipped to manage the financial statement volatility created by the new standard.
Also, the hedging of prepayment risk results in a narrowing of net spreads from servicing income. Hedge costs on mortgage servicing rights vary by the instrument used and can significantly reduce a given year's servicing income. Though mortgage banking was a thin-margin business before this change, servicing margins could erode further as mortgage bankers rush to insure their low-margin assets against the perils of prepayment.
Mr. Ryan is a senior manager with Price Waterhouse in Boston. Pitfalls in New Accounting Rule on Servicing Rights