The Financial Accounting Standards Board has proposed eliminating the accounting distinction between purchased and originated mortgage servicing rights. This change will affect institutions that originate mortgage loans, since they will now be able to report - on their balance sheets - a servicing asset for originated loans.
The amendment has several implications. First, if it is implemented as proposed in the FASB exposure draft, commercial and mortgage banks will be on a more even competitive footing because of the creation of the servicing asset for originated loans. Currently, many commercial banks cannot effectively compete with mortgage banks because mortgage bankers routinely sell their servicing rights in order to recognize the servicing asset, thereby enhancing the proceeds of a loan origination and sale.
Commercial banks usually avoid this strategy because they routinely use the relationship they have created with their mortgagors to cross-sell other financial products.
In addition, through disaggregation of the servicing portfolio, the proposal creates a series of specific guidelines for identifying and measuring the impairment of MSRs and excess servicing receivables. Therefore, institutions will need an active hedging program if they want to minimize or avoid the charges to income associated with impairments.
The amendment also will result in a more stringent standard of disclosure. Servicers will be required to report the activity in the valuation allowances for capitalized MSRs and detail their portfolios' specific risk characteristics.
As a direct result, we expect investors to become more comfortable with the earnings predictability and asset valuations of mortgage servicers. This should generally increase the price/earnings multiple that investors are willing to assign to publicly traded securities.
Near-term earnings are expected to rise as originators capitalize previously expensed items and benefit from gains on the sale of originated loans.
Prices paid for wholesale and bulk servicing rights should generally decrease. This is because the elimination of the accounting preference for purchased servicing rights will remove a primary motivation for purchasing wholesale servicing rights.
Much of the FAS 65 amendment's impact will depend upon the scope and amount of expenses included in the definition of "total origination costs."
While the amendment does not state which costs qualify as total origination costs, most industry pundits expect direct origination costs to be included - for example, loan officer commissions, hedging costs, and some pro rata share of the overhead that results from the successful closing of a loan.
However, the potential for abuse does exist, as aggressive institutions will surely try to include costs that do not result directly from the successful origination process. Many of these costs are likely to flow from the periphery of the origination process. In fact, this particular practice has long been observed in the wholesale/correspondent side of mortgage banking.
FASB's amorphous definition of total origination costs proba- bly means that comparing the financial statements of different originators will continue to be confusing. A conservative institution might include only direct origination costs in its total origination cost calculation and therefore incur higher current period expenses.
A more aggressive institution might artificially load its calculation of total origination costs, thereby deferring expenses to future periods and generally increasing near-term income. Naturally, the downside of this approach is that the balance sheet will become laden with high-basis assets; this will ultimately subject the institution to the greater potential loss associated with impairments and result in lower prospective earnings.
Determining the fair value of MSRs is an area that FASB has left open to some interpretation. While the intention is to move toward a market-based valuation, this is not always possible because the myriad of possible loan characteristics simply do not facilitate a readily "observable market price."
Further complicating the valuation process is the fact that the market for servicing rights is notoriously technical in nature, moving drastically higher or lower depending upon both supply and demand issues and, of course, timing.
In the absence of an observable market price, FASB requires that the fair value of the MSRs be estimated based on the present value of expected future net servicing income discounted at an appropriate current interest rate.
However, two important issues are still unresolved: What discount rate should be used and at what prepayment speed?
On the surface, the haziness of the definition of the proper discount rate and prepayment speed may seem irrelevant. However, the prepayment speed and discount rate are as important as the price, for they ultimately and absolutely determine it.
Consequently, these poorly defined components of the valuation calculation will again create confusion when the balance sheets of different servicers are compared.
Moreover, these issues have been a source of much abuse. Often, unrealistic discount rates and prepayment speeds have been used - depending on the servicer's desire to affect valuation - clouding the true impact of both prepayments and changes in the general market for MSRs.
Rather than an arbitrarily selected rate and speed, we believe that the broader, more liquid market for mortgage-backed securities should be the standard for determining proper discount rates and prepayment speeds.