Financial Accounting Standard 122 is now a part of generally accepted accounting principles and must be adopted no later than 1996 for companies whose fiscal year ends Dec. 31.
But how does an executive responsible for a mortgage banking business manage the potential pitfalls associated with this new standard?
The first step is to determine whether or not to adopt FAS 122 early. This decision will be driven by several factors, primarily focusing on the company's profit goals for 1995.
If reported earnings in 1995 are a priority, then FAS 122 can be adopted retroactively to Jan. 1 for a calendar yearend company, resulting in what could be a significant increase in reported earnings.
If, however, current-year earnings and budgetary targets are not a significant issue, companies can opt to defer adoption. This could cause a business to forgo additional book income in 1995, but would allow for 1995's servicing rights to have no accounting basis. These rights could be sold in future years without applying the proceeds to any recorded basis in these assets.
The adoption provisions of FAS 122 provide Dec. 31 yearend companies with one year to build a "cushion" in the form of servicing rights with no accounting basis, which can then be used in the future to generate gains. Early adoption of the standard, however, eliminates this feature.
The decision on timing of the adoption must be made from the organization's overall perspective, not just from the standpoint of the mortgage banking subsidiary.
FAS 122 requires that servicing rights be capitalized. This, however, does not mean that companies concerned about capitalizing future income today have no alternatives.
The standard requires that rights be capitalized based on their relative fair value. While it provides guidance on determining values, servicing rights are not homogeneous. There is a degree of subjectivity that allows for assumptions to be used that will limit a company's exposure to future prepayments.
Using market quotes on the low end of the range or conservative discounted cash flow assumptions that reflect the company's views on the fair value of the servicing rights takes significant discipline. The temptation to increase current-period reported earnings by using more aggressive assumptions needs to be managed.
Management can also control exposure to prepayments by adopting more conservative amortization approaches for capitalized servicing rights. FAS 122 requires that the asset be amortized in proportion to, and over the period of, estimated net future servicing income. Once again, however, determining how and over which period net servicing income will be earned is subjective and can change dramatically as assumptions change.
In addition, regulatory guidelines set by the OCC require that mortgage servicing rights be amortized over no more than 15 years. Using this regulatory requirement for GAAP purposes could result in quicker amortization, thereby limiting the financial reporting exposure to prepayment risk.
Summary analyses of servicing rights capitalized and comparisons of capitalization rates to peers will provide senior management with a sense of how conservative their company is. In addition, management should request analyses that show how much of the total estimated servicing income on any given servicing right is being capitalized.
Remember, FAS 122 requires that rights be recorded based on relative fair value applied to costs. That results in rights being capitalized to the extent that certain costs were incurred and not necessarily what management believes to be the total fair value.
Senior management that continuously challenges the appropriateness of capitalization and amortization rates will have a better understanding of the profit levers behind reported earnings and will be less likely to be surprised by future writedowns.
In addition, management must understand the factors influencing the mortgage bankers' motivation, such as programs that compensate based on short-term profits, thereby encouraging aggressive assumptions. Failure to exercise this type of oversight could lead to unexpected results.
FAS 122 will result in increased volatility in most mortgage bankers' balance sheets. This is a result of the capitalization of mortgage servicing rights and the fact that the ultimate collectability of servicing rights depends on several factors, the most significant of which is mortgage prepayment rates.
Thus, the ultimate realization of recorded mortgage servicing rights depends, to a large extent, on the accuracy of assumptions made at the time of capitalization.
While using more conservative assumptions will decrease volatility exposure, servicing rights will nonetheless be capitalized and volatility will not be eliminated.
Mr. Ryan is a senior manager with Price Waterhouse in Boston.