Warning! Proceed with extreme caution!
These disclaimers should be required on all mortgage bank financial statements until the industry and the accounting profession come to terms with the inadequacies and inconsistencies in how mortgage servicing rights are treated by generally accepted accounting principles.
GAAP accounting can obscure the true value of mortgage companies, ignore servicing runoff, and lead to short-term decisions that are inconsistent with long-term strategic plans.
These inadequacies have led a number of equity analysts, lenders, and mortgage executives to advocate an alternative approach known as net value added. NVA adjusts GAAP earnings for changes in the market value of a mortgage bank's entire loan servicing portfolio, on and off the balance sheet.
It captures the effects of unexpected prepayments on servicing revenues - a significant factor in this low-rate environment - and gives a truer picture of the economic performance of a mortgage bank.
A discussion of this subject is timely since this fall the Financial Accounting Standards Board will address the issue of mortgage servicing.
Distortions in GAAP accounting are primarily due to the difference in the way originated and purchased servicing are treated.
In general, GAAP does not immediately reflect the value of mortgage servicing rights on loans originated by a mortgage bank. Instead, this income is recognized over time as the servicing fees and other ancillary revenues are collected.
In contrast, purchased servicing rights may be capitalized on the balance sheet, and generally result in higher current year GAAP earnings. Servicing fees and ancillary revenues for purchased servicing are then offset by amortization as they are collected.
This practice makes it difficult to compare the profitability of mortgage banks with different mixes of retail and wholesale origination volume. It also encourages uneconomic decisions - such as selling a portion of originated servicing and then purchasing servicing from others - to bolster GAAP earnings.
A Telling Example
Let's look at how GAAP can distort the economic profile of a company.
Assume that Mortgage Bank A originates a $100,000 mortgage through its retail network. It collects a 2-point fee ($2,000), spends $2,500 to originate the asset, and sells the loan at par into the secondary market, producing no gain or loss.
Under GAAP, the value of the originated mortgage servicing rights, or $1,300 (130 basis points), is not capitalized on the balance sheet. As a result, GAAP reflects only a $500 loss ($2,000 in fees minus $2,500 in costs).
But suppose that $100,000 loan were acquired by a wholesale lender, rather than originated, and sold into the secondary market at par. The purchaser, Mortgage Bank B, would pay a servicing, release premium of $1,300, or 130 basis points, and earn $400 in fees, against which it would incur $100 in expenses.
Under GAAP, Mortgage Bank B can capitalize the purchased servicing on its balance sheet and record $300 gain earnings ($400 minus $100).
Who Outperformed Whom?
On a GAAP basis, Mortgage Bank B appears to have outperformed Mortgage Bank A by $800 (a $300 gain versus a $500 loss). But has it?
On a net-value-added basis, Mortgage Bank A's loss would be offset by the value of the servicing it has created - $1,300, showing a net value added of $800. For the purposes of comparison, this example ignores the impact of income taxes).
Mortgage Bank B's earnings would remain at $300 on a net-value-added basis, because the value of the servicing is already reflected in the GAAP results.
In contrast with GAAP earnings, the real economic performance of a mortgage bank is captured by NVA. Moreover, NVA permits management to focus on strategies to maximize long-term value.
While NVA provides a more accurate measure of a mortgage bank's performance, it should not be considered the only yardstick. One must also assess operating strategies, risk/return profile, and cost of capital. But with NVA, you at least start with a level playing field.