After years of anxiety over the FAS 133 accounting rule for hedges, the industry is reporting earnings for the first quarter in which it had to use the rule.
Most in the industry say that the new rule means at least some extra earnings volatility for mortgage lenders. The debate appears to be whether FAS 133 will be a horror or just a nuisance.
When asked to name the biggest challenges facing the mortgage industry, Wells Fargo Home Mortgage chief executive Pete Wissinger pointed to compliance with FAS 133. "In the next six to 12 months, it will be interesting to see how the industry deals with it," he said.
The Financial Accounting Standards Board spent more than three years formulating the rule, which implements stricter and more complex requirements for a company to take advantage of the hedge-accounting method. The board even delayed implementation by a year.
Though the larger members of the Mortgage Bankers Association monitored progress every step of the way, the rule is still nettlesome, said Alison Utermohlen, the group's senior director of financial management.
"It is impossible for mortgage bankers to completely avoid the headaches associated with complying with FAS 133, because risk management through hedging is an integral part of the business," Ms. Utermohlen said.
In hedging, a company creates investments designed to cushion the effects of adverse price movements on its assets. As a company's assets decline in price, the hedges should increase. Mortgage companies use hedges to protect their loan portfolios and servicing rights against interest rate fluctuations and prepayment risk.
But to be calculated into a company's quarterly earnings, a hedge must meet certain criteria - and FAS 133 has raised the bar considerably.
For example, companies now must predict the value of their hedges with more accuracy and track these hedges' success more precisely. Expected changes in value and actual changes must be within a range of 80% to 125% for a company to qualify for hedge accounting. Taj Bindra, chief financial officer of Chase Manhattan Mortgage Corp., says FAS 133 "is a complicated piece of literature. It took a while for the industry to get there and understand it."
And hedges are hard to track, since they do not always perform the way asset managers hope.
"As everyone in industry knows, no hedge is perfect," said David Zulauf, a senior vice president at Chase Manhattan Mortgage. "There are no linear relationships with value of servicing."
Fannie Mae said this week that because of FAS 133 its net first-quarter interest income had to be adjusted down $64.1 million, to $1.643 billion, and Washington Mutual reported that under the rule $102 million of its $187 million in loan sale gains were "unrealized" gains.
In addition, Golden West Financial reported a one-time pretax charge of $10 million, or 4 cents a share, upon adopting FAS 133 on Jan. 1. The San Francisco thrift company also reported a pretax expense of $8 million, or 3 cents a share, associated with the ongoing quarterly valuation of its derivatives position in conjunction with falling short-term rates.
Some lenders and industry observers argue that earnings volatility resulting from FAS 133 could drive out smaller companies. Mr. Bindra of Chase said that, while companies may be hard-pressed to garner the resources and staff needed to weather the rule, larger ones will be able to use the risk and hedging expertise of other divisions.
That may push the industry into further consolidation, Mr. Bindra said. "Folks will look at it as, 'What impact will it have on my earnings? Will I have enough scale on my business to manage the volatility?' "
The MBA's Ms. Utermohlen said smaller mortgage companies now question whether they want to stay in the business. "Some parents may not be able to tolerate the earnings volatility that a mortgage company may be required to report under FAS 133," she said.
To adapt, mortgage companies have beefed up staffing in their analytical ranks and the methods they use to track hedges and risk management.
Gerald Baker, president of mortgage services for First Horizon Home Loans, said some lenders now split a servicing portfolio into a series of risk, or hedge, "buckets" of similarly performing loans. But, techniques aside, tracking hedge movements still takes a lot of time, he said.
"The hedges used to preserve the value in servicing have to be managed on a day-in and day-out basis," he said. "The hedge strategies used have to be changing constantly to protect the value of servicing as it went up and down over time. The new rules have made it more complicated."
Other industry leaders, however, argued that FAS 133 will produce no more than a few quarters of adjustment - tinkering with numbers - and a minimal impact if any on a company's profitability or long-term prospects.
Thomas O'Donnell, an analyst with Citigroup's Salomon Smith Barney Holdings Inc., said the rule will not cause a shift in the industry. "Consolidation is based on economics, not accounting," he said. "I am expecting FAS 133 to be a nonevent."
Whatever effects it may have on earnings figures "are not indicative of long-term economic value," Mr. Baker said. "They have little to do with the operational integrity or operational value of the mortgage banking franchise."
Most companies are well prepared for the new rule, said Sachit Ramdas Kumar, senior vice president at Mortgage Industry Advisory Corp., which provides FAS 133 software and consulting to mortgage companies. Mr. Kumar said FAS 133 might increase earnings volatility a bit, but he maintains that the industry's first-quarter earnings would have been erratic anyway, because most banks already faced a bad situation hedging their mortgage servicing rights.
"Everybody falls into the same camp; everybody had losses" on their mortgage servicing rights, he said. "FAS 133 only helps if hedges are performing well."
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