Pitfalls lurk in plan to change servicing rules.

The Financial Accounting Standards Board initiated in the fall of 1993 a project to make the accounting for originated mortgage servicing rights more like that for purchased mortgage servicing rights.

The FASB expects to issue in the near future an exposure draft that will provide, in certain circumstances, for servicing from originated mortgages to be capitalized.

If such a pronouncement is approved, the need for mortgage bankers to sell servicing in order to immediately recognize its value for accounting purposes will disappear.

Currently, this proposed amendment to statement 65, still a preexposure draft, requires that its provisions be applied prospectively, with retroactive application prohibited.

Consequently, the value of servicing from mortgage loans originated before the adoption of the proposed pronouncement cannot be immediately recognized unless sold.

Excess Servicing

In addition to conforming accounting for originated and purchased mortgage servicing, the proposed statement addresses accounting for excess servicing and measuring impairment of mortgage servicing assets.

Excess servicing is the value of fees that the servicer will receive over and above a normal servicing fee. The value of excess servicing, as well as other mortgage servicing assets, is highly susceptible to prepayment risk resulting from changes in interest rates.

Under the proposed accounting for initially recording originated servicing, no servicing asset is to be recognized on a loan that is to be held rather than sold. If the loan is to be sold with servicing retained, the asset is recognized.

If the originator plans to sell the loan upon origination and has a definitive plan in place to securitize or sell the loan while retaining the servicing right, the measurement of OMS would be at the date of origination.

If a plan is not in place but the loan is ultimately sold and the servicing right retained, the measurement would be at the sale date.

The allocation of the cost basis of OMS and the underlying loan is to be done using relative fair values of each component applied to the carrying value of the originated loan at the date of measurement.

Changes in Practices

The fair value used for OMS should exclude any value of excess servicing and be based on a quoted market price or the present value of expected future net servicing income discounted at an appropriate current interest rate.

Accounting for excess servicing will not be significantly changed from current practice, except that in initially recording excess servicing, an allocation between the underlying loan (without OMS) and excess servicing would be done on a relative fair-value basis.

The proposed statement provides for another significant departure from current accounting for mortgage servicing rights, in that gains realized from the sale of purchased loans, for which servicing is retained, no longer result in a reduction of the mortgage servicing asset but are recognized as income.

Statement 65 currently restricts gain recognition from loans purchased with the intent to be sold with servicing retained. This accounting, like the lack of recognition of OMS, often brings criticism from the mortgage banking industry as the basis for such accounting appears to be one of conservatism rather than of accounting theory.

Reduced Impact of Impairments

However, with the dramatic drop in interest rates in the early 1990s, this conservative accounting often reduced the impact of substantial impairments in mortgage servicing assets caused by increased prepayments.

Under the proposed FASB statement, a very broad approach in determining impairment of all mortgage servicing assets is presented. It provides that mortgage servicing assets be evaluated by stratifying the assets based on risk. The FASB has not yet provided a definition of risk characteristics.

In evaluating risk, the FASB proposes that impairment be determined using current values, and any impairment of individual strata be provided, not in the form of a writedown but as a valuation allowance. Contrary to present practice, this would allow later increases in value to be realized. Because the provisions of this proposed statement will be substantially different from current practice, it is expected that there will be a great deal of response during the comment period.

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