Accounting for Loan Commitments MBA Presentation to the Financial Accounting Standards Board December 3, 2003
Topics to be Discussed • Single-Family Residential Loan Commitment Process • Characteristics of Single-Family Residential Interest Rate Lock Commitments (IRLCs) • Valuation of Single-Family Residential IRLCs • Commercial/Multifamily Mortgage Commitments
Single-Family Residential Loan Commitment Process Topics: • Steps in Commitment Process • Relevance of FAS 133 Model
Single-Family LoanCommitment Process Steps in Commitment Process: • Borrower completes loan application • Mortgage banker evaluates application based on underwriting requirements • Mortgage banker approves/denies application • If approved, mortgage banker issues commitment letter specifying loan amount, term, interest rate, fees, points and qualifying conditions
Single-Family Loan Commitment Process Steps in Commitment Process: • Upon commitment, mortgage banker has entered into an interest rate lock commitment (IRLC) • Commitment period generally extends from 30-60 days • The IRLC exposes mortgage banker to interest rate risk if the lender intends to sell the loan upon origination • Consequently, mortgage banker typically hedges this interest rate risk using derivatives
Single-Family Loan Commitment Process Relevance of FAS 133 Model: • Under FAS 133, as amended by FAS 149, the IRLC is required to be accounted for as a derivative • FAS 133 appropriately provides for offsetting changes in the values of the IRLCs and related hedge instruments to be recognized in earnings in the same period to avoid misleading recognition of only half of a paired transaction • FAS 133 model is critical to the accurate portrayal of the economics of mortgage banking companies’ operations due to the magnitude of their loan production hedging activities
Characteristics of Single-Family Residential IRLCs Topics: • Similarities of IRLCs and Written Options • Dissimilarities of IRLCs and Written Options • Implications of Written Option Treatment
Characteristics of Single-Family Residential IRLCs Similarities of IRLCs and Written Options: • Mortgage banker is obligated to perform if borrower meets qualifying conditions • Business practice permits nonperformance by borrower
Characteristics of Single-Family Residential IRLCs Dissimilarities of IRLCs and Written Options: • Borrower does not pay a premium at inception of commitment • Borrower’s evaluation of option value takes into account factors beyond the financial terms of the commitment itself • Potential for loss of appraisal, credit report, other qualifying costs • Risk of not meeting terms of home purchase contract • Borrowers therefore exercise “out-of-the-money” options all the time • The optionality risk in an IRLC is embedded in the loan pricing which is established by the lender
Characteristics of Single-Family Residential IRLCs Implications of Written Option Treatment: • Mortgage banking companies are in the business of making money which conflicts with written option treatment • Mortgage banking companies routinely value IRLCs when acquiring production franchises • Option treatment would significantly misrepresent the economics of mortgage banking companies’ IRLCs and related hedging activities
Valuation of Single-FamilyResidential IRLCs Topics: • Definition of “Fair Value” in FAS 133 • Applicability of “Fair Value” definition to IRLCs • Valuation techniques for IRLCs at inception • Valuation techniques for IRLCs subsequent to inception • Diversity in Practice
Valuation of Single-FamilyResidential IRLCs Definition of Fair Value: • SFAS 133 defines “Fair Value” as follows: • “..the amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” • Quoted market prices in active markets are the best evidence of fair value and should be used, if available. • If quoted market prices are not available, the estimate of fair value should be based on the best information available in the circumstances. • Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved… • Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, future expenses, including assumptions about interest rates, default, prepayment and volatility.
Valuation of Single-FamilyResidential IRLCs Applicability to IRLCs: • Quoted market prices for IRLCs are not available • Occasionally, through company acquisitions, market prices for IRLCs can be observed • In general, valuation techniques are utilized to value IRLCs by estimating the expected future cash flows
Valuation of Single-FamilyResidential IRLCs Valuation Techniques at Inception: • Consider the cash flows that a third party would include in bidding on an IRLC or commitments • Those cash flows would include the cash inflows and outflows that the third party would anticipate receiving/paying related to the commitment, including secondary market gains/losses on the sales of the loan, as well as FAS 91 costs and fees, adjusted for the portion expected to close • A third party would discount the future cash flows to: • compensate for estimation errors predominantly around closing ratios and loan quality/characteristics that could affect value, and • to ensure that a sufficient return would be earned on their investment
Valuation of Single-FamilyResidential IRLCs Valuation Techniques at Inception: • Specifically, the following cash flows would be taken into account when estimating the future cash flows expected to be received/paid: • Expected gain/loss on sale of the loan, which would include: • a direct valuation of the entire interest rate on the underlying loan • the total coupon can be valued as the sale of the entire note rate on the loan or as the sale of the majority of the interest strip, with a retained servicing right • any origination fees to be collected • any discount/premiums on the underlying loan • any costs expected to be incurred in originating and selling the loan • These cash flows would then be directly adjusted for the expected close ratio and then risk-adjusted to compensate for estimation errors predominantly around closing ratios and loan quality/characteristics that could affect value
Valuation of Single-FamilyResidential IRLCs Valuation Techniques at Inception: • These cash flows can be benchmarked to observable market evidence • quoted prices for MBS securities (the likely outlet for the loans once funded) • service release premiums paid through the correspondent channels of production • Other evidence, such as historical fallout ratios, can also be observed • Ultimately, variances between assumptions utilized in the valuation techniques and the realized cash flows can be observed within a short time period (45-60 days) as the loans move through the origination and sale processes • This ongoing comparison ensures that the valuation techniques are consistent with the realized cash flows
Valuation of Single-FamilyResidential IRLCs Valuation Techniques Subsequent to Inception: • Subsequent to inception, mortgage market rates are likely to change, such that the value of the IRLC will also change as this will impact the ultimate secondary marketing gains/losses expected to be realized upon loan sale • In addition, as the IRLC moves through the origination process and is closer to being funded, this valuation approach would likely result in an increasing value as the risk associated with pipeline management diminishes
Valuation of Single-FamilyResidential IRLCs Diversity in Practice: • Similar to other financial instruments, diversity in practice can exist due to some of the judgement involved in the valuation techniques for IRLCs • Increased disclosure around valuation techniques and accounting policies could enhance financial reporting and investor understanding
Commercial/Multifamily Mortgage Commitments Topic: • Major differences between Commercial/Multifamily and Single-Family Residential Mortgage Loan Commitments
Commercial/Multifamily Mortgage Commitments Differences: • Borrower has a short timeframe (usually days or weeks) to accept the commitment • Borrower must pay a commitment fee upon acceptance of the commitment. • At that time, the commitment is a legally binding contract between mortgage banker and borrower. • This is the primary reason why a very high percentage of commercial/multifamily commitments are closed.
Commercial/Multifamily Mortgage Commitments Differences: • Many commercial/multifamily commitments, particularly those that are underwritten for government agencies, like FHA and Fannie Mae, are subject to the mortgage banker finding a purchaser of the loan. In this case, the mortgage banker is not subject to interest rate risk.