Accounting for Loan Commitments

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Accounting for Loan Commitments

• MBA Presentation to the
• Financial Accounting Standards Board
• December 3, 2003

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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

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Single-Family Loan Commitment Process

• Topics
• Steps in Commitment Process
• Relevance of FAS 133 Model

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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

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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

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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

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Characteristics of Single-Family Residential IRLCs

• Topics
• Similarities of IRLCs and Written Options
• Dissimilarities of IRLCs and Written Options
• Implications of Written Option Treatment

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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

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Characteristics of Single-Family Residential IRLCs

• Dissimilarities of IRLCs and Written Options
• Borrower does not pay a premium at inception of
  commitment
• Borrowers 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

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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

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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

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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.

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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

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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/characteris
  tics that could affect value, and
• to ensure that a sufficient return would be
  earned on their investment

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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

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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

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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

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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

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Valuation of Single-FamilyResidential IRLCs
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Commercial/Multifamily Mortgage Commitments

• Topic
• Major differences between Commercial/Multifamily
  and Single-Family Residential Mortgage Loan
  Commitments

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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.

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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.