With recent changes in accounting treatment, mortgage servicers will need to relearn the art of risk management. With originated servicing now on the balance sheet, lenders are entering a whole new environment, where hedging will be all important.
Last year marked the end of the golden age of independent mortgage banking. Gone are the days of true entrepreneurialism. Look for fewer full-service retail mortgage bankers and higher cost of entry to the industry, and all due to a simple accounting change.
Welcome to a new era under Financial Accounting Statement (FAS) 122 with a bigger, wilder, more thrilling roller-coaster ride for earnings, demanding more capital and new ways to manage financial risk. The Financial Accounting Standards Board (FASB) pronouncement 122 modifies the treatment of mortgage servicing rights (MSR) from the way servicing had been treated under FAS 65. It eliminates the distinction between purchased mortgage servicing rights and originated mortgage servicing rights.
FAS 122 sends thinly capitalized companies to the showers because it removes the accounting impediment for public capital and for publicly traded financial institutions to enter retail mortgage banking. The new accounting guidelines perpetuate the evolution of mortgage banking that began with the introduction of GNMA securities, continued with the overhaul of the thrift industry and regulatory changes, and accelerated with the proliferation of wholesale lending. FAS 122 changes the industry's focus, players and way of doing business. It changes the whole landscape.
Public capital sources looking to invest in the mortgage banking industry will no longer consider only wholesale lenders or financial institutions. Now they will include retail mortgage companies. Capital sources no longer focus on origination volume and servicing portfolio size. Instead, they concentrate on the cheapest method of production and weigh the risk to future earnings through unanticipated prepayments called impairments.
Capitalizing originated servicing rights allows mortgage bankers to exchange near-term income gain for long-term amortized expense. Implementing FAS 122 requires selecting an amortization method, developing portfolio risk characteristics, estimating fair value and analyzing impairment periodically. Initially income grows, but so does the on-balance sheet mortgage servicing and the risk of impairment. Thus, over time, the balance sheet becomes more vulnerable to changes in the value of servicing rights. Mortgage bankers must manage this "new" volatility, because public capital sources demand sustainable returns.
Mortgage bankers acquire and maintain income-generating assets. They need low-cost capital sufficient to fund the ongoing acquisition of servicing through retail production, and they need the technology necessary to stay competitive. Low-cost capital sources need stable earnings growth. How else do price/earnings multiples expand? Sustainable earnings growth is a tall order for an industry marked by wild swings in returns on equity, even with the governor of servicing sales helping to smooth the gyrations in income. FAS 122 complicates the task, but it forces companies to see and to do away with the structural impediments to reducing earnings uncertainty.
Most mortgage bankers manage risk by reacting to events. FAS 122 removes the ability to sell servicing to manage income shortfalls, a chief tool for reactive managers. Gone are the choices of when to recognize the servicing value created under the old FAS 65. Managers can no longer sell servicing to generate income, thus avoiding or minimizing operating losses.
Some of the banks that decided to sell their mortgage divisions state they are victims of "irrational pricing," and their mortgage divisions "detract from shareholder value." Their actions display a belief that the "new" balance sheet volatility is unmanageable. It is, if they are reactive hedgers.
FAS 122 shuts down the reactive manager and makes it difficult for managers with a responsive risk-management style. Some mortgage bankers respond to trends or patterns of behavior by boosting originations or restructuring their servicing portfolio. But now, managers will no longer be able to handle servicing runoff by simply increasing loan production equivalent to the run-off. The numbers do not work (see "Whistling Past the Graveyard" in the May 1995 issue of Mortgage Banking).
Nevertheless, managers try to increase production by "buying the market" to mitigate the runoff problem. They offer borrowers rates lower than investors require. The justification often is "rates cannot go much lower so the servicing associated with the new production is more valuable" than previous period production. Accounting guidelines for determining "fair market value" allow them to make this justification. Unfortunately, it soothes the symptom of lower profits due to runoff, but the real or systemic problem of profit instability remains. Increasing the cost to produce servicing ends up making matters worse, but the delay between origination and impairment (the writedown of the mortgage servicing rights) can be so great that managers never see the error of their ways.
Others look to solve the problem of lower earnings due to runoff by suggesting that secondary marketing can "go long" or "make up the difference." Why not...