Most warehouse lenders think that net worth calculations for mortgage banking firms are incorrect because of the way that locked pipelines are valued. The correction of the calculations could significantly impact the reported net worth of companies.
A Place to Begin
Generally Accepted Accounting Principles require that everyone follows the same accounting rules. GAAP financials are produced for the benefit of users of financial statements, whom I will refer to in this foreword as Readers. Readers can include Fannie Mae, Freddie Mac and Ginnie Mae as well as secondary market investors, warehouse banks and for public companies. In addition, the category can include the Securities and Exchange Commission and the investing public.
GAAP is a good thing because it provides for comparability across an industry, across the country, or even around the world.
Mortgage companies obtain warehouse lines of credit from regulated depository institutions insured by the Federal Deposit Insurance Corp. These FDIC-insured warehouse lenders are required to receive financial statements prepared in accordance with GAAP every month or every quarter from their independent mortgage company customers.
However, there is significant controversy among certified public accountants regarding how GAAP is applied to interest rate lock commitments that comprise a significant portion of equity reported on financial statements.
I have written this foreword to lay the foundation for understanding the white paper prepared by Andy Greer, CPA that follows it. I have simplified GAAP to present this issue to the non-accountant mortgage banker.
There are significantly more complex details associated with the hedge accounting and basis adjustment to the loans held for sale and additional details addressed in the Accounting Standards Codifications surrounding the IRLC asset, fair value and mark to market, many of which are covered in the white paper.
How it Was
When GAAP is applied to mortgage lending, there are a few interesting anomalies which occur. In the normal operation of a mortgage company, a loan is often closed just before month-end. This loan is expected to be sold within two weeks at the price locked with its investor. At month-end the mortgage company prepares their financial statements. Expenses are typically sub-divided and called direct expense and indirect expense.
As an example, indirect expenses include rent for the home office and the president’s salary, while direct expenses include loan originator commission and processor bonuses. These definitions are important later: home office rent is indirect expense and originator commission is direct expense.
GAAP has very specific rules about how to count profit driven from detailed revenue recognition guidelines. As crazy as it seems today, until recently the loan fees collected at closing could not be counted as revenue because GAAP deferred loan fees until a loan was sold. Also, the anticipated loan sale gain could not be recognized until the loan was sold and the cash was received. This practice of revenue recognition when cash is received is called conservatism — one of the guiding principles among CPAs.
Many mortgage companies rightly argued that deferring all revenue until the loan is sold distorted their financial presentation for the month because all expenses (both direct and indirect) were counted without the off-setting revenue.
GAAP agreed to allow mortgage companies to defer the direct loan expenses at the same time loan fees are deferred. This way, both loan fee revenue and direct loan expense was deferred.
But what about the gain on sale?
No; the gain was still not recognized until the loan is sold. The exclusion of the gain on sale created a misalignment of expense to revenue because all of the indirect expenses were counted. We knew intuitively we should count all direct and indirect expense along with all revenue; nevertheless, this practice was followed by CPAs for many years dating back to the 1980s.
The New World for Loans Held for Sale
Around 10 years ago, GAAP introduced new standards designed to address a strategy called Fair Value Accounting. Under the strategy, a mortgage company is allowed to recognize the gain on sale (mark to market) on the loans held for sale and count the loan fees associated with closed loans. At month-end, the financials are prepared including all the direct and indirect expenses and including the revenue from loan fees and pending loans held for sale gain on sale, thus putting all revenue and expense into the month of closing. This is a simplified explanation, but it is widely accepted as the appropriate revenue recognition method for Loans Held for Sale.
Remember, at month-end when the financial statements are prepared, all direct and indirect expenses are counted for the closed loans. Users such as warehouse lenders, investors and other counterparties who receive the GAAP financial statements understand and accept this presentation for the loans held for sale using fair value accounting.
And Then, Enron
Any businessperson who lives in Texas remembers Enron, the failed energy company in Houston. Because of accounting scandals at Enron, WorldCom and a few other factors, GAAP decided it was important to evaluate the financial impact from off-balance sheet financing commitments that are subject to market risk. Enron had many special-purpose financing entities with off-balance sheet financing commitments subject to market risk that significantly, if not solely, contributed to the crash of Enron and the failure of its CPA firm, Arthur Anderson.
When I graduated from college in 1980, landing a job with Arthur Anderson was like being drafted by the Yankees. However, everything changed after Enron. With the Enron-induced demise of Anderson, GAAP said the value of these off-balance sheet financing commitments must be considered when GAAP financials are prepared.
Counting the Profit in Loan Applications
Do mortgage companies have off-balance sheet financing commitments?
Yes. IRLC we deliver to a mortgage borrower is an off-balance sheet financing commitments subject to market risk. The value of the IRLC must be considered when preparing financial statements.
But how is the value of the IRLC calculated?
First, we are talking about applications in process or potential loans, not closed loans. I’ve had mortgage company owners ask me: ‘GAAP makes me to count revenue on applications?’ Yes. GAAP requires us to count the future potential gain on sale in the locked pipeline called mark to market. GAAP calls this unrealized revenue: counted, but not collected.
To further confuse the issue, because this unrealized revenue was generated from an off-balance sheet activity, there was no asset to adjust. So, GAAP then required us to create a new asset to hold the unrealized gain. This asset was known as a derivative asset. The derivative asset exists to count the potential gain on sale from the applications in process. The important point here is the amount of the increase in the derivative asset generates the same increase in net worth.
This value of the derivative asset adds to capital. A $1 million derivative asset means net worth increased by $1 million. But, this value is what I term “funny money” because the overwhelming majority of it can never be realized in cash. As the former chief financial officer of a mortgage company, I want to increase my net worth because it makes the agencies happy and because my warehouse lenders will lend more money. So, am I going to look for a CPA firm who will give me the biggest derivative asset?
Is your Net Worth Wrong? The Battle of the CPAs
A few paragraphs ago, I mentioned how we need to offset revenue with all expenses both indirect and direct. This is where the deviation in perspective begins: The Battle of the CPAs. Under GAAP before we had fair value option, we deferred direct expense and recognized Indirect expense when intuitively we knew we should off-set all direct and indirect expenses from revenue on closed loans.
Some CPAs think the IRLC revenue should be reduced by the amount of direct costs only, while others think the IRLC revenue should be reduced by both direct and all indirect expenses. Still others favor a combination of both direct and indirect. A few think there should be no reduction in the IRLC revenue.
Who is correct?
Most of the sophisticated mortgage companies I support implement a combination approach which includes all direct expense and some indirect expense like branch rent and an allocation of overhead associated with branch activity to reduce IRLC gain.
It is astonishing to see, but some CPAs say the IRLC unrealized gain should be valued like a TBA-MBS short position with no costs to complete considered.
Is the IRLC immediately tradeable on an open market like a TBA-MBS?
No. An IRLC must experience the transformation to a closed loan and therefore must be impacted by all transformational costs, aka “costs to complete.”
The Referee — FASB
In all cases, these expenses applied to reduce the IRLC unearned revenue are called cost to complete or transformational costs.
So, what is the right amount of transformation costs? To get this question answered, I along with a group of CPAs led by Andy Greer, CPA (warehouse lender) asked the folks who control GAAP to help. The Financial Accounting Standards Board’s Emerging Issues Task Force is currently reviewing this issue to find the right GAAP to support the degree to which transformation costs are applied to the IRLC unrealized gain.
The Bottom Line
When a mortgage company sets daily pricing, the intent is to make a profit. The profit is based on all revenue and all expense. A Texas lender may price a $200,000 loan to generate 105 percent price and a 5 percent gain on sale which produces a 60-basis-point pre-tax profit. A Hawaii lender may price a $600,000 loan to generate a 2 percent gain on sale that produces a 60-basis-point pre-tax profit. The difference in the loan size changes the gain on sale to arrive at the same pre-tax profit.
What if we calculate the derivative asset using only direct expense using these examples? If Direct expense is 1 percent and both companies have a $10 million locked pipeline, then the Texas lender has a 4 percent mark-to-market gain or $400,000 derivative asset, and the Hawaiian lender has a 1 percent mark to market gain or a $100,000 derivative asset. How is a reader of a financial statement to address this circumstance when both lenders generate the sane 60-basis-point pre-tax profit but record significantly different derivative assets?
The Unrealized Issue
The derivative asset value presented on the CPA audited balance sheet of a mortgage company is often unreliable because it materially overstates and distorts the financial position of the company. The reader of the CPA audited financial statements either ignore, or reduce, or omit the impact of the derivative asset because they have no idea the extent to which costs to complete were applied.
Some warehouse lenders and other counterparties completely exclude the derivative asset amount from net worth, while others arbitrarily reduce the amount of the derivative asset by 50 percent — which if the lender is in Texas is not enough, and if the lender is in Hawaii is too much. Some warehouse lenders recalculate the derivative asset based on IRLC volume and pre-tax profit in basis points.
It is unlikely a CPA knowingly produces a report with a material misstatement, and all CPAs believe their interpretation of GAAP is correct.
However, we have a problem when each CPA’s financial statement has a different application methodology for the calculation of transformation costs.
The agencies, the SEC, and warehouse lenders, all of whom rely on CPA-audited financial statements, should not have to reduce or ignore the derivative asset because CPAs should do a better job at finding a consistent and reasonable interpretation of GAAP that embraces our shared accounting principle of conservatism.
