2013 Financial Institutions Conference Mortgage Banking Accounting

Transcription

1 2013 Financial Institutions Conference Mortgage Banking Accounting

2 Mortgage Banking: Session Overview Accounting treatment Issues related to borrower interest rate lock commitments Case Study Issues related to derivatives used to hedge exposure Case Study Options available for accounting for loans held for sale Practice observations and regulatory matters Disclosure matters 2013 Crowe Horwath LLP 2

3 Accounting Treatment Relevant Accounting Guidance: ASC 815, Derivatives and Hedging (formerly FAS 133 DIG C-13) and ASC Loan Commitments that relate to the origination of mortgage loans that will be held for resale must be accounted for as derivatives. ASC 820, Fair Value Measurement (formerly FAS 157 par 17d) Initial fair value may not equal transaction price Value of borrower loan commitment is of whole loan, which includes servicing rights Recording borrower loan commitment at fair value typically results in Day 1 gain ASC 825, Financial Instruments (formerly FAS 159) Fair Value Option 2013 Crowe Horwath LLP 3

4 Accounting Treatment Securities & Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 109 Codified as: Topic 5: Miscellaneous Accounting DD. Written Loan Commitments Recorded at Fair Value Through Earnings Supersedes SAB 105 (IRLC value excludes MSR) Borrower IRLC value includes MSR (Conforms to ASC 820) Borrower IRLC value continues to exclude internally generated intangibles Crowe Horwath LLP 4

5 Accounting Treatment Overview of Accounts (Balance Sheet): Assets Borrower Loan Commitment Derivatives IRLC Derivative Asset Sales Contract Derivatives Hedge Instrument Derivative Asset Loan Held For Sale FV Gain/Loss on Loans HFS Liabilities Borrower Loan Commitment Derivatives IRLC Derivative Liability Sales Contract Derivatives Hedge Instrument Derivative Liability Derivative assets and liabilities should not be netted unless there is legal right of offset as per ASC Even if netted on balance sheet, derivatives must be shown gross in footnotes per ASC Crowe Horwath LLP 5

6 Accounting Treatment Overview of Accounts (Income Statement): Income Statement G/L Loan Commitment Derivatives Accrual G/L Sales Contract Derivatives Accrual FV Gain/Loss on LHFS Accrual Gain on Sale Cash Report in one line Mortgage Banking Income Accrue at period end, reverse first day of next period Transfer Deferred Fees/Costs Direct costs of origination should be reported with mortgage banking income 2013 Crowe Horwath LLP 6

7 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) Borrower Interest Rate Lock Commitments (IRLCs) Rate lock offered to borrower Forms commitment to lend at stated rated for stated period Creates derivative that needs to be valued Primary components: Projected sales price of loan based on market interest rates Projected fall-out rate Remaining origination fees/costs to be incurred Level 2 valuation in fair value hierarchy, generally Borrower derivative assets and liabilities cannot offset for accounting purposes 2013 Crowe Horwath LLP 7

8 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) IRLC Valuation + Today s forward sales price (10~60 days) + Anticipated ASC (Formerly FAS 91) Fees - Anticipated ASC Costs - Recourse Loss Exposure = Gross Value x Anticipated Pull Through Rate Lock Value Notes: Valued as whole loan, which includes value MSRs (regardless if being sold released or retained) Valued independent of related sales contract 2013 Crowe Horwath LLP 8

9 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) Case Study Let s walk through hypothetical transaction from origination to sale We ll start with borrower IRLC side, taking look at various components that impact fair value: Impact of passage of time on probability of pull through Movement in market rates We ll follow borrower IRLC from lock date with customer (T0) to funding of loan (T3), and see what impact passage of time and movement in rates have on transaction We ll look at this exclusive of hedge instruments used to mitigate interest rate risk, which we will cover separately Facts: Lock with customer to originate $100,000 at 4.375% within 60 days 2013 Crowe Horwath LLP 9

10 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) Case Study IRLCs Illustrative Valuation Example T0 Inception T1 Rates up 50 bp Loan at Processing T2 Rates down 100 bp Loan Approved T3 Loan at Close Loan amount A $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 Market value with servicing % % % % % % Origination costs to be incurred 1.00% 1.00% 0.50% 0.50% 0.00% 0.00% Value as percent of loan (1) B 1.25% -0.75% -0.25% 3.75% 4.25% 4.25% Dollar value A * B C $1, ($750.00) ($250.00) $3, $4, $4, Pull through percentage D 70.00% 80.00% 85.00% 85.00% 90.00% % Derivative value C * D $ ($600.00) ($212.50) $3, $3, $4, Amount recorded $ ($1,475.00) $ $3, $ $ Includes servicing rights and considers net cost of origination Pull through is often affected by changes in interest rates 2013 Crowe Horwath LLP 10

11 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) Case Study Recording transaction (continuing from our illustrative example) Inception (T0): T1 Enter borrower IRLC to originate $100,000 loan at 4.375% valued at 1.250% Market rates increase 50bps to 4.875% Pull through increases to 80% based on evolution of IRLC T2 Dr IRLC Derivative Asset $ Cr Mortgage Banking Income (IRLC) $ Dr Mortgage Banking Income (IRLC) $1, Cr IRLC Derivative Asset $ Cr IRLC Derivative Liability $ Market rates decrease 100bps to 3.875% and pull through increases to 85% Dr IRLC Derivative Asset $3, Dr IRLC Derivative Liability $ Cr Mortgage Banking Income (IRLC) $3, Crowe Horwath LLP 11

12 Issues Related to Borrower Interest Rate Lock Commitments (IRLCs) Case Study Loan at Closing (T3): Market rates hold at 3.875% Pull through is now 100% at closing Dr Loan Held for Sale $100, Dr FV on Loan Held for Sale $ 4, Cr Cash $100, Cr IRLC Derivative Asset $ 3, Cr Mortgage Banking Income (IRLC) $ 1, Recap Cumulative gain of $4,250 on the IRLC/loan Origination costs of $1,000 incurred 2013 Crowe Horwath LLP 12

13 Issues Related to Instruments Used To Hedge Exposure Forward Sales Commitments and To Be Announced (TBA) Securities Mandatory forward sales commitments and TBA securities are derivatives and are accounted for at fair value Can be accounted for as cash flow hedge but very complex Loan level and bulk sale Commitments can be written on individual loan basis or bulk sale Bulk sales offer better margins, but increase risk in fulfillment and associated cost of pair off Best efforts sales contracts are also considered derivatives because delivery of loan typically becomes mandatory after closing, and closing contingency is not considered within evaluation Generally Level 2 in fair value hierarchy 2013 Crowe Horwath LLP 13

14 Issues Related to Instruments Used To Hedge Exposure Case Study Using previous borrower IRLC to funding scenario, let s take a look at accounting for instruments we use to hedge interest rate risk We ll follow hedge instrument from contract date with investor (T0) to loan sale, or fulfillment of contract (T4), and see what impact passage of time and movement in rates have on transaction Keep other side of transaction in mind, which is borrower IRLC and net impact on income statement as we record changes in fair value Note mismatch in movement in borrower IRLC value and hedge instrument, caused by the pull through assumption on IRLC If hedging entire pipeline, this would represent need to manage over/under hedging Facts: Commit to sell to investor loan principal of $100,000 at 4.375% at point in time in the future (T4) 2013 Crowe Horwath LLP 14

15 Issues Related to Instruments Used To Hedge Exposure Case Study Illustrative example Let s visit other side of borrower IRLC example from earlier T0 Inception T1 Rates up 50 bp Loan at Processing T2 Rates down 100 bp Loan Approved T3 Loan at Close Loan amount A $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 Market value with servicing % % % % % % Origination costs to be incurred 1.00% 1.00% 0.50% 0.50% 0.00% 0.00% Value as percent of loan (1) B 1.25% -0.75% -0.25% 3.75% 4.25% 4.25% Dollar value A * B C $1, ($750.00) ($250.00) $3, $4, $4, Pull through percentage D 70.00% 80.00% 85.00% 85.00% 90.00% % Derivative value C * D $ ($600.00) ($212.50) $3, $3, $4, Amount recorded $ ($1,475.00) $ $3, $ $ Hedge instrument value $ - $2, $2, ($2,000.00) ($2,000.00) ($2,000.00) Assumptions Mandatory forward sales contract with terms matching loan and borrower IRLCs and sales contract offset except for impact of pull through on IRLC Loan sale occurs on date of closing 2013 Crowe Horwath LLP 15

16 Issues Related to Instruments Used To Hedge Exposure Case Study Illustrative Example (cont.) Inception (T0) Enter into forward commitment to sell loan and record associated derivative $100,000; 4.375% loan at T1 T2 No entry Contract is written at market rate Market rates increase 50bps to 4.875% Dr Hedge Instrument Asset $ 2, Cr Mortgage Banking Income (FC) $ 2, Market rates decrease 100bps to 3.875% Dr Mortgage Banking Income (FC) $ 4, Cr Hedge Instrument Asset $ 2, Cr Hedge Instrument Liability $ 2, Crowe Horwath LLP 16

17 Issues Related to Instruments Used To Hedge Exposure Case Study Illustrative Example (cont.) Loan at Closing (T3) No entry, value of sales contract did not change Loan sells (T4): Sells at forward commitment contract price of Reverse accrual entries Record cash gain Recap Dr Mortgage Banking Income (IRLC) $ 4, Dr Hedge Instrument Liability $ 2, Cr FV on Loan Held for Sale $ 4, Cr Mortgage Banking Income (FC) $ 2, Dr Cash (Loan Sale) $102, Cr Loan Held for Sale $ 100, Cr Mortgage Banking Income (cash) $2, Loss on sales contract of $2,000; Gain on loan of $4,250; costs of $1,000 Net gain of $1, Crowe Horwath LLP 17

18 Options Available for Accounting For Loans Held For Sale Prior to introduction of FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (ASC 825), loans held for sale were required to be accounted for on LOCOM basis With introduction of the Fair Value Option (FVO), entities had ability to record asset at FV rather than LOCOM SAB 109 addresses components considered in determining FV of loan 2013 Crowe Horwath LLP 18

19 Options Available for Accounting For Loans Held For Sale Fair Value Option Application: Item by item Policy decision/election (i.e., class or entire line) Election must occur at or prior to closing Election is irrevocable Applied to entire item Cannot apply to specified risks, specific cash flows, or portions of item Election Date When entity first recognizes eligible item When entity enters into eligible firm commitment 2013 Crowe Horwath LLP 19

20 Options Available for Accounting For Loans Held For Sale The Choice: FVO Since FVO option was made available to mortgage banking industry, it has been generally accepted as preferential method of accounting Recording commitment at FV allows for natural hedge against most of derivative products used to reduce interest rate exposure (such as sales contracts) Derivative instrument is also recorded at FV Assuming commitment and derivatives are closely related, changes in market forces will have an offsetting effect resulting in lock on gain/loss LOCOM Application of LOCOM results in potential exposure to income unless hedge accounting is applied which is generally complex 2013 Crowe Horwath LLP 20

21 Options Available for Accounting For Loans Held For Sale Determining FV for FVO Value should be based on principal market for each loan type If financial institution has access to multiple markets, then most advantageous market should be used FV should include value of mortgage servicing right (MSR) (SAB 109) Regardless of whether loan is sold servicing released or retained Any liabilities assumed upon sale must also be included Recourse Normal warranties Factor in direct costs Since sales contact derivative has already been recorded, loan s value is determined exclusive of related sales contracts 2013 Crowe Horwath LLP 21

22 Options Available for Accounting For Loans Held For Sale Assuming FVO is elected: + Today s forward sales price (5~15 days) - Cost to complete - Accrued liabilities (Commissions) - Recourse Loss Exposure Value Notes: Valued as whole loan, which includes value MSRs (SAB 109) Costs also include bonuses not yet accrued or paid No fee/cost deferral MSR and recourse liability are recorded separately when loan is sold 2013 Crowe Horwath LLP 22

23 Issues Related to Repurchase Risk Recourse Loss Exposure: Value of borrower IRLC and loan held for sale may need to be reduced for recourse provisions Early payoff Loss sharing Failure to follow investor guidelines (aka reps and warranties) Particularly an issue for non-conforming loans Conforming loans are not immune Estimate based on actual history 2013 Crowe Horwath LLP 23

24 Practice Observations and Regulatory Matters Observations Day 1 value is requirement, not an option Applies to public and non-public companies Might be material where immaterial before Pre ASC 820, BS error only Post ASC 820, IS error too! Borrower IRLC and loan are valued mutually exclusive of sales contract Borrower IRLC or Loan is not sold until ASC 860, Transfers and Servicing (formerly FAS 140) criteria is met Even though specific sales contract has been entered Recourse reserves for loan buy backs are of specific regulatory focus 2013 Crowe Horwath LLP 24

25 Practice Observations and Regulatory Matters Observations (cont.) Borrower IRLC and loan HFS value includes value of servicing, irrespective of whether servicing will be released or retained Best to compute at loan level, avoid averaging Estimate pull through by type, source, age, etc. LOCOM and deferred fees/costs no longer applicable if FVO elected Separate MSR, recourse liability, etc. not recorded until contractually separated Effectively transfer from valuation account to own account upon sale Consider materiality, but watch for changing circumstances and evolve as necessary 2013 Crowe Horwath LLP 25

26 Practice Observations and Regulatory Matters 2005 Interagency Advisory Record mortgage banking derivatives, report in financials and call reports Failure to account and report for mortgage banking derivatives may be an unsafe and unsound banking practice ARMs and float-to-close may not be material, but notional amounts still need to be reported (i.e., even though no rate risk, they are still derivatives) Discount values for fall-out, but not notional amounts Crowe Horwath LLP 26

27 Disclosure Matters Balance Sheet 2013 Crowe Horwath LLP 27

28 Disclosure Matters Balance Sheet CONSOLIDATED BALANCE SHEETS December 31, 2013 and 2012 ASSETS Loans held for sale Loans held for sale, at fair value Note Mortgage banking derivatives are included in other assets and liabilities 2013 Crowe Horwath LLP 28

29 Disclosure Matters Accounting Policies 2013 Crowe Horwath LLP 29

30 Disclosure Matters Accounting Policies Transfers of Financial Assets: Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold. Loans held for sale, for which the fair value option has been elected, are recorded at fair value as of each balance sheet date. The fair value includes the servicing value of the loans as well as any accrued interest Crowe Horwath LLP 30

31 Disclosure Matters Accounting Policies (cont.) Mortgage Banking Derivatives: The Company enters into commitments, known as rate lock commitments, to originate loans whereby the interest rate on the loan is determined prior to funding. Rate lock commitments on mortgage loans that are intended for sale are considered to be derivatives. Therefore, they are recorded at fair value with changes in fair value recorded in revenues from mortgage loans. The Company estimates the fair value of a rate lock commitment based on the underlying mortgage loan and the probability that the mortgage loan will fund within the terms of the rate lock commitment. The fair value of the underlying mortgage loan is based upon quoted mortgage backed security prices. Closing ratios derived using the Company's recent historical empirical data are utilized to estimate the quantity of mortgage loans that will fund within the terms of the rate lock commitments. Rate lock commitments expose the Company to interest rate risk. Changes in fair value are recorded in revenues from mortgage loans. The Company manages that risk by entering forward commitments, also derivatives, that are recorded at fair value with changes in fair value recorded in revenues from mortgage loans. The cash flows from these forward sales agreements are classified as operating activities in the statement of cash flows Crowe Horwath LLP 31

32 Disclosure Matters Commitments 2013 Crowe Horwath LLP 32

33 Disclosure Matters Commitments In the normal course of business, loans sold to certain investors may need to be repurchased by the Company should they become delinquent within a predefined period. These periods vary from investor to investor, pursuant to their agreements, and are generally short-term. Although the loans are insured primarily through FHA, VA or, in the case of a conventional loan that exceeds 80% loan-to-value, private mortgage insurance, there exists some potential loss to the Company on each such loan sold under these repurchase clauses. To minimize this potential loss, the Company has representations and warrant relief agreements with each investor. The Company estimates loss reserves based on current market data and historical losses incurred by year to total mortgage volume generated by year over the indemnity periods. Although considerable variability is inherent in estimating the contingent reserves, management believes the loss reserves are adequate. The estimates are continually reviewed and any adjustments are reflected in operations of the current period. Activity related to the loan indemnification is summarized below Loan indemnification reserves at January 1, 2012 $ Indemnification losses paid during 2012 ( ) Loan indemnification reserve accrued during 2012 Loan indemnification reserves at December 31, 2012 Indemnification losses paid during 2013 ( ) Loan indemnification reserve accrued during 2013 Loan indemnification reserve at December 31, 2013 $ 2013 Crowe Horwath LLP 33

34 Disclosure Matters Commitments (Continued) During 2013 the Company reached settlements with certain banks for all repurchase liabilities associated with loans originated during certain years. The settlements are included in the loan indemnity reserve at December 31, 2013 and are to be paid as follows: 2014 $ $ Amount 2013 Crowe Horwath LLP 34

35 Disclosure Matters Derivatives 2013 Crowe Horwath LLP 35

36 Disclosure Matters - Derivatives Commitments to fund certain mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. It is the Company's practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from its commitments to fund the loans. These mortgage banking derivatives are not designated in hedge relationships. At December 31, 2013, the Company had approximately $2B of interest rate lock commitments and $1.7B of forward sales commitments for the future delivery of residential mortgage loans. The fair value of these mortgage banking derivatives was reflected by a derivative asset of $30mm and a derivative liability of $20mm respectively. At December 31, 2012, the Company had approximately $2B of interest rate lock commitments and $1.6B of forward commitments for the future delivery of residential mortgage loans. The fair value of these mortgage banking derivatives was reflected by a derivative asset of $1.7B and a derivative liability of $10mm, respectively. Fair values were estimated based on changes in mortgage interest rates from the date of the commitments. Changes in the fair values of these mortgage banking derivatives are included in net gains on sales of loans Crowe Horwath LLP 36

37 Disclosure Matters - Derivatives (Continued) Location Forward sale contracts related to Mortgage loans held for sale Mortgage banking income $ $ Interest rate lock commitments Mortgage banking income $ $ 2013 Crowe Horwath LLP 37

38 Disclosure Matters - Derivatives (Continued) The following table reflects the notional amount and fair value of mortgage banking derivatives included in the Consolidated Balance Sheets as of December 31: Notional Fair Notional Fair Amount Value Amount Value Included in other assets: Interest rate lock commitments $ $ $ $ Forward sale contracts related to mortgage banking Total included in other assets Included in liabilities: Interest rate lock commitments $ $ $ $ Forward sale contracts related to mortgage banking Total included in other liabilities 2013 Crowe Horwath LLP 38

39 Disclosure Matters Financial Instruments 2013 Crowe Horwath LLP 39

40 Disclosure Matters - Financial Instruments The derivative instruments consist of interest rate lock commitments and forward sale contracts that trade in liquid markets. The value is based on mortgage backed security pricing for comparable assets. As such, significant fair value inputs can generally be verified and do not typically involve significant management judgments (Level 2 inputs). The fair value of loans held for sale is based upon binding quotes from third party investors (Level 2 inputs) Crowe Horwath LLP 40

41 Disclosure Matters Financial Instruments (Continued) Financial Instruments Recorded Using Fair Value Option The Company has elected the fair value option for loans held for sale. These loans are intended for sale and the Company believes that the fair value is the best indicator of the resolution of these loans. Interest income is recorded based on the contractual terms of the loan and in accordance with the Company s policy on loans held for investment. None of these loans are 90 days or more past due nor on nonaccrual as of December 31, 2013 and As of December 31, 2013 and 2012, the aggregate fair value, contractual balance (including accrued interest), and gain or loss was as follows: Aggregate fair value $ $ Contractual balance Gain (loss) 2013 Crowe Horwath LLP 41

42 Disclosure Matters Financial Instruments (Continued) Financial Instruments Recorded Using Fair Value Option (Continued) The total amount of gains and losses from changes in fair value included in earnings for the years ended December 31, 2013 and 2012 for loans held for sale were: Interest income $ $ Change in fair value Total change in fair value $ $ 2013 Crowe Horwath LLP 42

43 Crowe Horwath LLP is an independent member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath International is a separate and independent legal entity. Crowe Horwath LLP and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath International or any other member of Crowe Horwath International and specifically disclaim any and all responsibility or liability for acts or omissions of Crowe Horwath International or any other Crowe Horwath International member. Accountancy services in Kansas and North Carolina are rendered by Crowe Chizek LLP, which is not a member of Crowe Horwath International Crowe Horwath LLP 2013 Crowe Horwath LLP 43