IRLC Transformational Costs Risks, Consequence & Best Practices

Transcription

1 IRLC Transformational Costs Risks, Consequence & Best Practices Andy Schell, CPA/CFF, CMB Managing Partner, Mortgage Banking Solutions Andy Greer, CPA Vice President First Tennessee Warehouse Lending Santo Chiarelli, CPA Partner Acquavella, Chiarelli, Shuster, LLP

2 The Importance of Understanding IRLC Transformational Costs Presented by: Andy Schell, CPA/CFF, CMB Managing Partner Mortgage Banking Solutions

3 Purpose of Presentation Information & Education on IRLC issues Goal is Understandable Financial Results We ll Explore IRLC Challenges & Risks Unintended Consequence of Decisions Lots of material Going FAST Hold Questions until the end Andy Schell, CPA, CMB

4 A Place to Begin GAAP provides foundation for comparability GAAP financials are produced for the benefit of Users Users include: Warehouse Banks, Agencies and SEC/Public Warehouse Lenders provide funds for IMB to close loans IMB Balance Sheet is the basis for the Warehouse Loan, Investor and Agency Approvals CPA Report presents IRLC Asset and IMB Capital o Lenders Andy Schell, CPA, CMB

5 Fair Value of Loans Held for Sale Before FV, most expense at closing; revenue deferred to sale With FV, Financials are correlate to loan closing volume FV Month-End Financials All Direct and All Indirect expenses All Revenue including fees and LHFS MTM (gain on sale) Volume Correlates to Financials Andy Schell, CPA, CMB

6 And Then, Enron Enron, WorldCom, and Arthur Anderson (formed 1913) GAAP says: include the impact from Off-Balance Sheet Financing Commitments subject to market risk when preparing GAAP financials Do IMB have Off-Balance Sheet Financing Commitments? Yes. Every Interest Rate Lock Commitment (IRLC) is an Off-Balance Sheet Financing Commitments Subject to Market Risk Andy Schell, CPA, CMB

7 What is the Locked Pipeline? IRLC is an Off-Balance Sheet Financing Commitments Subject to Market Risk What are the characteristics of an IRLC? They are Applications in Process or Potential Loans They are NOT an Tradeable (or saleable) Asset There is nothing to basis adjust So we create an asset Derivative Asset Andy Schell, CPA, CMB

8 Derivative Asset We Create a Derivative Asset by: DR Derivative Asset; CR Income CR Income INCREASES Capital IMBs want more Capital More IRLC means more Income More Income means more Capital More Capital means more Warehouse borrowing More Capital means qualifying for FHA & Agency More IRLC means more Capital Andy Schell, CPA, CMB

9 Is an IRLC a TRUE Derivative? Example of Derivative Hedging sells TBA-MBS via broker dealer TBA-MBS is a tradable commodity with an active market Is a TBA-MBS tradeable with no additional processing? YES Is the IRLC tradable with no additional processing? NO An IRLC must experience Transformation Costs to be Loan Andy Schell, CPA, CMB

10 Transformation Costs or Cost to Complete What is the value of the IRLC? Pull-thru adjusted MTM less Costs to Complete What is the right amount of Transformation Costs? Direct Cost Deduction Method - direct costs only Full Cost Absorption Method - both direct and indirect costs IRLC is a pure derivative no adjustment (IRLC same as TBA-MBS) Andy Schell, CPA, CMB

11 IMB Transformational Costs Best Practices Direct Expenses LO commissions, production commissions Other Direct Production Costs: appraisals, outsourcing, courier, credit reports, other costs Other Direct Expenses LO wages, processors, LOA, underwriting, funding, disclosure and post closing Indirect Expenses Allocated Production Rent, Branch Rent, Branch Overhead Andy Schell, CPA, CMB

12 Consequence of Ignoring Indirect Costs Hawaii vs Texas High Balance vs Low Balance Loan Size Matters

13 ONE LOAN High Balance low gain Low Balance high gain Loan Size creates Different Ratio Higher Gain % Derivative Asset Is Similar Processing costs as % of loan are different Profit % is same Andy Schell, CPA, CMB

14 $50,000,000 Locked Pipeline Texas lender s capital is more than double Different Derivate Asset Identical Cash Realization. Indirect Costs Matter At year end, cut rates in Texas to fill-up pipeline to increase DA and increase capital Andy Schell, CPA, CMB

15 CPA Presentation of the Derivative Asset Derivative Asset / IRLC How can two CPAs say the Mortgage IRLC is worth 6% and.5%? Where is Comparability?

16 Remember FAS 5 & FAS 91 FAS 5 Receivable Collectability: Probable, Possible or Remote IRLC Derivative Asset Collection is??? FAS 91 Capitalize Direct Costs from Successful Efforts Pull-Thru Defer all Revenue; Defer some some Costs IRLC Recognize all Revenue; Recognize some Costs Andy Schell, CPA, CMB

17 Unresolved Impact: Warehouse Lender Concerns CPA Audit is the basis for Warehouse Lender Risk Exposure CPAs inconsistently calculate Costs to Complete Under applying Costs to Complete increases Capital Overstated Capital creates Risk Exposure to Warehouse lender Warehouse Lenders deduct and adjust the Derivative Asset What can CPAs do to make Audit meaningful to Users? Andy Schell, CPA, CMB

18 When Fair Value Isn t User Perspectives on the IRLC Asset The Reality of Warehouse Lending in a Regulatory Environment OCC, FDIC, FRB when CPA Audited Financial Statement are Unreliable Your Logo here Slides by: Andy Greer, CPA Vice President First Tennessee Warehouse Lending

19 Warehouse Lenders Position One: The Direct Cost Deduction Method Isn t Useful to Users

20 What does it mean to be useful? Conceptual Framework for Financial Accounting, FASB: Financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity s future cash inflows and outflows (the entity s future cash flows).

21 One Characteristic of Usefulness: Comparability Comparability is the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena. --- Conceptual Framework for Financial Accounting, FASB

22 Perspective The Direct Cost Deduction Method Isn t Useful to Users Not comparable Materially Overstates Future Cash Flows by a Factor of 2-10 times --- Amounts and Timing Volatile --- Uncertainty Elements we all care about

23 Compared to what?

24 Quarterly Mortgage Bankers Performance Report (MBA) IMBs Q Total Loan Production Revenue Total Loan Production Expense Total Net Production Income bps (336.84) bps bps * Direct Loan Production Expenses: bps Average Net Production Income Since 2008: 55 bps

25 Comparing the Direct Cost Deduction Method s Results Gross Pipeline Revenues, Pull-Through Adjusted -- From Analytics Report ( Direct Costs ) -- Management Estimate = Value Assigned to Pipeline -- IRLC Asset Hedging Instruments

26 Methodology: Non-random selection of 4 publicly-traded mortgage entities Random selection of 32 Independent Mortgage Bankers (IMBs) Valuation in basis points= IRLC Asset (Balance Sheet) Notional Amount of Pipeline at December 31, 2016 (Notes) Not Pull-through adjusted

27 Not Useful- Not Comparable v

28 Not Useful- Not Comparable Public Mean: 142 bps

29 Not Useful- Not Comparable Public Mean: 142 bps IMB Mean: 261 bps

30 Not Useful- Not Comparable Public Mean: 142 bps IMB Mean: 261 bps

31 Which Method?

32 Financial Results are Not Comparable. IRLC asset averaged 35% of equity - Material 72% of average asset will never be converted to cash - Overstated 261 bps - 74 bps* 261 bps = 72%

33 Warehouse Lender Position Two: The direct cost deduction method materially overstates the value of unclosed loan pipeline. How: Ignores the majority of pipeline cash outflows.

34 Cash Flows Matter in Fair Value Income Approach (ASC 820) An estimate of future cash flows for the asset being measured. Cash Flows Matter for IRLCs OCC: When quoted market prices are not available, which is typically the case for derivative loan commitments [...] estimates of fair value should be based on the best information available in the circumstances (e.g., valuation techniques based on estimated expected future cash flows). - Interagency Advisory On Accounting And Reporting For Commitments To Originate And Sell Mortgage Loans

35 Future Cash Flows: 1. Cash Inflows 2. Cash Outflows

36 Quarterly Mortgage Bankers Performance Report (MBA) IMBs Q Average Net Production Income Since 2008: 55 bps

37 CPAs Argue GAAP, but fall into Two Ditches

38 Ditch One: Incurred Costs

39 Life of a Loan: From Lock, Funding, to Sale How much commission is due if UW declined?

40 Total Revenue Total Expenses Net Margin Incurred Costs Life of a Loan Gross Revenue, Pull-Through Weighted - Costs to Be Incurred = Value of a Pipeline Loan Prevents Double-Deducting Costs Already Incurred 2 Costs to be Incurred 1 W&W = FASB?? 1 Accounting for Mortgage Banking Activities: Interest Rate Lock Commitments, Forward Sales Commitments, and Closed Loans Held for Sale. Wilary Winn, Accounting and Regulatory Guidance for the Mortgage Partnership Finance Program Wilary Winn, 2016 September 1 September 30 October 15 Measurement Date

41 Total Revenue Total Expenses Net Margin Life of a Loan Pipeline of Loans Going Concern September 1 September 30 October 15 Measurement Date

42 Ditch One: Incurred Costs Incurred Costs Don t Matter In an Asset Net Of Costs Presentation When revenue recognition is triggered at lock (the earliest possible point), incurred costs don t affect the loan pipeline s value. pencil Sales Price: $2.00 COGS: ($1.50) Margin: ($0.50)

43 Ditch One: Incurred Costs Revenue Recognition Matching Principle Raw Materials Manufacture Sale $0.50 of Costs $1.00 of Costs Sale for $2.00 WIP Raw Material Inv. WIP Wages Payable A/R Sales Revenue COGS Finished Goods

44 Ditch One: Incurred Costs Revenue Recognition Matching Principle Raw Materials Manufacture Sale $0.50 of Costs $1.00 of Costs Sale for $2.00 WIP Raw Material Inv. WIP Wages Payable A/R Sales Revenue COGS Finished Goods

45 Ditch One: Incurred Costs Incurred Costs Don t Matter In a Net Of Costs Presentation When revenue recognition is triggered at the creation of pencil WIP (the earliest possible point), incurred costs don t affect the finished pencil s anticipated value. When revenue recognition is triggered at lock (the earliest possible point), incurred costs don t affect the loan pipeline s anticipated value. Pull-through affects the loan pipeline s value Causal Relationship to Fair Value When estimating the fair value of derivative loan commitments [...] institutions should consider predicted pull-through [...]. Some factors that may be considered in arriving at appropriate pull-through rates include [...] the origination channel [...],current mortgage interest rates in the market [...], the purpose of the mortgage (purchase versus refinancing), the stage of completion of the underlying application and underwriting process, and the time remaining until the expiration of the derivative loan commitment. -- OCC: Interagency Advisory On Accounting And Reporting For Commitments To Originate And Sell Mortgage Loans, 2005.

46 One more rabbit trail

47 Sales Price: $2.00 COGS: ($1.50) Sample Margin: Segue ($0.50) Slide 1. Materials 2. Labor 3. Overhead

48 Overhead is a Reality.

49 If a market does not exist for the asset [...] the market for the securitized loan can be used to determine the fair value of the asset or liability, adjusted, as appropriate, for transformation costs and margins (or profit) to reflect the fair value of the asset or liability held by the reporting entity. - PwC, Fair Value Measurements 2015

50 Indirect Costs are a part of Transformation Costs Absorption-Like Method

51 Ditch Two: What Else Could Affect Pipeline Cash Flows?

52 Business Combination

53 Ditch Two: Business Combination The Purpose of Fair Value: To estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date. ASC 820 Occurs in the asset s principal market The Orderly Transaction : Selling the unclosed loan pipeline to another entity

54 Ditch Two: Business Combination The Argument: A buyer of IRLCs wouldn t consider fixed/indirect costs in determining the purchase price. Sales Price When Complete: $100,000 More engine work More body work More paint Seller s lease Seller s salary Seller s electric bill

55 Ditch Two: Business Combination The Problem: There is no market for IRLCs But, there is a market for selling a mortgage company Fair Value of IRLCs = Business Combination

56 Ditch Two: Business Combination Principal Market Requirement in Fair Value / 820 Market in which the reporting entity normally would enter into a transaction to sell the asset ( A ) Contains the greatest volume and level of activity for that asset ( Principal Market definition) Must be accessible at measurement date ( A) Minimizes unobservable inputs ( C) Business Combination as Principal Market Never entered into as a going concern. No level of activity for the asset as a going concern. Is accessible one time: during a sale Maximizes unobservable inputs

57 Principal Market Requirement in Fair Value / 820 Ditch Two: Business Combination Market in which the reporting entity normally would enter into a transaction to sell the asset ( A ) Business Secondary Combination Market as Principal Market Is the market normally entered into Contains the greatest volume and level of activity for that asset ( Principal Market definition) Must be accessible at measurement date ( A) Minimizes unobservable inputs ( C) 100% of loans originated by IMBs are sold into this market Is accessible at the measurement date Minimizes unobservable inputs

58 Ditch Two: Business Combination IMBs Net Value of Unclosed Loans: Mean: 261 bps MBA s Net Production Profit Margin: Mean: 74 bps We re all in the wrong market.

59 Ditch Two: Business Combination Excess of the price paid at a takeover for an entity over its fair market value Anticipated Goodwill

60 Result of the Second Ditch: IRLC Asset represents Goodwill

61 Whichever Ditch We Picked

62 Financial Results Containing IRLC Asset are Not Useful. IRLC asset averaged 35% of equity 72% of asset, on average, will never be converted to cash

63 Not Liquid: Fixed Assets MSRs Loans held for Investments Liquid: IRLCs Materially Overstated We routinely count Goodwill as a component of liquidity and tangible net worth under the Direct Cost Deduction Method

64 We all think we re right. We account for this asset differently, and those differences are material. We need clarification.

65 Perspective on Direct Cost Deduction Method Not comparable Materially Overstates Future Cash Flows Volatile Applying More Costs (Absorption-like) = More Useful

66 OVERSTATEMENT OF AN IRLC ASSET OR LIABILITY CREATES TAX AND CASH FLOW UNPREDICTABILITY Slides by: Santo Chiarelli, CPA Partner Acquavella, Chiarelli, Shuster, LLP

67 Overview An IRLC is an off balance sheet commitment subject to market risk This commitment must be considered when preparing GAAP financial statements.

68 Overview (continued) GAAP requires this commitment to be recorded at Fair Value at its measurement date either as a derivative asset, or in rare cases, a derivative liability with income or expense being recorded through the P & L. Internal revenue code section 475 requires the reporting of income or loss on this derivative asset or liability when the income or expense is recognized, thus creating a GAAP to Tax timing difference

69 The cash inflows or outflows will be recognized in the subsequent tax reporting period

70 Interest Rate Volatility Historically as interest rates increase origination volume will typically decrease. When origination volume decreases, pipelines decrease thus causing the IRLC to decrease

71 In an environment where origination volume and pipeline value decrease, independent mortgage bankers need to manage expenses and liquidity as profits and cash flows will typically decrease

72 However when the value of IRLC is overstated it can become extremely difficult to manage tax liability and cash flow, as illustrated in the following example

73 ITS ONLY A TIMING DIFFERENCE

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77 SUMMING IT UP Net Income $3,496,000 $2,331,388 Taxable Income $2,083,600 $3,006,788 Pay Tax on Timing Difference

78 SUMMING IT UP Can t have it both ways Although a timing difference, overstated IRLC Asset - Can lead to greater taxable income when volume declines - Requires Paying taxes as Asset adjusts

79 IMB Transformational Costs Best Practices Direct Expenses LO commissions, production commissions Other Direct Production Costs: appraisals, outsourcing, courier, credit reports, other costs Other Direct Expenses LO wages, processors, LOA, underwriting, funding, disclosure and post closing Indirect Expenses Allocated Production Rent, Branch Rent, Branch Overhead Andy Schell, CPA, CMB

80 How do we fix it? Don t make it worse by ignoring cost Add Transformational Costs as volume grows Wait for FASB to force a one-time adjustment

81 Thank You & Contact Information Andy Schell, CPA/CFF, CMB Managing Partner Mortgage Banking Solutions Andy Greer, CPA Vice President First Tennessee Warehouse Lending Andy Greer is leading team of CPAs in discussion with FASB