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1 eé~çë=ré Audit and Enterprise Risk Services j~êåü=omi=omms sçäk=npi=fëëìé=o få=qüáë=fëëìéw Summary of Statement 156 Provisions On the Horizon Your Input Requested Appendix: Questions and Answers Related to Statement 156 péêîáåáåö=déíë=~=qìåé=ré= c^p_=^ãéåçë=dìáç~ååé=çå=péêîáåáåö=çñ=cáå~ååá~ä ^ëëéíë= by David Moline, Deloitte & Touche LLP Mortgage bankers and other entities that service financial assets take note: last week, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No Statement 156 (the Standard) may be adopted as early as January 1, 2006, for calendar year-end entities, provided that no interim financial statements have been issued. Those not choosing to early adopt are required to apply the provisions as of the beginning of the first fiscal year that begins after September 15, 2006 (e.g., January 1, 2007, for calendar year-end entities). Key concepts of Statement 156 are summarized below, with detailed guidance provided in question and answer format in the Appendix. See Question 1 in the Appendix for a brief review of servicing. Summary of Statement 156 Provisions Hedgers Get Help As developments warrant, Heads Up is prepared by the National Office Accounting Standards and Communications Group of Deloitte & Touche LLP ( Deloitte & Touche ). For subscription information, see the back page. This publication contains general information only and Deloitte & Touche is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte & Touche, its affiliates and related entities shall not be responsible for any loss sustained by any person who relies on this publication. The Standard provides some relief for servicers that use derivatives to economically hedge fluctuations in the fair value of their servicing rights. Currently, in a rising interest rate environment, the derivatives used for hedging must be written down to their fair values; however, corresponding increases in the fair value of the related servicing rights cannot be recognized since Statement 140 mandates that servicing rights be carried at the lower of cost or market. This mismatch generates income statement volatility. Prior to Statement 156, the only way to reduce this volatility was to meet the stringent Statement requirements for hedge accounting a difficult task given that few financial instruments respond to interest rate fluctuations in a manner similar to servicing rights. Statement 156 allows servicers to opt to measure their servicing rights at fair value ( fair value method ), which is the same accounting basis they use to measure derivatives, thus neatly avoiding the difficulties created by lower-of-cost-or-market accounting. A servicer can also choose to continue applying the existing accounting model in Statement 140 ( amortization method ). 1 FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. 2 FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities.

2 Gain/Loss on Sale Calculations Will Change Statement 156 also changes how gains and losses are computed in transfers or securitizations that qualify for sale treatment in which the transferor retains the right to service the transferred financial assets. Previously, servicing assets were characterized as retained interests of the transferor and were recorded at an amount representing an allocation of the carrying amount of the financial assets prior to the transfer. The allocation was based on the relative fair values of all components retained and sold in the transaction, and typically resulted in the servicing assets being initially recorded at an amount less than fair value. Under the new Standard, servicing assets must be initially recorded at fair value and treated as part of the proceeds received by the transferor, thus affecting the gain/loss calculation. See Question 6 in the Appendix for additional discussion. Comparison of Measurement Alternatives Under Statement 156 The table below compares the accounting treatment for servicing rights measured under the amortization method with servicing rights measured under the fair value method. What value do I initially assign to servicing rights acquired or obtained in a securitization or transaction accounted for as a sale? How do I recognize income? At what value are servicing rights carried on the balance sheet? How do I recognize an impairment or increased obligation? Amortization Method Fair value Recognize periodic servicing fee income; amortize the servicing rights in proportion to and over the period of estimated net servicing income (loss) Original fair value adjusted for accumulated amortization, valuation allowances, write-downs, and fair value hedge adjustments, if any Impairment Recognize via a valuation allowance established for an individual stratum of servicing assets when its carrying amount exceeds fair value. Changes in the valuation allowance are recognized in earnings; however, fair value in excess of the carrying amount of a stratum cannot be recognized. Statement 140 does not preclude a direct write down of servicing assets Increased Obligation Recognize the increased obligation as a loss in earnings Fair Value Method Fair value Both servicing fee income and fair value adjustments are recognized in earnings currently (the Standard does not specifically address income statement classification) Current fair value Any impairment or increased obligation would be reflected in the fair value of the servicing right 2

3 Class Distinction The fair value option provided under this Standard is not an all-or-nothing proposition Statement 156 introduces the notion of classes and requires companies to make a measurement election for each class of its servicing rights. A servicer should define its classes based on (1) the availability of market inputs used in determining the fair value of servicing rights, (2) the servicer s method for managing the risks of its servicing rights, or (3) a combination of (1) and (2). How this differs from the identification of strata currently used in assessing impairment depends on the servicer s specific facts and circumstances. A stratum for impairment analysis can be based on any predominant risk characteristic, including financial asset type, size, interest rate, origination date, term, or geographic location. Thus, a servicer could conceivably conclude that one of its existing strata is a class. When determining classes, a servicer should keep the following in mind: 1. The decision to subsequently measure a class of servicing rights at fair value does not have to be made when Statement 156 is adopted. After a servicer adopts the Standard, it can begin measuring an existing class of servicing assets at fair value; however, that decision must be made as of the beginning of a fiscal year for which the servicer has not issued any financial statements (including interim statements). 2. A decision to subsequently measure a class of servicing rights at fair value is irrevocable the servicer can t decide later to go back to the amortization method. 3. Defining classes is not merely an academic exercise Statement 156 requires certain comprehensive rollforward disclosures that must be presented for each class (see Questions 13 and 14 in the Appendix). 4. For the classes of servicing rights for which a servicer wishes to continue to apply its current accounting under Statement 140 (i.e., those that follow the amortization method), the stratification necessary for assessing impairment must be performed within each class. Servicing assets from more than one class cannot be combined into a single stratum for impairment assessment. See Question 3 in the Appendix for a discussion of other factors to consider when identifying classes of servicing rights. One-Time Reclassification of Available-for-Sale Securities Some servicers use financial instruments other than derivatives (e.g., available-for-sale securities) to offset the risks inherent in servicing rights. To encourage more servicers to elect the fair value method, Statement 156 permits reclassification of certain available-for-sale securities to the trading category without calling into question the treatment of such securities under Statement This one-time reclassification may be made only on initial application of Statement 156 (i.e., the beginning of the year of adoption). Which available-for-sale securities can be reclassified? See Question 10 in the Appendix for guidance. Presentation and Disclosures To enhance comparability across entities, Statement 156 requires extensive additional disclosures for servicing rights, regardless of whether a servicer avails itself of the fair value election. See Questions in the Appendix for more information on financial statement presentation and required disclosures. Effective Date and Transition See Questions in the Appendix for additional detail regarding the effective date and transition for specific provisions of Statement FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. 3

4 lå=íüé=eçêáòçå The fair value election guidance provided in Statement 156 is limited to servicing rights; however, the FASB recently issued an Exposure Draft of a proposed Statement, The Fair Value Option for Financial Assets and Financial Liabilities, whose scope is much broader. The proposed Statement creates a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for many financial assets and financial liabilities, contract by contract, with changes in fair value recognized in earnings as those changes occur. The FASB is also redeliberating another project that will significantly change the accounting for transfers of financial assets. As the issuance dates of these final Statements draw near, look to our publications for more information. vçìê=fåéìí=oéèìéëíéç What information do users of financial statements need to analyze companies that report some or all financial instruments at fair value? If you have views on this topic, the FASB and the International Accounting Standards Board (IASB) are seeking your input. A questionnaire can be found on the IASB Web site, and responses are due April 14,

5 ^éééåçáñw==nìéëíáçåë=~åç=^åëïéêë=oéä~íéç=íç=pí~íéãéåí=nrs 1. What is a servicing right? Servicing rights arise in most instances in which an entity undertakes an obligation to service financial assets. As discussed in Statement 140, servicing activities can include collecting principal, interest, and escrow payments; paying taxes and insurance from escrowed funds; monitoring delinquencies; executing foreclosure, if necessary; and accounting for and remitting principal and interest payment to the interest holders. A servicer of financial assets commonly receives the benefits of servicing (e.g., contractually specified servicing fees, late charges, and other ancillary sources, including float on the collected payments) and incurs the cost of servicing the assets. Statement 140 observes that the benefits of servicing are typically expected to more than adequately compensate the servicer, and the contract would thus result in a servicing asset. A servicing liability results if the benefits of servicing are not expected to provide adequate compensation to the servicer. Scope 2. Are there any circumstances in which a servicing right should not be separately recognized? A servicing right should not be separately recognized when the servicing obligation results from either of the following: A servicer s transfer or securitization of financial assets that is accounted for as a secured borrowing under Statement 140, or An acquisition or assumption of an obligation to service financial assets of the servicer or its consolidated affiliates. If an entity transfers assets to a qualifying special-purpose entity in a guaranteed mortgage securitization (as defined in Statement 140) and the transferor retains all of the resulting securities and classifies them as held-tomaturity debt securities, the entity may either recognize the servicing rights (1) separately or (2) combined with the assets being serviced (i.e., no separate recognition of servicing rights). Classes of Servicing Rights 3. What are some factors a servicer should consider when identifying its classes of servicing rights? Factors to consider in identifying classes of servicing rights include the reliability of fair value information (i.e., are there adequate observable market inputs?), and those factors that would affect the way a servicer manages its risk exposure, such as the nature of the collateral; whether the interest rate mechanism is fixed or floating; the nature of the loan (i.e., commercial or consumer); the credit quality of the underlying loans; and the expected variation in customer prepayments. 4. May a servicer transfer servicing rights between classes? A servicer may transfer servicing rights from a class measured under the amortization method to a class measured under the fair value method as of the beginning of any fiscal year (provided no financial statements have been issued for that year). A transfer of servicing rights must be consistent with the parameters established for identifying classes of servicing rights. For example, it may not be appropriate to transfer sub-prime loans to a class of conforming loans. Statement 156 prohibits transferring servicing rights from a class measured under the fair value method to a class measured under the amortization method. 5

6 5. How will a servicer s class designations impact its impairment analysis? Because any impairment will be captured in determining fair value, a servicer does not have to perform a separate impairment analysis for classes of servicing rights measured at fair value. Each class of servicing rights measured under the amortization method must be stratified to evaluate and measure impairment. No stratum can be a part of more than one class of servicing assets; however, multiple strata can exist within a class. Initial Measurement 6. How does Statement 156 affect the way an entity initially records a transfer of financial assets that satisfies the necessary conditions to be accounted for as a sale? Statement 156 requires servicing rights to be recorded initially at fair value and treated as proceeds of the sale. Before Statement 156, servicing assets were recorded at allocated carrying amount and treated as retained interests in transferred assets. As a result, the amount of gain or loss related to the sale will be impacted. Note that the change in initial recording applies to all transfers of financial assets accounted for as sales, regardless of whether the servicer applies the amortization method or the fair value method. Statement 156 provides the following example illustrating the application of the guidance for calculating gain or loss on sales. Example Company A originated $1,000 of loans that yield 10% interest. Company A sold those loans plus the right to receive interest income of 8% to another entity for $1,000. Company A will continue to service the loans in exchange for half of the 2% interest income that was not sold. The remaining half of the interest income not sold represents an interest-only strip receivable that Company A has classified as an available-for-sale security. At the date of the sale, the fair values of the respective components of the transaction are as follows: Fair Values Loans sold $1,000 Servicing asset 40 Interest-only strip receivable Gain on Sale Calculation (prior to adoption of Statement 156) Fair Value % of Total Fair Value Allocated Carrying Amount Loans sold $1, % $910 Servicing asset Interest-only strip receivable Total $1, % $1,000 6

7 Gain on Sale Net proceeds $1,000 Less: Carrying amount of loans sold Gain on sale... $90 Gain on Sale Calculation (after adoption of Statement 156) Fair Value % of Total Fair Value Allocated Carrying Amount Loans sold $1,040 * 94.6% $946 Interest-only strip receivable Total $1, % $1,000 Gain on Sale Net proceeds $1,040 Less: Carrying amount of loans sold 946 Gain on sale... $94 * In the examples in Statement 156, the fair value of the servicing asset is included as part of the fair value of the loans sold for purposes of this calculation. The accounting for the interest-only strip receivable is not affected by Statement 156. The interest-only strip receivable carried as an available-for-sale security should be subsequently marked to fair value with changes in fair value recognized in other comprehensive income and would be subject to the provisions of Issue EITF Issue No , Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. 7

8 Fair Value Measurement Election 7. If a servicer elects to subsequently measure a class of servicing assets at fair value, how does it account for any valuation allowance that previously was associated with those assets? The carrying amount of the servicing assets should be reduced by any related valuation allowance. The difference between the fair value and the net carrying amount is recognized as a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year the election is made. The amount of the cumulative-effect adjustment must be separately disclosed in the financial statements. 8. How should a servicer determine the fair value of its servicing rights? Statement 156 does not provide any additional fair value measurement guidance. Until the FASB finalizes its proposed Statement, Fair Value Measurements, preparers should continue to look to paragraphs of Statement 140 for guidance on determining fair value. As a general rule, fair value is presumptively the price paid or received if the servicing right was purchased or assumed. 9. What are the consequences of a servicer s conclusion that determining the fair value of a servicing right would not be practicable? In situations in which estimating fair value is not practicable, a servicer should record a servicing asset at zero, or, in the case of servicing liabilities, recognize no gain on the transaction. Refer to the guidance in paragraph 71 of Statement 140 for further details. If a servicer is unable to reasonably estimate the fair value of a servicing right, that servicing right must be included in a class that is measured using the amortization method. According to question 69 of FASB Staff Implementation Guide (Statement 140), 5 a servicer should be able to reasonably estimate the fair value of a servicing right in most circumstances. Because a quoted market price is not available, a servicer should use other valuation techniques, such as a present value of estimated future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, or fundamental analysis. Reclassification of Available-for-Sale Securities 10. How should a servicer identify securities that may be reclassified from available-for-sale to trading on adoption of Statement 156? The transition provisions permitting a transfer of securities classified as available-for-sale to the trading category are limited to those securities that are held to offset the income statement effect of changes in the fair value of servicing rights that a servicer has elected to subsequently measure at fair value. A servicer is not required to provide specific documentation that links an available-for-sale security to a servicing right; however, the servicer should be able to demonstrate that those securities it has identified offset its exposure to changes in the fair value of its servicing rights. 11. If, after its initial adoption of Statement 156, a servicer decides to begin measuring an existing class of servicing rights at fair value, may it still reclassify available-for-sale securities to trading? No. The reclassification of available-for-sale securities to the trading category is a one-time event that can occur only when a servicer initially adopts Statement FASB Staff Implementation Guide (Statement 140), The Meaning of the Term Practicable in Statement 140, Question 69. 8

9 Presentation and Disclosures 12. Can servicing rights accounted for under the fair value method and the amortization method be aggregated into one line item in the balance sheet? Yes. A servicer may aggregate servicing rights measured under the fair value method and the amortization method into one line item on its balance sheet as long as the amount of those servicing rights measured at fair value is disclosed parenthetically on the face of the balance sheet. Alternatively, the servicer may display separate line items on its balance sheet for those servicing rights measured under the fair value method and those measured under the amortization method. 13. Does Statement 156 create additional disclosure requirements for servicing rights that continue to be measured under the amortization method? How do the disclosure requirements in Statement 156 compare to the existing disclosure requirements in Statement 140? Even if a servicer does not avail itself of the fair value option, Statement 156 requires additional disclosures not currently mandated in Statement 140. The table below highlights those differences: Disclosures Under New Standard What new disclosures are required regardless of which method is applied? What disclosures have been amplified for those servicers that continue to use the amortization method? Have there been any other changes to the disclosure requirements? A servicer must now disclose: Management s basis for determining its classes of servicing rights; A description of the risks inherent in servicing activities and any instruments used to mitigate the income statement effect of changes in fair value of servicing rights; The amount of contractually specified servicing fees, late fees, and ancillary fees earned for each period for which an income statement is presented; The activity in the balance of each class of servicing rights (i.e., a rollforward), including a description of where changes are reported in the income statement (see paragraph 349A of Statement 140, as amended by Statement 156, for an example); and A description of the valuation techniques or other methods used to estimate the fair value of each class of servicing rights. The following disclosures must now be provided for each class measured under the amortization method: The fair value at the beginning and end of each period, if estimable; The risk characteristics of the underlying financial assets used to stratify servicing assets for purposes of measuring impairment; and The activity in any valuation allowance, for each period in which an income statement is presented. No other notable changes have been made to the existing disclosure requirements, except to replace the term retained interests with interests that continue to be held by the transferor. The Standard also clarifies that servicing rights must be included in an entity s sensitivity analysis. 9

10 14. May a servicer aggregate classes of servicing rights when presenting the roll-forward disclosures required in Statement 156? No. A servicer is required to disclose the activity for each separate class of servicing rights. Effective Date and Transition 15. When is a servicer required to apply the provisions of Statement 156? Statement 156 is effective as of the beginning of the first fiscal year that begins after September 15, 2006, with earlier adoption permitted as of the beginning of the servicer s fiscal year, provided no financial statements (including interim periods) have been issued for that year. The table below summarizes the effective dates of the specific provisions of Statement 156. Effective Date and Transition When must a servicer begin measuring servicing rights acquired at fair value? Can a servicer elect to begin measuring existing classes of servicing rights at fair value as soon as it adopts Statement 156? After a servicer has adopted Statement 156, can it decide at a later date to begin measuring an existing class of servicing rights at fair value? After adoption of Statement 156, a servicer acquires a new class of servicing rights associated with financial assets for which it previously had not recognized servicing rights. When can the servicer elect to subsequently measure that class at fair value? Once it adopts the Standard, the servicer must begin, prospectively, to initially record all servicing rights it acquires at fair value. Yes. Any difference between the fair value and the carrying amount of those servicing rights will be recognized as a cumulative-effect adjustment to retained earnings at the beginning of the period. The cumulative-effect adjustment must be disclosed separately in the financial statements. Yes, it can begin measuring an existing class of servicing rights at fair value as of the beginning of any fiscal year for which financial statements (including interim statements) have not been issued. Any difference between the fair value and the carrying amount of those servicing rights will be recognized as a cumulative-effect adjustment to retained earnings at the beginning of the period. The cumulative-effect adjustment must be disclosed separately in the financial statements. The servicer can elect to subsequently measure the new class of servicing rights at fair value at the date it initially recognizes the class. If a servicer does not elect fair value measurement at initial recognition, the election may be made later, as of the beginning of any fiscal year for which financial statements (including interim statements) have not been issued. 16. When can a servicer reclassify available-for-sale securities to the trading category without calling into question the treatment of those securities under Statement 115? An irrevocable decision to reclassify qualifying available-for-sale securities to trading may be made as of the beginning of the fiscal year in which the servicer adopts Statement On adoption of Statement 156, how does a servicer account for any gains and losses recorded in accumulated other comprehensive income that were associated with reclassified available-for-sale securities? Gains and losses in accumulated other comprehensive income related to those securities are recorded as a cumulative-effect adjustment to beginning retained earnings and separately disclosed in the financial statements. 10

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