Few industries are as sensitive to changes in laws, regulations and accounting rules as mortgage banking. Loan servicing is one area that's frequently affected by governmental or quasigovernmental activity. It's so pervasive, it is hard to imagine what servicing would be like without an annual dose of new regulations to accommodate.
Yet, the changes in servicing operations and markets that are the offshoot of these legal and regulatory developments affect the profits of all mortgage bankers. This is the case whether the business strategy focuses on loan servicing, origination or both.
To survive and prosper in today's dynamic environment, it is important to keep abreast of current legislative and regulatory issues and to understand their impact on mortgage servicing and the mortgage banking industry.
An issue that first emerged in 1992 was the Financial Accounting Standards Board (FASB) exposure draft regarding accounting for certain investments in debt and equity securities. On April 13 of this year, FASB finally issued its new standard, which creates three classes of securities: held for maturity, available for sale and trading instruments. This change could prompt a swing toward ARM financing and thus produce a new abundance of ARM servicing, which would have an impact on industry profits.
The way it works is that assets in the held-for-maturity category are held at book value. Securities falling into the available-for-sale category must be marked-to-market quarterly, with price differences added or subtracted from equity. Securities classified as trading instruments must also be marked-to-market quarterly, with changes in value added or subtracted from earnings.
Currently, financial institutions hold some mortgage-backed securities (MBS) at the lower of cost-or-market valuation, but many are held at their original book value. Under the new standards, most MBS and other financial instruments will fall into the available-for-sale or trading-instruments categories. The effect will be greater volatility in a financial institution's capital position, due to increased use of mark-to-market accounting.
This change will probably cause holders of mortgage-backed securities to shorten the maturities of their portfolios, to avoid fluctuations in capital caused by marking to market. This could increase the attractiveness of ARMs over fixed-rate loans.
As institutions shorten the maturities of their securities, the spread for longer term maturities could widen, making long-term interest rates less attractive to the consumer. To the extent that ARM financing becomes more attractive, market share could swing back to thrifts.
Furthermore, to the extent that consumers actually show a preference for ARMs over fixed-rate loans, lenders will be making loans for which the servicing value is approximately half the value of fixed-rate servicing. All other things being equal, industry profits would be hurt because the cost to originate either loan type is the same and ARMs are generally more costly to service.
It will be interesting to watch the effects of this change during the next year or two.
PMSR CAPITAL TREATMENT
In late 1992, the Federal Reserve approved a uniform rule relating to purchased mortgage servicing rights (PMSRs) and their capital treatment. The Fed decided that purchased mortgage servicing rights may be included in capital if the aggregate amount does not exceed 50 percent of Tier 1 capital. Interestingly, the Fed may view the excessive holding of PMSRs as an unsafe and unsound practice.
The rule goes on to state that the original purchase discount rate, or a higher rate, must be applied to cash flows for call reports and consolidated financial statements. This is important because it will put some Fed-member banks in the position of having to understate asset value when the current market yield is below the historical discount rate.
These changes may inhibit servicing portfolio purchases by member banks during periods of high interest rates, because of the required use of the original purchase discount rate for reporting purposes. This may hurt servicing prices during such periods because of reduced demand.
In late 1992, President Bush vetoed a bill that, if enacted, would have had a negative impact on servicing prices. Last January, this legislation was reintroduced as H.R. 13 in essentially the same form. Originally conceived as a means of defusing legal battles over write-offs for goodwill, the key element of the bill would require that purchased mortgage servicing rights be amortized over 14 years using the straight-line method.
Under FAS 65, purchased mortgage servicing rights are amortized in accordance with the actual life of their positive cash flows. Under H.R. 13, amortization would no longer match cash flows. In most cases, use of a 14-year straight-line method would result in too little amortization in the early years and too much in later years. Mortgage bankers who buy servicing would find it much more difficult to match revenues with expenses.
Enactment of the legislation, as introduced, could cause a decrease of about 5 percent in the price of a hypothetical servicing portfolio made up of 10,000 fixed-rate loans with an average balance of $100,000, remaining term of 28 years, average note rate of 8.25 percent and average escrows of 1 percent.
There had been hope that the April 20 Supreme Court ruling on the depreciation of goodwill (Newark Morning Ledger Co. vs. U.S., No. 91-1135) would lead to the defeat of the "intangible assets" provisions of H.R. 13. Although the ruling did not deal with PMSRs, it clarified the accounting treatment of many other intangible assets covered by the bill. It also transformed H.R. 13 from a revenue-neutral bill to a revenue raiser, which could raise complications in getting the bill through Congress. As a result, it was hoped that Representative Dan Rostenkowski (D-IL), chairman of the Ways and Means Committee, would decide to either scrap H.R. 13 or restore revenue neutrality to the bill by dropping PMSRs or by providing a more generous depreciation formula.
Unfortunately, the Ways and Means Committee has decided to take advantage of the revenue-raising aspect of H.R. 13 by using it to help make up for revenue shortfalls elsewhere. On May 13, when the committee approved its version of President Clinton's tax plan, it attached the "intangible assets" depreciation provision to it.
It appears that the 14-year amortization plan would apply to all bulk purchases of mortgage servicing rights. However, at this point, it is still not completely clear. Depending on the final language, it is possible that the provision could be interpreted to apply only when a going concern is being purchased or when substantially all the assets of an entity are being purchased. Also, if the FASB ever reclassifies mortgage servicing as a tangible asset, it is possible that this could protect PMSRs from the 14-year amortization rule.
Finally, some hope remains that PMSRs will be dropped from the bill at some point before it gets to the president's desk. Obviously, this is an issue that must be watched very closely as the tax bill continues on its way through Congress.
HUD FORECLOSURE GUIDELINES
Another issue that emerged last year concerned the revision of HUD foreclosure guidelines. The new guidelines became effective November 19, 1992, and, while more stringent than before, they will be easier to implement than the guidelines HUD originally proposed.
Briefly, the guidelines establish a nine-month period within which a foreclosure must be initiated; the original proposal was six months. The new rule establishes a 60-day time frame to initiate foreclosure after the discovery of a vacancy or abandonment, or once a property has been vacant for 60 days. But it is unclear to many servicers exactly how HUD will interpret vacancy and abandonment. It will be interesting to see how this provision works in real life. Although HUD was scheduled to issue a mortgagee letter on May 1, as of this writing, it still had not been issued, so it's difficult to assess the economic impact on servicing prices. However, if the change results in higher costs, we estimate the price of an average government servicing portfolio would drop about 1 basis point for every $250 increment in foreclosure expense.
Much has been written about last year's HUD final rule on the Real Estate Settlement Procedures Act (RESPA) and its likely affect on the industry. But not much discussion has focused on the fact that the impact of these provisions may extend to the mortgage servicing market. To the extent that Realtors actually end up taking loan applications, we could see the development of two-tiered pricing for servicing.
Such a development might be similar to what occurred a few years ago in connection with servicing produced through retail networks versus wholesale production. At that time, there arose a marked preference for retail production, based mostly on the perceived higher quality of the loans. Many buyers of servicing believed that retail production produced better-quality loans and consequently, bid lower for wholesale; produced servicing, if they bid at all. It seems, in my view, as though the same kind of market dynamic could develop in connection with Realtor-originated loans.
The Mortgage Bankers Association of America (MBA) has filed a lawsuit over the RESPA final rule, on the grounds that HUD did not properly justify this major policy shift from prior departmental positions on RESPA and that the regulations may violate the federal law that establishes the exact steps to follow in such policymaking. We may see a decision on this matter from the U.S. District Court as early as this summer.
Turning to a more positive development, a March 26 federal district court decision (U.S. District Court in Washington, D.C., Citicorp vs. FDIC) has provided some welcome reassurance for buyers and sellers of mortgage servicing rights. Although the decision applied to a case involving purchased credit card receivables (PCCRs), it strongly implies that purchased mortgage servicing rights have quantifiable values and cannot be repudiated without compensation.
The case dealt with whether or not the Federal Deposit Insurance Corporation (FDIC) can repudiate a specific provision in a PCCR contract without compensation. Those supporting the argument that compensation was required, argued that PCCR contracts do have value because the FDIC recognizes some PCCRs for regulatory capital purposes. The FDIC has explained that it recognizes some PCCRs because they have characteristics similar to PMSRs, which are also recognized for regulatory capital purposes. The judge referenced this explanation in his decision.
Repudiation became an issue back in 1991 when the FDIC caused an uproar by repudiating some PMSR contracts, including a Southeast Bancorp contract for a servicing portfolio purchased by Sears Mortgage Corporation, Vernon Hills, Illinois. Sears Mortgage had purchased servicing rights from an affiliate of Southeast Bancorp. Southeast still held the loans, and the FDIC repudiated the contract so that it could reclaim the servicing and sell the loans servicing-released. There was nothing wrong with the contract per se, but the FDIC simply holds the power to repudiate such contracts.
Since then, the number of repudiations has been very few, but nonetheless, they have remained a source of concern to some buyers of PMSRs.
This decision may suggest that we've seen the end of repudiation-without-compensation to the buyer of the servicing when a contract is repudiated. But that's not necessarily the case. The FDIC failed to issue a statement when the court announced its decision in March. It will be interesting to watch the FDIC's response to determine whether or not repudiation of PMSR contracts will remain an issue.
As a result of last year's hurricanes and other natural disasters, flood insurance compliance became an issue of increasing interest to some lawmakers.
A bill introduced in the U.S. House of Representatives by Representative Doug Bereuter (R-NE) would require lenders to review their portfolios within five years for flood insurance compliance and would require recertification of loans if a flood-zone determination was five-years-old or more. Similar legislation was also introduced in the last Congress but failed to get sufficient consensus support to be enacted, largely because of other provisions in the bill.
As a practical matter, a seller of loan servicing could make a specific indemnity regarding potential costs associated with compliance, so any immediate impact on servicing prices would be negligible. Industry estimates regarding the cost of compliance range from $2 to $48 per loan.
Mention should be made of some hedge accounting developments that are on the horizon. FASB is considering allowing the deferral of gains and losses on hedging instruments, to the extent that the hedge is effective. This would apply to hedges of existing assets and liabilities and firm commitments, but not for forecasted transactions. FASB has tentatively decided that hedging instruments and hedging items would have to be specifically designated as such, be highly inversely correlated to price movements in the asset being hedged and have a dear economic relationship that reduces business unit risk.
Depending on FASB's final document, this change could result in more-favorable accounting treatment of servicing portfolio hedges. The utilization of sophisticated hedging instruments by holders of servicing portfolios is already growing in popularity. Encouragement of this practice may increase market liquidity for servicing rights during periods of falling interest rates because prepayment risk has been hedged away. (In essence, one would be selling a portfolio with prepayment protection.)
INTEREST ON ESCROWS
In recent times, there have been a number of lawsuits relating to escrow administration that hold significance for servicers. In a landmark case, GMAC Mortgage Corporation, Elkins Park, Pennsylvania, settled a suit filed by 12 state attorneys general by agreeing to use aggregate accounting and to reserve according to what the mortgage documents dictated. (U.S. District Court, Southern District of New York, People of the State of New York vs. GMAC Mortgage Corporation, No. 90 CIV 7924, January 27, 1992.) The consent judgment allows for modifications allowing GMAC Mortgage to conform to whatever rule HUD may issue on escrow practices or to future amendments to RESPA. It is interesting to note that the state attorneys general pointed out on numerous occasions that GMAC wasn't out of sync with common industry practice and HUD has endorsed the escrowing practices used by GMAC as being in conformity with RESPA.
The industry has been hearing for quite some time about the possibility of federal legislation covering interest on escrows and escrow accounting. The 103rd Congress is gearing up to put this on the front burner.
Last year, Representative Henry Gonzalez (D-TX), chairman of the House Banking, Finance and Urban Affairs Committee, introduced legislation that would require:
* servicers to pay interest on escrows at a rate of 5.25 percent;
* the escrow balance, at least once a year, to drop to the lesser of a two-month reserve or the amount specified in the mortgage document; and
* the performance of an aggregate escrow analysis.
The bill also granted the borrower the right to terminate an escrow account when the unpaid principal balance fell to less than 80 percent.
On January 5 of this year, Chairman Gonzalez reintroduced the bill as H.R. 27, the Escrow Reform Act of 1993. The new bill tracks the old one with two exceptions:
* Interest on escrows would be paid at the current passbook savings rate, as defined by HUD, instead of 5.25 percent;
* Interest would be paid prospectively on accounts established one year after enactment of the legislation.
If enacted, failure to comply with the act would subject the lender to civil money penalties, with provision for actual and punitive damages.
A hearing on H.R. 27 was held on May 19 in the House banking committee's Housing and Community Development Subcommittee, also chaired by Gonzalez. While this legislation at this point is far from being considered a done deal, it has a lot of consumer appeal. For this reason, and a renewed pro-consumer zeal in the Congress, it's likely that the legislation will attract a good deal of support.
H.R. 27 could result in direct savings to the consumer of about $35 a year. (This is based on a typical loan size of $100,000, average escrow balance of 1 percent and average interest rate of 3.5 percent.) However, this bill would also result in a reduction of about 25 percent in the value of the previously described hypothetical servicing portfolio, assuming that interest on escrows is not currently paid. Lenders in states with higher average escrow balances will experience a more severe impact, and those in states with lower average balances will be affected less. Also, mortgage bankers in states that already require payment of interest on escrows, would be less dramatically affected by this legislation.
COMMUNITY REINVESTMENT ACT
Another piece of legislation to watch is H.R. 1700, the Community Reinvestment Reform Act. This new bill would, among other things, bring mortgage bankers under the Community Reinvestment Act (CRA). (CRA was originally enacted in the 1970s to prevent banks and thrifts from redlining low-income or minority neighborhoods.)
H.R. 1700, introduced by Representative Maxine Waters (D-CA), would have the effect of making compliance with the law more burdensome for the institutions already covered. It also would make CRA requirements applicable to non-depository lenders. Mortgage bankers would have to submit a community support statement every two years. This statement would include Home Mortgage Disclosure Act (HMDA) data as well as supplemental information on lending practices, including a description of any actions taken to serve low-income neighborhoods. They could face fines of $10,000 per month if they were found to be neglecting segments of the local community.
Obviously, depending on final language approved with such legislation, mortgage bankers could be faced with additional onerous and costly compliance burdens, and the impact on the industry could be significant. However, the other items on the banking committees' agendas will determine whether an issue such as this has a chance of moving in the new Congress.
CAPITALIZING ORIGINATED SERVICING
Good news is on the horizon in the form of proposed changes to FAS 65, "Accounting for Certain Mortgage Banking Activities." In December, FASB issued a proposal for a mortgage servicing project that would very likely result in the approval of capitalizing originated mortgage servicing rights (OMSRs). FASB received 48 comment letters on its proposal, 40 of which are in favor of the project.
Under existing accounting rules, purchased mortgage servicing can be capitalized, but originated servicing cannot. This inconsistency requires mortgage bankers to expense the entire cost of originating servicing and has encouraged some lenders to sell the servicing rights they generate and to purchase servicing rights from others, in order to realize the value of servicing for accounting purposes.
Capitalization of originated servicing makes sense. The development of an active secondary market for servicing has increased asset liquidity and, as a result, has made servicing more like assets classified as tangible. Clearly, the only thing that now differentiates OMSRs from PMSRs is ownership.
As of this writing, action by FASB appears imminent. FASB staff was expected to recommend to the board that it go ahead with the mortgage servicing project. If the board does so, the most likely result is approval of a cost allocation plan for originated mortgage servicing capitalization.
Under the plan, when a lender originates a loan, a share of the loan's value would be attributed to the servicing rights. It is still unclear how the value of servicing would be determined. Presumably, it would bear some relationship to market values. The value of servicing could then be capitalized.
If FASB does decide to allow capitalization of originated servicing, the market will see an impact on supply and demand that most likely will boost pricing. With time, a 5 percent to 10 percent increase in servicing prices may occur. There would also be a dramatic short-term increase in the reported profits of many mortgage bankers because the entire cost of originating servicing would no longer be expensed in the first year.
One rumor currently making the rounds should be noted, though it shouldn't be taken too seriously as yet. There have been some rumblings that the Federal Reserve Board and other bank regulatory agencies may once again attempt to treat GNMA servicing as recourse.
This issue was believed to have been put to rest some time ago. If anything like this actually happens, it would result in a significant drop in the value of GNMA servicing. No details are available at this time; the rumor, may in fact, be groundless. However, it's important to keep an eye out for any reliable signs of action in this area.
While these legislative and regulatory initiatives have the potential to greatly affect the way we do business, they are by no means the only issues facing the mortgage banking industry. New challenges continually arise. The mark of the successful mortgage banker will be the ability to adapt to our ever-changing environment.
Stephen Z. Hoff is president and chief executive of Hamilton, Carter, Smith and Company, Inc., Los Angeles.…