Securitized Profits: Understanding Gain on Sale Accounting

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EXECUTIVE SUMMARY

* Securitizations in the mortgage industry are collateralized with home or commercial mortgage loans and are packaged into mortgage-backed securities (MBS) that are sold to institutional investors seeking to realize higher returns on investment-grade debt instruments compared with other securities of similar credit quality.

* Mortgage bankS generate revenue through interest income, the sale of loans and loan servicing income. Loan sales are usually structured as whole loan sales, loans securitized and accounted for as a sale, and loans securitized and accounted for as financing.

* A gain on sale of loans can be either a cash gain or a non-cash gain. When the sale is accounted for as financing, no gain is recognized. When loans are securitized and accounted for as financing, a company recognizes interest income on the mortgage loans and interest expense on the debt securities (as well as ancillary fees) over the life of the securitization, instead of recognizing a gain or loss upon closing of the transaction.

* In recording a gain on the sale of loans securitized and accounted for as a sale, two accounting estimates need to be made: (1) the value of the retained interest and, if applicable, (2) the value of the mortgage servicing rights. Both require the projection of future cash flows that are derived from loans that underlie the MBS. The fair values of each of these assets are based on a series of key assumptions that can significantly impact their fair value and are determined by management judgment.

* In the recent past many banks followed a business model of originating mortgage loans and then passing all or most of the risk to the capital markets. This model is now less popular, but securitization is by no means dead. The segregation of risk to allow a greater degree of leverage is what the world of finance is all about and will continue to be in the future, albeit in potentially different forms.

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In the wake of the subprime meltdown, many investors in struggling mortgage banking companies have been asking themselves how these companies could have been recording such huge profits on the sales of bad loans. The answer is simple. These companies were required by existing accounting guidance to record a gain or loss on the sales of these loans based upon future estimates of economic conditions, interest rates and borrower default rates.

A proper appreciation of gain on sale accounting requires an understanding of the basic definition of a securitization. Asset-backed finance expert Richard A. Graft defines a securitization as "the process by which loans, consumer installment contracts, leases, receivables, and other relatively illiquid assets with common features are packaged into interest-bearing securities with marketable investment characteristics."

Securitizations in the mortgage industry are collateralized with home or commercial mortgage loans and are packaged into mortgage-backed securities (MBS). MBS are sold to various institutional investors that seek to realize higher returns on an investment-grade debt instrument compared with other securities with similar credit quality.

How MORTGAGE BANKS MAKE MONEY

Mortgage banks commonly originate, finance, securitize, sell and service various types of mortgage loans secured by some type of real estate, typically a single-family residence. Subprime mortgage banks lend to borrowers who do not meet the underwriting guidelines that would typically permit their loan to be sold to Fannie Mae or Freddie Mac, such as a high loan-to-value ratio, absence of income documentation, a short credit history, a high level of consumer debt, or historic credit difficulties. The banks charge a higher interest rate to these borrowers because the loans are at greater risk of default.

A warehouse facility is a line of credit extended by a financial institution to fund the purchase or origination of new mortgages. …