Consulting Corner
Interest
Rate Lock Commitments and the SEC
By Andrew Davidson
Background
Following the implementation of FAS133, mortgage bankers had been
treating Interest Rate Lock Commitments (IRLCs) as derivatives. This
practice allowed them to mark the IRLCs at fair value, which could
be positive or negative depending on the specific rate lock and the
movement of interest rates. There was some diversity in the treatment
of IRLCs, as some firms were showing gains at the inception of rate
locks (day 1), while other firms showed IRLC values to be near zero
at inception. The diversity in treatment may have resulted from differing
estimates of the value of the servicing component of the rate lock,
but may also have resulted from different treatment of the costs associated
with the rate lock and loan closing process. Subsequent movements
in the value of the IRLCs and the associated hedges (day 2, and following
days) generally would offset each other, both on an economic basis
and for financial reporting. There was little or no diversity in accounting
for these subsequent market moves.
The Issue
In late 2003 a staff accountant for the SEC suggested in a speech
that the SEC was looking into the accounting treatment of interest
rate lock commitments (IRLCs). At the time, the SEC suggested that
it would be appropriate to treat IRLCs as written options, and that
their view would be expressed in a forthcoming Staff Accounting Bulletin
(SAB). The accounting implication would be that IRLCs would be treated
as liabilities and could have only negative values.
This treatment would have had a significant detrimental
effect on mortgage bankers and borrowers. The written option treatment
would have created earnings volatility for firms who were hedging
the economic risk of rate locks. Firms would have reacted either by
switching to more expensive hedges, which would increase rates to
borrowers, or by reducing the availability of longer-term rate locks.
The Outcome
Rather than imposing written option treatment, the SEC issued Staff
Accounting Bulletin 105 on March 9, 2004, requiring mortgage bankers
to exclude the value servicing cash flows in their computation of
the fair value of IRLCs. The SAB specifically includes portions of
the interest >>>
