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 in the definition of servicing.
The SAB states, "servicing assets are to be recognized only once the
servicing asset has been contractually separated from the underlying loan
by sale or securitization of the loan with servicing retained." Generally,
this means that 25 basis points of coupon must be excluded from the computation
of the IRLC value.
While this treatment creates some degree of misalignment between economics and accounting, most firms believe that it is a degree of uncertainty they can manage. The SEC action appears to reflect on-going concern about the how servicing is valued and issued related to revenue recognition for "intangible assets." Interestingly, the concern over intangibles is so great, the SEC required that even "tangible" interest (the 25 basis points) be excluded from the valuation of IRLCs, because it is so entwined with the servicing rights.
Since the SAB did not impose written option treatment on IRLCs, firms can continue to treat IRLC (excluding the servicing component) as derivatives recorded at fair value. The SEC position allows the standard practice of estimating fallout and hedging to expected closing ratios to remain unchanged. Therefore, firms may continue to offer their current set of mortgage products and rate locks to consumers without incurring significant additional costs or face large swings in reported financial results.
