Accounting for mortgage servicing rights

National Public Accountant, The, Sept, 1995 by Brian M. Reynolds

Is it time for the Financial Accounting Standards Board (FASB) to amend the Statement of Financial Accounting Standards (SFAS) No. 65, Accounting for Certain Mortgage Banking Activities, again? Yes, and this time it's SFAS No. 122, Accounting for Mortgage Servicing Rights, amending SFAS No. 65 (the third amendment since the fall of 1982). Also amending SFAS No. 65 were SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial-Direct Cost of Leases and SPAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

The Board (FASB) was asked in November 1992 by the Mortgage Bankers Association of America (MBAA) to reconsider the accounting treatment of mortgage servicing rights. The MBAA wanted the FASB to eliminate the accounting distinction between mortgage servicing rights chat are acquired through loan origination activities and chose chat are acquired through purchase transactions. To MBAA, it is illogical to account for these similar assets (mortgage servicing rights) differently just because a mortgage banking entity originated a loan vs. purchasing a loan with mortgage servicing rights, as was required by SFAS No. 65.

Under SFAS No. 65, if a mortgage banking entity originated a loan, it was prohibited from capitalizing the cost of chose mortgage servicing rights; however, it required the separate capitalization of chose rights acquired through a purchase transaction. By not allowing for the separate capitalization of the cost of mortgage servicing rights (on originated loans), a mortgage bank entity often reported accounting losses on the sale of mortgage loans with the servicing rights retained. The reason for these accounting losses was chat the cost of the mortgage servicing rights were deducted from the sales price of the mortgages that were sold. As a result, current net income was understated and future net income would be overstated (dine mortgage servicing income didn't reflect the cost of those mortgage servicing rights).

This accounting treatment is inconsistent with the accounting principal of matching revenues with the related expenses (Costs). SFAS No. 122 addresses this inconsistency and requires the allocation of the cost of these rights for loans chat will be sold with the mortgage servicing rights retained.

The Board decided that SFAS No. 122's scope (dine amendments to SFAS No. 65) should be limited to the recognition of mortgage servicing rights and measurement of the impairments of these rights. A mortgage banking entity chat has a definitive plan to sell or securitize mortgage loans, but retains the mortgage servicing rights, shall allocate the cost of these rights (capitalize these rights as assets) based on the relative fair values at the date of purchase or origination of the loans. If the entity doesn't have a definitive plan to sell or securitize these mortgage loans, no allocation will be made for the servicing rights.

However, if at a later date the mortgage loans are sold or securitized and the mortgage servicing rights retained, then an allocation (capitalization of these rights) based on the relative fair values shall be made on the date of sale or securitization. A mortgage banking entity can value these rights by taking the net mortgage servicing fee (gross mortgage servicing fee minus estimated cost of servicing = net mortgage servicing fee) and projecting the present value (of an annuity) of the net cash flows to be received.

Concerning the impair-ments of the mortgage servicing rights, they will need to be accounted for by a valuation allowance account. The mortgage banking entity shall stratify those rights based on one or more of the predominant risk characteristics of the underlying loans. Characteristics of the loan may include the following examples: amount, interest rate, date, term and geographic location. These mortgage servicing rights (capitalized assets) can be impaired by prepayment of the mortgage loans or by the mortgagees' defaulting on their mortgage loans. Generally, when interest rates are lower, people are more likely to refinance; however, when the economy is bad, people are more likely to default on their loans. Thus, when assessing individual stratums (for the valuation allowance account), these economic influences must be taken into account.

The effective date for SFAS No. 122 is for fiscal years beginning after December 15, 1995. Early application is encouraged, as long as the financial statements have not been issued. SFAS No. 122 replaces the following paragraphs of SFAS No. 65: 16, 17, 18, 19 & 30. Small changes apply to paragraphs 1,10 & 15 (SFAS No. 65) and to paragraph 9 of FASB Technical Bulletin No. 87-3. A copy of this SFAS can be ordered by writing:

Order Department
Financial Accounting
  Standards Board
401 Merritt 7
P.O. Box 5116
Norwalk, CT06856-5116
Product Order Code No.
  S122