IRLC Transformational Costs Risks, Consequence & Best ... · Income Approach (ASC 820) “An...

Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update

Andy Schell, CPA/CFF, CMBManaging Partner, Mortgage Banking Solutionswww.MBS-team.com

IRLC Transformational CostsRisks, Consequence & Best Practices

Santo Chiarelli, CPAPartnerAcquavella, Chiarelli, Shuster, LLP

Andy Greer, CPAVice President First Tennessee Warehouse Lending

The Importance of UnderstandingIRLC Transformational Costs

Presented by:Andy Schell, CPA/CFF, CMBManaging Partner Mortgage Banking Solutionswww.MBS-team.com

Purpose of Presentation• Information & Education on IRLC issues• Goal is Understandable Financial Results• We’ll Explore IRLC

• Challenges & Risks • Unintended Consequence of Decisions

• Lots of material – Going FAST • Hold Questions until the end

Andy Schell, CPA, CMB – www.MBS-Team.com

A Place to Begin• GAAP provides foundation for comparability

• GAAP financials are produced for the benefit of Users• Users include: Warehouse Banks, Agencies and SEC/Public

• Warehouse Lenders provide funds for IMB to close loans• IMB Balance Sheet is the basis for the Warehouse Loan, Investor

and Agency Approvals

• CPA Report presents IRLC Asset and IMB Capital o LendersAndy Schell, CPA, CMB – www.MBS-Team.com

Fair Value of Loans Held for Sale• Before FV, most expense at closing; revenue deferred to sale

• With FV, Financials are correlate to loan closing volume

• FV Month-End Financials• All Direct and All Indirect expenses• All Revenue including fees and LHFS MTM (gain on sale)• Volume Correlates to Financials

And Then, Enron• Enron, WorldCom, and Arthur Anderson (formed 1913)

• GAAP says:include the impact from Off-Balance Sheet Financing Commitments subject to market risk when preparing GAAP financials

• Do IMB have Off-Balance Sheet Financing Commitments? Yes.

• Every Interest Rate Lock Commitment (IRLC) is an Off-Balance Sheet Financing Commitments Subject to Market Risk

What is the Locked Pipeline?• IRLC is an Off-Balance Sheet Financing Commitments

Subject to Market Risk

• What are the characteristics of an IRLC? • They are “Applications in Process” or Potential Loans • They are NOT an Tradeable (or saleable) Asset • There is nothing to basis adjust

• So we create an asset – Derivative AssetAndy Schell, CPA, CMB – www.MBS-Team.com

Derivative AssetWe Create a Derivative Asset by:• DR Derivative Asset; CR Income• CR Income INCREASES Capital

IMBs want more Capital• More IRLC means more Income• More Income means more Capital• More Capital means more Warehouse borrowing• More Capital means qualifying for FHA & Agency• More IRLC means more Capital

Is an IRLC a TRUE Derivative?Example of Derivative• Hedging sells TBA-MBS via broker dealer• TBA-MBS is a tradable commodity with an active market

Is a TBA-MBS tradeable with no additional processing? YES

Is the IRLC tradable with no additional processing? NO

An IRLC must experience Transformation Costs to be Loan

Transformation Costs or Cost to CompleteWhat is the value of the IRLC?

• Pull-thru adjusted MTM less Costs to Complete

What is the right amount of Transformation Costs?• Direct Cost Deduction Method - direct costs only• Full Cost Absorption Method - both direct and indirect costs• IRLC is a pure derivative – no adjustment (IRLC same as TBA-MBS)

IMB Transformational Costs – Best PracticesDirect Expenses• LO commissions, production commissions• Other Direct Production Costs:

• appraisals, outsourcing, courier, credit reports, other costsOther Direct Expenses

• LO wages, processors, LOA, • underwriting, funding, disclosure and post closing

Indirect Expenses• Allocated Production Rent, Branch Rent, Branch Overhead

Consequence of Ignoring Indirect Costs

Hawaii vs TexasHigh Balance vs Low Balance

Loan Size Matters

Loan Size creates Different RatioONE LOAN

High Balance low gainLow Balance high gain

Derivative AssetIs Similar

Processing costs as % of loan are different

Profit % is same

Higher Gain %

$50,000,000 Locked Pipeline

Texas lender’s capital is more than double

Different Derivate AssetIdentical Cash Realization.

Indirect Costs Matter At year end, cut rates in Texas to fill-up

pipeline to increase DA and increase capitalAndy Schell, CPA, CMB – www.MBS-Team.com

CPA Presentation of the Derivative Asset

How can two CPAs say the Mortgage IRLC is worth 6% and .5%?

Where is Comparability?

Derivative Asset / IRLC

Remember FAS 5 & FAS 91FAS 5• Receivable Collectability: Probable, Possible or Remote• IRLC Derivative Asset Collection is ???

FAS 91 • Capitalize Direct Costs from Successful Efforts – Pull-Thru• Defer all Revenue; Defer some some Costs• IRLC – Recognize all Revenue; Recognize some Costs

Unresolved Impact: Warehouse Lender Concerns• CPA Audit is the basis for Warehouse Lender Risk Exposure• CPAs inconsistently calculate Costs to Complete• Under applying Costs to Complete increases Capital• Overstated Capital creates Risk Exposure to Warehouse lender

Warehouse Lenders deduct and adjust the Derivative Asset • What can CPAs do to make Audit meaningful to Users?

When Fair Value Isn’tUser Perspectives on the IRLC Asset

The Reality of Warehouse Lendingin a Regulatory Environment – OCC, FDIC, FRB

when CPA Audited Financial Statement are UnreliableSlides by:Andy Greer, CPAVice President First Tennessee Warehouse Lending

Your Logo here

Warehouse Lenders Position One:

The “Direct Cost Deduction Method” Isn’t Useful to Users

What does it mean to be useful?

“Financial reporting should provide information to help present and potential investors and creditors and others to assess the amounts, timing, and uncertainty of the entity’s future cash inflows and outflows (the entity’s future cash flows).”

Conceptual Framework for Financial Accounting, FASB:

One Characteristic of Usefulness:

Comparability

“Comparability is the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena.”

--- Conceptual Framework for Financial Accounting, FASB

Perspective

•Not comparable

Elements we all care about

•Materially Overstates Future Cash Flows by a Factor of 2-10 times

•Volatile

The “Direct Cost Deduction Method” Isn’t Useful to Users

--- “Amounts and Timing”

--- “Uncertainty”

Compared to what?

Quarterly Mortgage Bankers Performance Report (MBA) – IMBs Q3 2016

Total Loan Production Revenue 411.06 bps

Total Loan Production Expense (336.84) bps

Total Net Production Income 74.22 bps

Direct Loan Production Expenses: 318.59 bps

Average Net Production Income Since 2008: 55 bps

Comparing the Direct Cost Deduction Method‘s Results

Gross Pipeline Revenues, Pull-Through Adjusted -- From Analytics Report( Direct Costs ) -- Management Estimate= Value Assigned to Pipeline -- IRLC Asset Hedging Instruments

Methodology:

• Non-random selection of 4 publicly-traded mortgage entities

• Random selection of 32 Independent Mortgage Bankers (IMBs)

IRLC Asset (Balance Sheet)Notional Amount of Pipeline at December 31, 2016 (Notes)

Valuation in basis points=

Not Pull-through adjusted

Not Useful- Not Comparable

Public Mean: 142 bps

IMB Mean: 261 bps

Which Method?

Financial Results are Not Comparable.

• IRLC asset averaged 35% of equity

• 72% of average asset will never be converted to cash

- Material

- Overstated261 bps - 74 bps*

261 bps = 72%

Warehouse Lender Position Two:

The direct cost deduction method materially overstates the value of unclosed loan pipeline.

Ignores the majority of pipeline cash outflows.

Cash Flows Matter in Fair ValueIncome Approach (ASC 820)

“An estimate of future cash flows for the asset being measured.”

“When quoted market prices are not available, which is typically the case for derivative loan commitments [. . .] estimates of fair value should be based on the best information available in the circumstances (e.g., valuation techniques based

on estimated expected future cash flows). - Interagency Advisory On Accounting And Reporting For Commitments To Originate And Sell Mortgage Loans

Cash Flows Matter for IRLCs

Future Cash Flows:1. Cash Inflows2. Cash Outflows

Quarterly Mortgage Bankers Performance Report (MBA) – IMBs Q3 2016

Average Net Production Income Since 2008: 55 bps

CPAs Argue GAAP, but fall into Two Ditches

Ditch One: Incurred Costs

Life of a Loan:From Lock, Funding, to Sale

How much commission is due if UW declined?

Life of a LoanTo

September 1 September 30 October 15

Incurred Costs

Costs to be Incurred 1

Gross Revenue, Pull-Through Weighted- Costs to Be Incurred= Value of a Pipeline Loan

1 “Accounting for Mortgage Banking Activities: Interest Rate Lock Commitments, Forward Sales Commitments, and Closed Loans Held for Sale.” Wilary Winn, 2012

2 “Accounting and Regulatory Guidance for the Mortgage Partnership Finance Program” WilaryWinn, 2016

Prevents Double-DeductingCosts Already Incurred 2

Measurement Date

W&W = FASB ??

Life of a LoanTo

September 1 September 30 October 15

Pipeline of Loans

Measurement Date

• When revenue recognition is triggered at lock (the earliest possible point), incurred costs don’t affect the loan pipeline’s value.

Incurred Costs Don’t Matter In an Asset Net Of Costs Presentation

Sales Price: $2.00

pencil

COGS: ($1.50)Margin: ($0.50)

SaleRaw Materials Manufacture

$0.50 of Costs $1.00 of Costs Sale for $2.00

WIPRaw Material Inv.

WIPWages Payable

A/RSales Revenue

COGSFinished Goods

Revenue RecognitionMatching Principle

SaleRaw Materials Manufacture

$0.50 of Costs $1.00 of Costs Sale for $2.00

WIPRaw Material Inv.

WIPWages Payable

A/RSales Revenue

Revenue RecognitionMatching Principle

COGSFinished Goods

• When revenue recognition is triggered at lock (the earliest possible point), incurred costs don’t affect the loan pipeline’s anticipated value.

Incurred Costs Don’t Matter In a Net Of Costs Presentation • When revenue recognition is triggered at the creation of pencil WIP (the earliest

possible point), incurred costs don’t affect the finished pencil’s anticipated value.

• Pull-through affects the loan pipeline’s value – Causal Relationship to Fair Value

“When estimating the fair value of derivative loan commitments [. . .] institutions should consider predicted “pull-through” [. . .]. Some factors that may be considered in arriving at appropriate pull-through rates include [. . .] the origination channel [. . .],current mortgage interest rates in the market [. . .], the purpose of the mortgage (purchase versus refinancing), the stage of completion of the underlying application and underwriting process, and the time remaining until the expiration of the derivative loan commitment.” -- OCC: “Interagency Advisory On Accounting And Reporting For Commitments To Originate And Sell Mortgage Loans”, 2005.

One more rabbit trail

Sample Segue Slide

Sales Price: $2.00COGS: ($1.50)Margin: ($0.50)

1. Materials2. Labor3. Overhead

Overhead is a Reality.

- PwC, “Fair Value Measurements” 2015

“If a market does not exist for the asset [. . .] the market for the securitized loan can be used to determine the fair value of the asset or liability, adjusted, as appropriate, for

transformation costs and margins (or profit) to reflect the fair value of the asset or liability held by the reporting entity.”

Indirect Costs are a part ofTransformation Costs

Absorption-Like Method

Ditch Two:

What Else Could Affect Pipeline Cash Flows?

Business Combination

Ditch Two: Business Combination

• “To estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date.” – ASC 820

The Purpose of Fair Value:

The “Orderly Transaction”:

• Selling the unclosed loan pipeline to another entity

• Occurs in the asset’s principal market

Ditch Two: Business CombinationThe Argument:

A buyer of IRLCs wouldn’t consider fixed/indirect costs in determining the purchase price.

• More engine work

• More body work

• More paint

• Seller’s lease

• Seller’s salary

• Seller’s electric bill

Sales Price When Complete: $100,000

The Problem: There is no market for IRLCs

But, there is a market for selling a mortgage company

Fair Value of IRLCs = Business Combination

Ditch Two: Business CombinationPrincipal Market Requirement

in Fair Value / 820Business Combination as

Principal Market• “Market in which the reporting entity normally

would enter into a transaction to sell the asset” ( 820-10-35-5A )

• Contains the greatest volume and level of activity for that asset (820-10-20 “Principal Market” definition)

• Must be accessible at measurement date (820-10-35-6A)

• Minimizes unobservable inputs (820-10-05-1C)

• Never entered into as a going concern.

• No level of activity for the asset as a going concern.

• Is accessible one time: during a sale

• Maximizes unobservable inputs

Ditch Two: Business CombinationPrincipal Market Requirement

in Fair Value / 820Business Combination as

Principal Market• “Market in which the reporting entity normally

would enter into a transaction to sell the asset” ( 820-10-35-5A )

• Contains the greatest volume and level of activity for that asset (820-10-20 “Principal Market” definition)

• Must be accessible at measurement date (820-10-35-6A)

• Minimizes unobservable inputs (820-10-05-1C)

• Is the market normally entered into

• 100% of loans originated by IMBs are sold into this market

• Is accessible at the measurement date

• Minimizes unobservable inputs

Secondary Market

We’re all in the wrong market.

IMBs’ Net Value of Unclosed Loans:

Mean: 261 bps

MBA’s Net Production Profit Margin:

Mean: 74 bps

AnticipatedGoodwill

“Excess of the price paid at a takeover for an entity over its fair market value”

Result of the Second Ditch:

IRLC Asset represents Goodwill

Whichever Ditch We Picked

Financial Results Containing IRLC Asset are Not Useful.

• IRLC asset averaged 35% of equity

• 72% of asset, on average, will never be converted to cash

We routinely count Goodwill as a component of liquidity and tangible net worth

under the Direct Cost Deduction Method

Fixed AssetsMSRs

Loans held for Investments

Not Liquid:

Liquid:IRLCs Materially Overstated

We all think we’re right.

We need clarification.

We account for this asset differently, and those differences are material.

Perspective on Direct Cost Deduction Method

•Not comparable

•Materially Overstates Future Cash Flows

•Volatile

Applying More Costs (Absorption-like) = More Useful

OVERSTATEMENT OF AN “IRLC” ASSET OR LIABILITY CREATES TAX AND CASH FLOW UNPREDICTABILITY

Slides by:Santo Chiarelli, CPAPartnerAcquavella, Chiarelli, Shuster, LLP

Overview

• An IRLC is an off balance sheet commitment subject to market risk

• This commitment must be considered when preparing GAAP financial statements.

• GAAP requires this commitment to be recorded at Fair Value at its measurement date either as a derivative asset, or in rare cases, a derivative liability with income or expense being recorded through the P & L.

• Internal revenue code section 475 requires the reporting of income or loss on this derivative asset or liability • when the income or expense is recognized, • thus creating a GAAP to Tax “ timing difference”

Overview (continued)

• The cash inflows or outflows will be recognized in the subsequent tax reporting period

• Historically as interest rates increase origination volume will typically decrease.

• When origination volume decreases, pipelines decrease thus causing the “IRLC” to decrease

Interest Rate Volatility

• In an environment where origination volume and pipeline value decrease,

• independent mortgage bankers need to manage expenses and liquidity as profits and cash flows will typically decrease

• However when the value of “IRLC” is overstated it can become extremely difficult to manage tax liability and cash flow, as illustrated in the following example

• “ITS ONLY A TIMING DIFFERENCE”

2015 2016

SUMMING IT UP2015 2016

Net Income $3,496,000 $2,331,388

Taxable Income $2,083,600 $3,006,788

Pay Tax on Timing Difference

SUMMING IT UP

• Can’t have it both ways• Although a timing difference, overstated IRLC Asset

- Can lead to greater taxable income when volume declines- Requires Paying taxes as Asset adjusts

IMB Transformational Costs – Best PracticesDirect Expenses• LO commissions, production commissions• Other Direct Production Costs:

• appraisals, outsourcing, courier, credit reports, other costsOther Direct Expenses

• LO wages, processors, LOA, • underwriting, funding, disclosure and post closing

Indirect Expenses• Allocated Production Rent, Branch Rent, Branch Overhead

How do we fix it?• Don’t make it worse by ignoring cost• Add Transformational Costs as volume grows• Wait for FASB to force a one-time adjustment

Andy Schell, CPA/CFF, CMBManaging PartnerMortgage Banking Solutions512-501-2812Andy@MBS-team.com

Thank You & Contact Information

Andy Greer, CPAVice President First Tennessee Warehouse Lending901-759-7705AGreer@firsttennessee.com

Andy Greer is leading team of CPAs in discussion with FASB

IRLC Transformational Costs Risks, Consequence & Best ... · Income Approach (ASC 820) “An...

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