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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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
The Importance of UnderstandingIRLC Transformational Costs
Presented by:Andy Schell, CPA/CFF, CMBManaging Partner Mortgage Banking Solutionswww.MBS-team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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)
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Consequence of Ignoring Indirect Costs
Hawaii vs TexasHigh Balance vs Low Balance
Loan Size Matters
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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 %
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
$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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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?
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Warehouse Lenders Position One:
The “Direct Cost Deduction Method” Isn’t Useful to Users
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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:
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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”
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Compared to what?
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Not Useful- Not Comparable
v
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Not Useful- Not Comparable
Public Mean: 142 bps
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
IMB Mean: 261 bps
Not Useful- Not Comparable
Public Mean: 142 bps
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
IMB Mean: 261 bps
Not Useful- Not Comparable
Public Mean: 142 bps
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Which Method?
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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%
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Warehouse Lender Position Two:
The direct cost deduction method materially overstates the value of unclosed loan pipeline.
How:
Ignores the majority of pipeline cash outflows.
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Cash Flows Matter in Fair ValueIncome Approach (ASC 820)
“An estimate of future cash flows for the asset being measured.”
OCC:
“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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Future Cash Flows:1. Cash Inflows2. Cash Outflows
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Quarterly Mortgage Bankers Performance Report (MBA) – IMBs Q3 2016
Average Net Production Income Since 2008: 55 bps
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
CPAs Argue GAAP, but fall into Two Ditches
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch One: Incurred Costs
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Life of a Loan:From Lock, Funding, to Sale
How much commission is due if UW declined?
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Life of a LoanTo
tal R
even
ue
Tota
l Exp
ense
sN
et M
argi
n
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 ??
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Life of a LoanTo
tal E
xpen
ses
Net
Mar
gin
September 1 September 30 October 15
Tota
l Rev
enue
Pipeline of Loans
Measurement Date
Goi
ng C
once
rn
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch One: Incurred Costs
• 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)
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch One: Incurred Costs
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch One: Incurred Costs
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch One: Incurred Costs
• 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.
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
One more rabbit trail
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Sample Segue Slide
Sales Price: $2.00COGS: ($1.50)Margin: ($0.50)
1. Materials2. Labor3. Overhead
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Overhead is a Reality.
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
- 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.”
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Indirect Costs are a part ofTransformation Costs
Absorption-Like Method
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch Two:
What Else Could Affect Pipeline Cash Flows?
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Business Combination
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch Two: Business Combination
The Problem: There is no market for IRLCs
But, there is a market for selling a mortgage company
Fair Value of IRLCs = Business Combination
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch Two: Business Combination
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Ditch Two: Business Combination
AnticipatedGoodwill
“Excess of the price paid at a takeover for an entity over its fair market value”
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Result of the Second Ditch:
IRLC Asset represents Goodwill
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Whichever Ditch We Picked
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
We all think we’re right.
We need clarification.
We account for this asset differently, and those differences are material.
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Perspective on Direct Cost Deduction Method
•Not comparable
•Materially Overstates Future Cash Flows
•Volatile
Applying More Costs (Absorption-like) = More Useful
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
OVERSTATEMENT OF AN “IRLC” ASSET OR LIABILITY CREATES TAX AND CASH FLOW UNPREDICTABILITY
Slides by:Santo Chiarelli, CPAPartnerAcquavella, Chiarelli, Shuster, LLP
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Overview
• An IRLC is an off balance sheet commitment subject to market risk
• This commitment must be considered when preparing GAAP financial statements.
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• 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)
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• The cash inflows or outflows will be recognized in the subsequent tax reporting period
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• 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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• 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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• 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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
• “ITS ONLY A TIMING DIFFERENCE”
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
2015 2016
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Andy Schell, CPA, CMB – www.MBS-Team.com
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
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
Mortgage Banking Solutions MBS-Team.com AHACPA - Lender Update
Andy Schell, CPA/CFF, CMBManaging PartnerMortgage Banking [email protected]
Thank You & Contact Information
Andy Greer, CPAVice President First Tennessee Warehouse [email protected]
Andy Greer is leading team of CPAs in discussion with FASB