An Accountant’s Perspective on the Mortgage Industry September 2012

An Accountant’s Perspective on the Mortgage Industry September 2012

To Retain or Not To Retain

That Is The Question…

[author-style]By Jeanette Emmons, CPA, Senior Manager[/author-style]

No, not water, nobody wants to retain water! I’m talking about mortgage servicing rights! This seems to be the question on the minds of more and more independent mortgage bank’s management teams. Is there anybody out there who isn’t thinking about getting agency approval and entering the brave new world of servicing? OK, you’re right, it’s not such a new world, just one that most independent mortgage banks left years ago, and are now considering returning to.

WHY THE RECONSIDERATION? It seems the servicing release premium (SRP) isn’t what it used to be, which brings to light the need to consider the cost benefit of selling a loan servicing released versus servicing retained. This is not a simple consideration and not a decision that should be made quickly or without significant fact gathering. Of course we’re all interested in the bottom line impact on net profit (hello, accountant over here), so management must consider the immediate direct revenues and costs as well as the indirect and ongoing costs that will be incurred; but at the same time management can’t overlook the operational changes and risks that are added when retaining servicing. There are numerous factors to consider and if management hasn’t played the servicing game before they should seek the advice of trusted advisors and get opinions from peers in the industry who have gone before them. Questions to be answered:

• To retain or not (in general and on a per loan basis)?
• Which agency best suits your needs?
• How long will it take to get agency approval?
• How hard is it to get agency approval?
• Will we have to cover payments not made by borrowers?
• Should we service or hire a sub-servicer?
• How will the pending Dodd – Frank regulations impact the economics of retaining?
• What happens to my balance sheet when we start retaining and recording mortgage servicing rights (“MSRs”)?
• What happens to the MSRs on my balance sheet when interest rates and other factors change?
• How does all of this impact my compliance with minimum net worth, liquidity and other financial ratio requirements of regulators, lenders, and investors?

Since I’m limited to one page here I’ll jump to the balance sheet questions, as the balance sheet is near and dear to my heart. When a company sells a mortgage and retains the servicing rights, it must record the value of the servicing asset (or, in some cases, the servicing liability) at its fair value at the time that the loan is sold. Then management has an option. The MSRs can be amortized over the expected life of the loan or an election can be made to carry the MSRs at fair value with changes in value running through current earnings. Many companies find it easier to carry MSRs at fair value when using a third party to calculate the valuation. This requires a fairly simple adjustment to the newly calculated value, as opposed the sometimes complex and time consuming calculations needed for tracking amortization when assets are being added and removed every day. Other companies however, don’t like the potential volatility they are introducing to their balance sheet when electing fair value and therefore choose to amortize the MSRs. If the MSR value declines, a loss is recognized for the reporting period. REMEMBER – there are rules upon rules that must be considered when building accounting policies for MSRs. Here again, a consultation with a trusted advisor is likely in order if it is new territory for management.

Finally, what does this new asset do for a company’s net worth? Generally speaking, it increases net worth. HUD, Fannie, Freddie and Ginnie currently recognize servicing assets as acceptable assets (with the caveat that they are properly reported according to Generally Accepted Accounting Principles). Note however, that some warehouse lenders may not. Their covenant calculations may include an adjustment to pull them out when determining tangible net worth, which would mean that you’ve traded the cash you would have received selling a loan servicing released for an illiquid asset that does not increase your net worth for borrowing purposes.

“WE KNOW WHAT WE ARE, BUT KNOW NOT WHAT WE MAY BE.” ~HAMLET
I wish you luck and wisdom as you traverse the new landscape of Mortgage Banking!

Evaluate Internal Controls

and Lower Your Risk

[author-style]By Vivek Agarwal, CPA, CFE[/author-style]

The management of mortgage lenders and service providers should periodically assess the design and operating effectiveness of their internal controls, based on the organization’s risk profile and/or as required by regulations. This assessment should be performed by someone independent of operations such as an Internal Auditor (“IA”) or can be outsourced to a third party consultant (“TPC”), and always overseen by the Board of Directors.

BENEFITS OF ASSESSMENT

Periodic assessments help management proactively identify control gaps including non-performance of controls by process owners and take necessary corrective action resulting in a strong control environment. Given the seasonal nature of mortgage banking, mortgage lenders with strong internal controls will be able to maximize their efficiencies and economies of scale, and compete effectively. Improvement of operations also leads to happy customers, increase in referrals and growth of business. Fraud risk especially in the loan origination process is also reduced with anti-fraud controls such as segregations of duties, code of conduct policies, a whistleblower hotline, and background checks. Additionally, compliance to regulations is strengthened and lenders can avoid the penalties associated with non-compliance.

RISK ASSESSMENT AND SCOPING

The first step in the internal control evaluation process is to perform a comprehensive risk assessment and identify the “what can go wrong” scenarios. Both qualitative (such as competitive and regulatory environment, level and complexity of mortgage banking activities, extent of automation) and quantitative factors (financial numbers) should be considered. These would in turn facilitate the identification of controls that would address these risks. A scoping matrix should be developed, listing the significant processes and the locations at which these processes occur. Critical financial and operational processes to be considered are as follows:

• Loan Origination and Pricing
• Loan Underwriting
• Loan Servicing
• Secondary Market Sales
• Regulatory Compliance
• Financial Reporting
• Information Technology General Controls (such as Change Management, Logical Access, Backups, Physical Security, etc.) and Application Controls for the above business areas
• Corporate Governance – Entity Level: These controls set the tone at the top and help establish the expectations of the organization’s control environment
• Internal Controls at third party service vendors used by the organization such as closing agents

ASSESS THE DESIGN EFFECTIVENESS OF INTERNAL CONTROLS

For the critical processes identified, the IA/TPC will understand and evaluate the internal controls by:

• Interviewing Process Owners and actual persons performing tasks
• Walkthrough “live” transactions and obtain a sample copy of actual documents
• Cover the initiation, authorization, recording, processing and reporting of sample transaction.

For example: A Loan Origination process would typically cover the receipt of loan applications from the prospective borrower, pre-approvals / pre-qualifications, credit check LP / DP processing (Loan Prospector/ Desktop Underwriters), rate lock, generation of Good Faith Estimate, etc.

Based on the understanding obtained during walkthroughs, IA/TPC will prepare or confirm the existing process documentation. Process documentation can be maintained in the form of narratives, flowcharts or in an electronic repository. The process documentation should at a minimum identify the key controls, related assertions (completeness, existence, etc.), the frequency of performance, the preparer and reviewer/ approver, and documentation evidencing performance of control. A Risk Control Matrix may also be prepared mapping the risks identified with the associated controls. Any control gaps identified during this phase will be evaluated and remedial action taken.

WHAT IS A KEY CONTROL?

A “key control” is a control affected by an entity’s Board of Directors, management, and other key personnel that is the most effective in providing reasonable assurance that the entity has:

• Reliable financial reporting
• Effective and efficient operations
• Compliance with applicable laws and regulations

ASSESS THE OPERATING EFFECTIVENESS OF INTERNAL CONTROLS

In this phase, test plans are prepared to test the performance of identified key controls. Sample sizes to be tested will vary depending upon the nature of control, whether it is automated or manual. Testing of automated controls is normally less extensive than testing manual controls. If the IT general computer controls have been tested and are operating effectively, only one instance of the automated control needs to be tested to conclude effective operation. For manual controls, sample size would further depend on the frequency of performance such as daily, weekly, etc.

Sample items are then selected and the controls tested. Testing results are documented, evaluated and reported to management and the Board of Directors. Controls that failed may be retested after remediation.

For assistance in evaluating the design effectiveness and operational effectiveness of internal controls at your organization, please contact a member of our Mortgage Banking Services Group.

The Mortgage Interest Deduction: Helpful or Harmful?

[author-style]By Jessica Offer, CPA[/author-style]

There is a common myth which most people believe to be true: the mortgage interest deduction (“MID”) increases home ownership and that was the intention of the deduction in the first place. In theory, one may think that by the government “subsidizing” mortgage payments, it would make owning a home appear more affordable. What most people overlook is the potential for the MID to increase mortgage rates and housing prices which would negate part of the intended benefit. So which is it? Is the deduction beneficial to homeowners or unfavorable?

A BRIEF HISTORY LESSON: The first form for individual income tax, known as a “1040”, was first implemented in 1913. One of the deductions allowed on the Form 1040 in 1913 was “all interest paid within the year on personal indebtedness of the taxpayer” (direct from the 1913 Form 1040). During this time, the majority of loans were related to business expenses and for that reason the deduction existed to encourage entrepreneurship. The mortgage interest deduction therefore was created by accident. It was simply a by-product of an all inclusive interest deduction. At that time, mortgages were not as prevalent as they are now. In the 1930s the government created institutions such as Fannie Mae which purchased mortgages from local banks which provided them more capital to issue more loans. This revival of liquidity acted as a catalyst for the increase in home ownership. Through the 1980s, deducting interest on all personal debt was still allowed until tax legislation underwent a major reformation in 1986. The Tax Reform Act eliminated the interest deduction on credit card debt and personal loans but continued the deduction for mortgage interest. Additionally a limit was set for allowable mortgage interest on up to $1,000,000 of principal. Additional interest could be deducted on up to $100,000 of a home equity line (with the $100,000 having nothing to do with home ownership). And that is how the legislation stands today.

There have been many studies performed to analyze the effect of the mortgage interest deduction on the housing industry; such as its effects on homeownership, housing prices, and interest rates. A study performed by Georgia State University assistant professor Andrew Hanson, The Incidence of the Mortgage Interest Deduction: Evidence from the Market on Home Purchase Loans, examines the effect of the mortgage interest deduction on interest rates. His findings showed that the result of higher mortgage rates caused by the MID. His study focused on the change in interest rates on principal balance mortgages which approximated the $1,000,000 limit, as interest on principal above $1,000,000 would be nondeductible. The results of his study showed that as principal mortgage balances exceeded $1,000,000, interest rates were actually lower. This can be explained by the notion that since interest paid on principal greater than $1,000,000 is nondeductible, a homeowner’s monthly payment is the true cost, whereas, when a borrower receives the MID, they view it as a reduced cost of the mortgage therefore making mortgages less than $1,000,000 more desirable which causes an increase in rates.

Another study performed by Dean Stansel and Anthony Randazzo, titled Unmasking the Mortgage Interest Deduction: Who Benefits and by How Much?, focuses on who (types of taxpayers and geographic location) receives a greater benefit and how much of a benefit they are actually receiving. This study also echoes some of the theory in Hanson’s study that the mortgage interest deduction is a subsidy increases demand increased housing prices and interest rates. In recent times, interest rates have been at an all-time low, and one may think, how could they be even lower, if for example, the mortgage interest deduction were to be eliminated. If the MID were eliminated, again, economic theory would kick in, prices and rates would initially drop which would increase demand, which would drive up rates and prices and the cycle would continue.

There have been numerous other studies performed which discuss this topic. Each one results in different estimates as to the true effect of the mortgage interest deduction on the housing market including prices and interest rates (all are fairly agreeable to the fact that it does not increase homeownership). There are numerous other factors which affect these amounts thereby making it more difficult to isolate the effect caused directly by the MID. The deduction is costing the government billions of dollars; however the true savings to taxpayers remains unknown.

WHAT DO YOU THINK?

Would you repeal or reform the mortgage interest deduction? Does it impact potential homebuyers? Share your thoughts and visit:
https://www.surveymonkey.com/s/H9P6GG2

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An Accountant’s Perspective on the Mortgage Industry is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Mortgage Banking Services Group with your inquiries.

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