Nobody Said It Was Going To Be Easy! FAS133 Compliance Is A Daunting Task
Problems persist with the hedging treatment of pipeline mortgages and servicing portfolios issues.
By Jerry DeMuth
Mortgage bankers and servicers are finding that complying with FAS133, the accounting for derivative instruments and hedging activities, is still not easy, despite the one-year deferral that gave most until last Jan. 1 to begin to comply.
Many are following tentative advice from the Mortgage Bankers Association (MBA) or the Financial Accounting Standards Board (FASB) on how to comply with some provisions of FAS133. Everyone's greatest problems rest with the hedging treatment of pipeline mortgages and servicing portfolios, issues that have yet to be formally resolved.
But there is no shortage of other problems connected with predicting and determining values and value changes of mortgages and mortgage servicing rights and their hedges, and correlating these changes within the standard's guidelines to determine the effectiveness of the hedging activities.
More than 55% of corporate executives responding to a recent "Journal of Accountancy" survey of Fortune 1,000 companies on dealing with FAS133 were concerned about requirements for testing and assessing hedge effectiveness, documenting risk-management strategies and valuing derivatives.
FASB, which is still clarifying and interpreting FAS133 issues, recognized these and other potential compliance problems when it created its Derivatives Implementation Group to answer compliance questions even before the new standard took effect. Typically, FASB creates task forces to deal with such questions after a standard has been implemented.
Compliance involves developing new risk-management strategies and investing in more technology and personnel as the treatment of mortgages, especially loan commitments, and servicing rights, and hedging, changes.
Changes in fair value have to be predicted and correlated with outcome. As a result, many mortgage bankers and servicers are changing their methodologies and shortening the length of their hedge periods.
A mixed bag
"It's probably a mixed bag in terms of how far along mortgage bankers are in implementing it," says Alison Utermohlen, senior director of financial management at MBA. "Most are familiar with the standard and understand they need to document a risk management policy and achieve hedge accounting treatment.
They have completed their work and are marching along. But other companies are just now recognizing that the standard is in effect. A lot of companies are not even familiar with it.""FASB might not want to hear this," comments one consultant, speaking off the record in early February, "but I think it will take a year for them (many mortgage bankers and servicers) to go through all the systems and documentation changes to be able to feel like they've got it under control. I think it will take all of 2001.
"Officially they were supposed to have been ready to implement FAS133 by Jan. 1. But that didn't happen. A lot of people are still having problems and FASB keeps changing the rules, especially with some of the tricky areas with mortgages."
"Some folks basically don't have the tools or resources to run all these numbers (needed to correlate changes in value of hedges and hedged items)," says Sachit Ramdas Kumar, senior vice president at the New York-based Mortgage Industry Advisory Corp. (MIAC), which helps mortgage bankers and servicers, including Chase, Citi, Fleet and Homeside, formulate methods for compliance with FAS133. "So, maybe instead of going live with this FAS133 implementation in the first quarter, they will go live in the second quarter or the beginning of the third quarter."
Someone involved in compliance at one of MIAC's largest clients, declining to comment on their compliance efforts, explains: "There's a lot of back-and-forth discussion. There's a lot of interpretation of things. We want to wait until we have some final word coming down (from FASB). A lot is going on out there about this whole thing and until some of that settles down, we'd rather watch from the sidelines and see how things are going to go before we discuss how things are handled."
In compliance?
This and other mortgage companies, says Kumar, are still reviewing their implementation efforts and are not sure that what they have done is in compliance.
"A lot of things are not very clear," he says. "A lot of things are just open." "Mortgage companies," says the MBA's Utermohlen, "don't have the flexibility to continue to wait for formal resolution of all these issues. We need to move ahead. Companies need to document their risk management policies and get on down the road."
While FAS133 requires all companies to report their derivatives holdings at fair value and disclose the purpose and effectiveness of their hedging strategies, compliance is more difficult for mortgage bankers and servicers, says Jennifer E. Yoon, a senior manager in the Valuation Services Group at KPMG Consulting LLC in New York.
"With mortgages, there's this huge amount of flow through," she explains. "It's not like the static loan that has no change in the notational amount. New loans come in all the time. That's a huge problem because each of these mortgages has to be separately identified under FAS133 and hedged. And the underlying mortgage is changing (in value) all the time. Since every three months the pool is not the same anymore, you have to redesignate the pool every quarter. Other bonds don't have that problem."
The treatment of loan commitments is one troublesome area, Yoon says, because if they do not
meet the FAS133 definition of a derivative and thus do not qualify for hedge accounting, they will be treated as off-balance sheet, and any gains or losses will not be recognized in earnings.
This could be avoided, according to Utermohlen, if the hedging instruments for these loan
commitments are designated as cash flow hedges of the forecasted sales of the underlying loans, provided that all the qualifying criteria for a cash flow hedging relationship are met.
There are other potential problems with loan commitments under FAS133 that mortgage
companies are struggling with, she says.
"One significant issue the FASB board has yet to formally rule on, which has great implications for mortgage banking companies," she points out, "is whether or not loan commitments to borrowers and commitments to other lenders to purchase loans shall be treated as derivatives."
Positive endorsement
The MBA, which has published a 91-page question and answer guide to FAS133, has taken the
position that loan commitments should be accounted for as free-standing derivatives and marked to market through earnings and, correspondingly, any hedging instrument would be marked to market, says Utermohlen. "That's consistent with FASB tentative guidance," she explains. "And that's an answer we wanted, so we've endorsed that position.
"FASB's most recent interpretation of the standard draws a line in the sand between mortgage companies and portfolio lenders by putting out guidance that says if you intend to sell the loan, you shall account for the loan commitment as a derivative. If you do not intend to sell the loan, you shall not account for the loan commitment as a derivative."
But this still allows the portfolio lender to sell the loan some time in the future, even if the loan is not classified as held for sale, she adds.
More problematic, says Utermohlen, are the requirements that mortgage servicers must meet in order to hedge their servicing portfolios. "It's going to be very difficult, particularly in the current volatile interest-rate environment with interest rates changing almost daily," she points out.
"You have to estimate what the change in value of the whole portfolio is going to be, and then you have to assert that the change in value of each loan within that portfolio is going to change within a tight range of the change in value of the whole portfolio," she explains. "If you cannot do that, then you cannot designate that portfolio as a hedged item.
"That's a very difficult criteria to meet. It's very difficult to group servicing rights in such a way that you can meet that test. It gets very thorny."
This means that servicers cannot macro-hedge an entire portfolio if it is comprised of dissimilar mortgages, she explains. Thus, companies will have to identify multiple pools based on expected changes in the values of the servicing rights due to changes in the hedged risk.
Too much trouble
"My guess is there are companies out there that might just throw up their hands and say, 'This involves too much time and trouble. I'm just going to let the volatility flow through earnings and explain it to my investors and owners.' But a lot of companies don't have that option."
Compliance, says MIAC's Kumar, involves breaking down a portfolio into "buckets" of mortgages with similar price sensitivity. This could result in as many as 100 "buckets." But the top five to 10, in terms of size, would be subject to the largest price changes and probably would represent as much as 90% of the entire servicing portfolio, and only those "buckets" would be hedged.
"The 90 to 95 buckets that are left are very small, so you just leave them (unhedged)," he says.
At the start of every hedge period, mark to market the "bucket" and the hedge and predict what the changes in value will be. And then at the end of the hedge period you have to measure the actual changes in mark-to-market value of both items.
"You should be between 80 and 125 percent of what you predicted. If you're not, then basically you cannot prove correlation, so you cannot take hedge accounting. And if you don't take hedge accounting, hedging is useless.
"Before FAS133, most people did this correlation testing at the portfolio level, so it was pretty easy. They didn't have to worry about all this correlation testing at the FAS133 bucket level."
Also, while in the past most servicers used monthly hedges, doing weekly or twice-monthly hedges is now the better move. Most of MIAC's clients are doing this because the changes are going to be very close to what is predicted. The changes won't be as great for a one- or two-week period as for a month-long period, Kumar points out.
More effort
But this requires more effort and resources by servicers, he admits. "Some folks have hired people
like us to run the numbers for them on a weekly basis," he says, "because if you can't show correlation, you can't take hedge accounting. And that can cost you more than the money you spend on outsourcing."
One recent move by FASB, which is still clarifying and interpreting issues, provides more leeway for
using the regression method of analysis "so you can use cumulative data for a much longer period than the
hedging period," says KPMG's Yoon. "You can use as long a data period as your statistician sees fit. So you
can use five months when your hedge period is only one month."
MIAC, says Kumar, now goes back three to four months for greater accuracy when doing statistical
analyses to determine potential changes in the value of mortgage pools, resulting in greater correlation
between hedged loans and hedge instruments and the predicted change in value of the loans.
"To the extent mortgage companies," concludes Utermohlen "dot their 'i's and cross their 't's and
thoroughly document what they intend to do and meet all the necessary tests and requirements in FAS133,
then they will be effectively marking to market their hedging instrument and marking to market their loans
and their loan commitments."
But that remains a daunting task for many.
This article was previously published in the March 2001 Issue of Secondary Marketing Executive
