Accounting for mortgage servicing rights

under the FASB's proposed standard

The mortgage banking industry experienced tremendous growth in the area of mortgage
servicing rights in the past 10-15 years. Income from these rights has become increasingly
important to the overall financial health of mortgage banks. Rosenblatt (1993) states that
"a profitable servicing operation continues to be the key ingredient to long-term success in
the mortgage banking industry."

As the significance of these servicing rights to the mortgage banking industry has
increased, questions have been raised concerning their current accounting treatment.
Presently, Statement of Financial Accounting Standards (SFAS) No. 65, "Accounting for
Certain Mortgage Bank Activities," provides guidance in accounting for mortgage
servicing rights. The central problem with SFAS No. 65 is that it requires different
accounting rules for servicing rights depending upon whether the related loan was
purchased or originated by the financial institution. An institution is allowed to capitalize a
separate asset for the servicing rights if they were purchased with the loan. However,
servicing rights may not be capitalized for loans originated by the institution.

In 1992, responding to this reporting inconsistency, the Mortgage Bankers Association of

America asked the Financial Accounting Standards Board (FASB) to reconsider the rules
set forth in SFAS No. 65 for mortgage servicing rights. The FASB agreed that the rules
needed to be reconsidered and added the project to its agenda. This project recently
resulted in the issuance of an FASB Exposure Draft (ED), "Accounting for Mortgage
Servicing Rights and Excess Servicing Receivables and for Securitization of Mortgage
Loans," which outlines the proposed accounting guidelines for mortgage servicing rights.
This article outlines the inconsistencies of the current accounting guidelines for servicing
rights and summarizes the FASB's proposed rules for eliminating these problems.

CURRENT ACCOUNTING AND THE RESULTING PROBLEMS

Current accounting rules under SFAS No. 65 do not allow financial institutions that
originate loans, and subsequently sell those loans while retaining the servicing rights, to
record an asset for the servicing rights. On the other hand, financial institutions that
purchase loans with the servicing rights may capitalize an asset for the servicing rights and
subsequently sell the loan while retaining the servicing rights. This allows these latter
institutions to retain the servicing rights assets on their books, thereby improving their net
worth.

Mortgage bankers believe current accounting rules for servicing rights are inappropriate
for two main reasons. First, the inability to record an asset for servicing rights on
originated loans understates a firm's net worth and also impacts its reported earnings.
Second, financial institutions may be forced by the accounting rules to enter into
transactions that are not in the best economic interest of the firm.

A financial institution that purchases loans with servicing rights allocates a portion of the
purchase price to the servicing rights asset, thereby causing its basis in the loans to be less
than the full purchase price. A financial institution that originates loans identical to those
purchased by the firm above would not allocate any of the loans' costs to the servicing
rights. Therefore, the originating firm would have a higher basis in their loans. When the
originating firm sells the loans and retains the servicing rights, two inequities occur. First,
its net worth is understated because the firm has no basis in the servicing rights retained.
Second, the higher basis in its loans results in lower reported profit (or higher loss) when
the loans are sold.

The servicing rights on a mortgage loan are important to the financial institution for a
number of reasons. Two very important reasons are that these rights can produce
significant revenue over the life of the loan, and, maybe even more important, these rights
allow the institution to maintain contact with the customer for the life of the loan. This
contact provides opportunities to cross sell other services the financial institution provides.
For these and other reasons, most financial institutions prefer to retain the servicing rights
on loans that they originate or purchase, even though they sell the loan.

The economics of selling originated loans and retaining the servicing rights are favorable,
but, as mentioned above, the accounting results are not. It is even possible that, if
significantly large enough loan portfolios are sold at prices consistently less than the loans'
bases, the income statement losses combined with the lack of recorded servicing rights
assets could cause the firm to approach regulatory restrictions for net worth requirements.

An alternative for the firm is to sell the servicing rights along with the loan. This would
increase the sales price and, as a result, decrease the loss or increase the gain on the sale.
The income statement would be improved, and there would be no effect on the balance
sheet since there was no asset for the servicing rights. However, the firm has lost the
servicing rights and the potential benefits that go with them.