August 17, 2007

Ojai, CA --  Banks that engage in asset securitizations may not have as much capital as they purport, even by regulatory standards.  This is not good news in light of recent problems in the subprime mortgage business.  Asset securitizations lead to the creation of servicing assets -- for mortgages this is called mortgage servicing rights or MSRs.  MSRs are peculiar beasts, arguably intangible assets.   Yet bank regulations are not entirely clear on how to treat MSRs.  A strict reading of current regulations may indicate that banks are understating their intangibles and overstating their capital.  At a minimum, it may be time for regulators to re-visit the accounting for MSRs and their inclusion in primary capital. 

WHAT IS AN MSR?

An Mortage Servicing Right or MSR is a subset of an asset class known as servicing assets or servicing rights.  Banks that originate and sell loans such as mortgages, Small Business Assocation (SBA) loans, credit card receivables, student loans, and auto loans get to utilize one of the accounting profession's true gifts to bankers: gain-on-sale accounting (GOS).  GOS simply means that when an institution sells a pool of assets -- like mortgages or SBA loans -- it gets to take the assets off the balance sheet (this is good), record a profit, (assuming the pools are sold above their cost), and take all future income from servicing into income at the time of sale (this is even better). 

Under GOS accounting, once a pool of loans is sold, the assets -- usually mortgages -- disappear from the bank's balance sheet.  This event lowers total assets and therefore improves return on assets -- a key measure of bank performance.  But wait, it gets better.  Mortgages, SBA loans, etc. have to be serviced -- collecting payments, sending out statements, providing tax and insurance escrows, etc.  Even if a bank sells a pool of mortgages it can still retain the rights to service those mortgages.  Servicing is good because it is fee-based and doesn't use a bank's balance sheet.  Since the bank "sold" the mortgages, accounting convention allows the bank to front load ALL future servicing income at the time of sale.  That's right, all future earnings are taken into income at day one.  The offset to this accounting gift is the creation of an asset -- in this case an intangible asset -- called a Servicing Asset or Servicing Right.  For mortgages this is called a Mortgage Servicing Right or MSR. 

This is a little like you taking your next ten years of salary into income today and booking the offset as an asset, let's call it "unearned salary receivable."  This greatly improves your personal financial statement as it inflates your net worth by an accumulation of ten years of future earnings.  But what happens if you get laid off or fired?  What happens to all that future income?  If you could use GOS accounting on your personal statement, you would simply adjust the salary receivable account downward and then reverse all previously recognized income.  Your net worth goes down.

The same thing happens in the mortgage business.  Since an MSR is calculated by using assumptions about future events (mortgage prepayment speeds, default rates, refinancings), the value of the MSR is subject to constant revision.  Bankers admit that there is both art and science in valuing MSRs.  Accounting requires institutions to create valuation accounts to periodically readjust the MSR.  An impairment can either be temporary (and flow through the adjustment account) or permanent, in which case a special charge must be passed. 

Up until 2006, MSRs were benign creatures.  Mortgages behaved systematically and valuations were consistent and relatively easy.  All mortgage bankers had to have was a good knowledge of interest rate movements, since prepayment speeds appear to be related to interest rate moves.  Since 2006, a new wrinkle has entered the market -- defaulted mortgage payments, led by the subprime sector, but bleeding over to prime mortgages as property values decline.  In mortgage servicing, a default is little different than a prepayment, and it is generally unexpected and difficult to model and forecast.  As subprime defaults soar, bank models of MSR values are being adjusted as we speak.

HOW BIG IS THE PROBLEM?

MSRs are not a new concept.  They have been around for more than two decades.  In the 1990's regulators reviewed the impact of these instruments and amended the relevant regulations to take into consideration the increased risks to bank balance sheet that ensued from their creation.  Since regulators were convinced MSRs were fairly benign assets, they allowed banks to include MSRs as tangible assets up to 100 percent of their capital base. 

Although MSRs do not project an inordinate amount of risk when kept to a reasonable level, they do become worrisome as they grow as a concentration of bank capital.  Most of the biggest US banks have only a small exposure to MSRs as a percent of capital. At Citigroup, Chase, or Bank of America and Wells Fargo, the ratio is generally less than 5 percent of capital. 

It gets more interesting with Washington Mutual and Countrywide, two of the nation's largest mortgage originators and servicers.  Over the past decade, total MSRs at Countrywide have hovered around 100 percent of regulatory capital. That means Countrywide, notwithstanding current GAAP and gain-on-sale accounting, would appear to have no tangible Net Worth.  This comes on top of recent problems these insitutions are having with subprime and Alt-A lending.  

SO WHERE ARE THE REGULATORS?

In an obscure appendix to the Federal Reserve's Regulation Y, bank holding companies (corporations that own the banks) may only include portions of their intangible servicing assets if they meet certain criteria.  Otherwise, the assets must be treated as intangibles and deducted from regulatory capital.  Federal Reserve Regulation Y as well as instructions for the preparation of quarterly Regulatory reports provide guidance for activities of banks and Bank Holding Companies in the arcane world of MSRs.  Since the late 1990s, the Regulations, as mentioned, have allowed Bank Holding Companies to hold up to 100 percent of capital in MSRs.  

But hold on.  An appendix to Reg Y states that sevicing assets such as MSRs may be included in capital only to the extent that they are "readily marketable."  Since Regulation Y fails to define readily marketable, we can use any definition we find suitable.  Accounting texts clearly consider assets readily marketable if they are liquid, i.e., can be sold quickly at little discount, or have an active market.  Do MSRs meet the definition of readily marketable?  Perhaps not. 

Many bankers might agree.  There is no active secondary market for these instruments and there is no daily pricing information available on Bloomberg.  MSRs are generally brokered by intermediaries who match buyers and sellers.  However, there is really no market maker standing behind MSRs or making bid/ask quotes.  Although it may be possible to liquidate a small position in MSRs, it would be extremely difficult for a company like Countrywide to sell over $10 billion in such assets.  Essentially, to sell a substantial amount of servicing assets, an institution would probably have to liquidate a good portion of its servicing portfolio or more than likely sell the entire business line or the company.  

So where are the regulators in all this?  Countrywide is no longer regulated by federal bank regulators and it is no longer subject to Regulation Y.  In the past it was given a pass to continue its growing its MSRs and not really growing tangible net worth.  In the areas of MSRs as well as SBA servicing assets, the major US bank regulators appear to have turned a deaf ear to the fine print in Regulation Y.  With the current mortgage meltdown, it may now be time for regulators to dust off Regulation Y and fully enforce it for those institutions that service mortgages and other assets.  At a minimum, the Federal Reserve should provide an interpretation of what exactly "readily marketable" means. 

Barring this, the market will have to make its own adjustments, as is happening to Countrywide, Washington Mutual and other mortgage giants in the subprime arena.  In the absence of sharpened regulatory oversight, it appears to be business as usual in this arcare corner of the mortgage underwriting industry. 

-- Carl Hyndman
Contact: chyndman@aol.com