Third-Quarter Prepays Reignite Impairment

Not everyone has to worry about accounting for impairment anymore, but some lenders have chosen to stay with the traditional treatment of mortgage servicing rights in their quarterly financial statements. And for them, the third quarter is likely to include some negative surprises.

Mortgage rates ended the quarter lower than they started. According to Freddie Mac, the average contract rate on 30-year, fixed-rate mortgages was 6.78% on June 29. On Sept. 28, the average rate was 6.31%.

That 46 basis point decline in mortgage rates has revved up the refinancing engine again. Though refinancing activity hasn't shot up to refi boom proportions, there has been a notable increase in refinancing, according to the weekly mortgage application survey conducted by the Mortgage Bankers Association. At the end of the quarter, refinancing was running at about 45% of loan applications, up from the mid-30s earlier in the quarter.

So it's not surprising that early earning reports from the banking industry reveal some impairment damage. M&T Bank Corp., Buffalo, N.Y., said that it suffered a $5 million impairment to the value of its mortgage servicing rights. M&T Mortgage of Buffalo NY, ranked 37th among servicers at mid-year with $18.4 billion in servicing on its books, a 13% gain from mid-year 2005.

One year earlier, in the third quarter of 2005, M&T benefited from a $6 million reversal of impairment that raised the value of the MSRs.

This year's drop in MSR values didn't stop M&T from posting a 13% increase in its earnings per share for the quarter, but much of the company's earnings momentum seems to have come from an acquisition of branches from Citibank and from cost cutting measures.

As this edition of Mortgage Servicing News went to press, none of the top 10 mortgage servicers had reported earnings yet. Many have abandoned the old way of accounting for servicing rights, instead choosing to focus on changes in the fair value of servicing rights along with changes in the fair value of derivatives that may be used to hedge the economic risks in the MSRs.

It will be interesting to see if the new accounting framework adds earnings volatility or not. By opting for the more straightforward fair value accounting, companies have essentially chosen accounting simplicity and transparency over the more complicated rules associated with hedge accounting under Financial Accounting Standard 133, which requires that certain tests be passed in order to qualify for hedge accounting treatment. While many lenders, especially mega-servicers, will not likely miss the "lower of cost or market" quandary that they faced before, others may find that with rates once again dipping between the beginning and the end of the quarter, it's not the accounting rules that vex them but rather the "convexity" of the mortgage servicing asset itself.

The borrower's embedded right to refinance into a lower-rate loan means that servicing values can plummet quickly as rates fall, but will only rise modestly when rates start to rise again. Even if lenders aren't caught in the LOCOM trap, it might feel just as painful if a decline in MSR values offsets any gains used in derivatives that were supposed to offset those declines. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com