Mortgage Servicing Rights - Unhatched Chickens
(Elroy when those folks refinance - don't the banks get richer with all this funny accounting and booking of non existant earnings? Phil was freaking out today over countrywide and KBH and freddie/fannie CEO's sitting on the board - hehe)
The Art of Unhatched-Chicken Accounting
Elizabeth MacDonald, 03.15.04
The top four banks have taken significant charges for impairment of their mortgage-servicing rights. The bottom three have not.
Countrywide Financial Corp., the mortgage issuer, really raked it in during last year's rush to refinance. Profit nearly tripled in 2003 to $2.4 billion on $8.5 billion in revenue.
Or did it? Key to that profit figure was Countrywide's ability to count future mortgage-servicing income as income today. Right there on (nyse: CFC - news - people )Countrywide's 2003 earnings release is $6.1 billion in gains from the sale of loans and securities. These gains, by and large, do not take the form of cold, hard cash. Instead they represent mostly prospective future profits from servicing mortgage portfolios. In other words, unhatched chickens. "Servicing" means collecting the monthly payments and hitting the late payers up for penalties.
Counting future servicing revenue is perfectly legal in the mortgage industry; without it many lenders that are in an objective sense doing quite well would look as if they were headed for bankruptcy. The problem is that counting future income involves a certain amount of guesswork, and sometimes those guesses prove to be too optimistic. In the first nine months of 2003 Countrywide had to take writedowns of $1.9 billion on its mortgage-servicing portfolio. Guesses made in earlier years, that is, turned out to be too optimistic. Whoops, some of the chickens never made it out of the shell. Take a writedown.
Mortgage issuers differ greatly in their tendency to suffer these writedowns occasioned by faulty assumptions. Some, like Countrywide, seem to have more than their share. Other lenders, like Golden West, seem to be more conservative (see table). The writedowns usually show up on income statements as "impairment of mortgage-servicing rights."
Guesswork
The top four banks have taken significant charges for impairment of their mortgage-servicing rights. The bottom three have not.
Company Recent
price 52-week
high P/E Impact of
charges*
BAD EGGS
Countrywide Financial $88.71 $91.00 7 72%
Downey Financial 53.94 54.34 15 77
IndyMac Bancorp 33.44 33.90 12 36
Washington Mutual 44.93 46.85 11 18
GOOD EGGS
Golden West Financial 108.05 108.20 15 0
GreenPoint Financial 44.90 47.30 12 0
New Century Financial 48.78 51.80 7 0
Prices as of Feb. 18. *Total of impairment charges for 2002 and 2003 as share of year-end 2001 mortgage-servicing asset (except New Century asset is for 2002). Source: Reuters Fundamentals via FactSet Research Systems.
The reported net income figures, to be sure, are net of the impairment charges. But the charges are nonetheless unsettling, says Mark Agah, an analyst at Portales Partners, an investment boutique in New York City. In a busy year for refinancing, the huge profits to be made from issuing new loans soften the blow from impairment charges. What happens when the refi boom cools off? Ideally the impairment charges will recede as quickly as the gush of revenue from new loans. But they might not. That's the problem with guesswork accounting.
Countrywide is certainly not unusual in wrapping its business around the economics of servicing mortgages. The value of servicing rights represents a substantial part of the revenues for mortgage lenders, says analyst Daniel Michles at Moody's Investors Service. That may be one reason investors are not exactly in love with mortgage issuers. Countrywide, one of the country's busiest mortgage issuers (with a volume of $435 billion last year), trades at a mere seven times trailing earnings. Another problem is that refinancing has already cooled off. The Mortgage Bankers Association projects that overall mortgage issuance will fall to $2 trillion this year, a steep plunge from last year's $3.8 trillion.
To see how lenders get into the murky waters of future-income estimation, consider what happens when a lender commits to a hypothetical $100,000 loan. It may sell off the IOU on Wall Street (or to Fannie Mae, for example) for $100,000 or a bit more. If it retains the right to service the loan, it can count on an income stream of (typically) 0.37% of the loan balance annually, says Stanislas Rouyer, senior vice president at Moody's. That's $370 a year to start. If the loan lasts for seven years, that's $2,590 coming in. Now subtract future servicing costs--salaries for the people who dun late payers and so on. Now take a further haircut for the fact that a dollar coming in years hence is worth less than a dollar in the bank today. You might wind up with $1,000 as the putative value of the right to service a $100,000 mortgage.
But who knows? There is guesswork at every turn. You don't know what your future salaries will be. You especially don't know how long the loan will stay on the books. In refinancing booms, loans don't last for seven years.
If such accounting already wasn't sketchy enough, some lenders have pushed it beyond this point. They count not just the value of servicing for mortgages on the books but also the prospective future value of servicing rights for a portion of the mortgages that, not quite final, are the subject of interest rate commitments to borrowers.
That's counting the chick before the egg is laid. The Financial Accounting Standards Board has proposed to outlaw this particular maneuver. Washington Mutual and Flagstar Bancorp used to indulge in it, but backed off in anticipation of the FASB move. IndyMacBancorp still counts these futuristic gains.
Another slick maneuver has been perfected by the mortgage lending arm of tax preparer H&R Block. Block sells its loans to off-balance-sheet vehicles so it can book gains about a month earlier than it otherwise would. The company had $75 million of these chicklets on its books at the end of its fiscal 2003 year. Block notes correctly that what it does is totally within the rules.
If you want to buy into a mortgage company or thrift, take a look at its history of impairment charges for a clue as to how aggressive it is in its accounting. Golden West, New Century and GreenPoint Financial (due to be acquired by North Fork) have pretty conservative accounting, says Agah, the analyst at Portales. They managed to get through the refinancing boom of the past two years without any net impairment charges. By contrast Washington Mutual, the nation's largest thrift, has booked $1.1 billion in impairment charges over the past two years, a sum that comes to a sixth of the $6.2 billion mortgage-servicing asset it recorded at the outset of 2002. |
