14. August 2010 by Bob Jarmak.

The following are recommended for accounting estimates for Current Coupon loans, by CMB Clients:

These do not represent fair market values and are only for use by CMB Clients for estimation purposes, as described in CMB Client Documentation.  These do not represent an offer by CMB to purchase or sell at these levels.

 As loan rates rise above the 30Y Current rate, values decline, substantially in cases of a large drop in rates.

As rates reach new lows, clients should plan for significant declines in servicing values, and increases in impairment.

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10. August 2008 by Bob Jarmak.

There are a few (very few) advantages to age.  The key is experience.  As the old saying goes; you can have 1 year of experience for 10 years or 10 years of experience.   

If you have the latter, you can remember when all mortgage lending was portfolio lending.  While there is no question the growth of the secondary mortgage market led to some of the most positive economic outcomes of the past 20 years, there were certain advantages to the portfolio approach.

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6. July 2008 by Bob Jarmak.

There is increasing political pressure on the SEC and FASB to adopt global accounting standards. 

Clearly, most large US companies derive a substantial part of their income and sales outside the US, and it is a significant issue. Generally, foreign accounting standards can be described as principles based accounting as compared to the US rules based accounting.In theory, principles based accounting focuses on reporting which yields the “correct” results without specifying how these results should be obtained.Another way to view this is the “end justifies the means” although the public agencies would not use this term.

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30. August 2007 by Bob Jarmak.

Accounting for MSR’s (Mortgage Servicing Rights)

Specialized accounting for MSR’s began in the late 1970’s with the creation of GNMA MBS, which was the beginning of the secondary mortgage market. Prior to this, loans were traded on an individual basis outside of any formal, standardized market. The emergence and subsequent growth of the secondary mortgage market remains one of the most important finance events of the past 50 years.

The ability to reallocate capital flows has had beneficial effects for all involved. The conventional MBS market followed, several years later. This led to the development of FASB 65, the controlling standard for many years. FASB 65 dealt with many aspects, including the treatment of fees and the treatment of purchased loans.

It was common for large originators and sellers to purchase block loans from other originators and subsequently securitize them.This led to the unequal treatment of purchased loans and originated loans. It also led to the abuses of the early 1990’s which caused numerous bank failures, where banks were assigning unreasonably high values for future MSR’s.

FASB 122 was introduced to combat some of these abuses, as well as treating originated loans the same as purchased loans, from an accounting standpoint. Various iterations of this have been introduced since, up to the current FASB 156.

The principle remains consistent; mortgage servicers have a contract to receive future income.The only requirement is that they perform their servicing duties. This is a legally binding contract from typically a quasi-governmental agency which may be sold or transferred to another servicer. The only real risk of non-payment is early prepayment. As such, the present value of these future rights should flow through current period results.The alternative? If accounted for as cash income when received, the equity position is understated as this future income is not recognized.

For some, it’s not material, but regardless, it would still be an understatement, which is wrong. Investors/regulators would be forced to make their own calculations of this value, to properly value the institution. The “cost” of this is increased volatility as MSR’s are subject to substantial revaluation as loans prepay early. But, this revaluation just represents reality. Some find this treatment objectionable for a variety of reasons, not the least of which is this increased volatility.

Other objections include the cash/non cash components and the comparison between this treatment and other assets.Parenthetically, some with the largest objections have no problem with goodwill or other similar assets. Perhaps the best way to view this accounting is as an introduction to the coming fair value transition.Some will continue to object, strongly in many cases, but the future direction appears pretty clear, and changes will continue in this direction.

Why does fair value make sense? All financial valuation is based on a very simple concept. It is the present value of the expected future income streams. For non-financial assets, value is replaced by utility, which allows items such as art to be valued consistently. Banks are really pretty simple businesses. They borrow funds and they reinvest them.To maximize returns, is to maximize the spread between cost and earnings. The specific levels are generally a function of the local or regional market, while the spreads are relatively consistent among similar institutions.

The base value of the institution is the present value of the spread cash flow for as long a period of time as the spread is expected to continue at that level (in practice, a perpetuity). Although the amount of the spread will move within a range based on the overall yield curve shape, over time it will be relatively stable. To this, we can add the present value of other income streams, such as servicing revenue, fee income, etc., and subtract the present value of expenses. We can also adjust for other assets such as real estate.When we’re done, we have an economic model for the value of the institution. It may bear no resemblance to book value.

This is why fair value is so important.To analyze values, we need to adjust the book value to fair value.

Doesn’t it make sense to obtain management’s view of these adjustments through the use of fair value accounting? Some would object to this, claiming an oversimplification.

What about the value added by excellent customer service? This will flow through in the growth rate of the balance sheet, and an increase in the margin, as customer service contributes (albeit slightly) to these factors.What about innovative programs and solid marketing? The answer is the same; it all comes out in the growth rate and the margin. What about controlling expenses? Again, it all comes out in the present value analysis.

Fair value also promotes good management. Growth is the critical component in valuation, due to the nature of compounding, which should not need to be emphasized to a banker! Yet, many continue to focus on expense control to the exclusion of growth, which has a much lower payoff than growth in the valuation process.

Just look at the valuation of Microsoft for a concrete example. The reason their stock trades at a lower multiple is that their expected growth continues to decline, even as they pile up cash.

There are no real disadvantages to using fair value accounting, other than inconvenience and change. And the advantages are numerous.

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27. August 2007 by Bob Jarmak.

Fair Value Acconting

There are few topics that can cause stronger opinions from finance professionals than fair value (FV). After living with historical cost accounting (HCA) for so many years many see a myriad of issues when confronted with FV. Coupled with the valuation of future income streams, this is a guaranteed controversy.

This is probably due to a number of factors, both real and psychological (behavioral). There is the natural and normal reluctance to change and discard the large historical knowledge base acquired through years of experience. There is also the tendency to view the current method as best, to validate it’s use, much like the purchase of a new good.

But, when we look at the current system of accounting, we see a confusing, troubling mix of HCA and FV, leading to the current problematic environment. On many levels, it is difficult to support the continued reliance on HCA.

What is the purpose of presenting financial information? Who is the intended audience? as we all well know, these questions form part of the problem. The purpose likely depends on the audience. And there are many audiences, or stakeholders in the process. We have government regulators, whose interests may transcend the stated purposes. There may be multiple regulators, each with their own vested interests. And investors, some sophisticated and some not. For mutual institutions we have customers. Then, there is management, who may have vested interests and purposes.

If truly the purpose of publishing information is to permit the valid comparison of organizations, the method should not matter, as long as it is applied consistently. But with a large number of confusing and conflicting regulations, this is not possible.

There is also a movement to principle based accounting, from rule based accounting. Unfortunately this requires the presence of complete confidence in all involved in applying these principles, and based on a long history of observing human behavior, it’s highly unlikely we should believe in the consistent presence of principles where money and personal gain are involved. Is the support for the continuation of HCA rational and reasonable? On most levels, the answer has to be no. In a financial environment where the value of everything changes every day, how can we support the contention that the continued reliance on HCA presents the best view of an organization’s financial status and value?

How can you rationally argue that charging below market rates for loans and /or paying above market rates for deposits has no effect on the value of a financial institution? How can you rationally argue that because it is difficult to establish an exact value for less liquid assets and liabilities, it is better to ignore changes in values than to develop reasonable estimates or ranges of estimates? How can you rationally argue that because current HCA allows or forces certain transactions off the balance sheet, this is the correct way to present the information? How can you support a system that presents financial information in a way that is basically meaningless and useless without substantial further analysis?

While acknowledging there are potential issues with FV, it is difficult to ignore the value of this change.

For many years, market based firms, such as Wall St. dealers have used FV. With the value of much of their balance sheet items readily available through published market quotes, the task appears relatively simple. However, appearances are sometimes deceiving. Even a market as large and public as the MBS market can be “shaded” by dealers. If the market is dominated by the 5 or 6 largest dealers, and their natural position is “long”, it’s quite amazing how prices have a tendency to rise at year end. Similarly, the growth in derivative instruments has been dramatic over the past 15 years, and many of these instruments have no liquid markets. Clearly there is an incentive to establish market prices favoring dealer positions.

Yet, even with numerous hedge fund collapses, FV has remained an accurate way to measure balance sheets of market makers. Compared with these complex balance sheet valuations, community institutions have trivial valuation issues. If it were very difficult to establish FV, sales and mergers would occur at levels with very large price differences. But we know this is not the case. That’s because the normal balance sheet of a community institution is heavily concentrated in loans on the asset side, and deposits on the liability side. Since both are interest rate based, valuations are comparatively simple, with adjustments for credit quality, local market variations, etc. So, if an institution competes in a market where deposit rates are low and loan rates are low, the net will still be accurate. Similarly, competition in a highly competitive market will result in a narrowing of spreads and a resulting decline in value. Perhaps the class with the most significant effect on value will be real estate, as HCA does not take this into effect. However, institutions are very familiar with appraisal techniques to adjust for this value difference.

What’s the single largest advantage of FV? Accountability. It remains simple to move a purchase of securities or a loan acquisition program to “portfolio.” This still generally means the purchase was made or the program was made at higher market levels than the current levels, so the mark-to market is negative. It is often justified to “match” A/L positions. In some cases this is accurate, however, a loss is a loss, whether recognized today, or over time. Bleeding a slow death is just as fatal as a quick one; the only difference is time.

What if a deposit or loan program is priced to attract business? Of course, it may be a great business decision, but this is a marketing expense and should probably be recognized immediately and not amortized over time. Marking to market using FV will properly account for this, where traditional HCA will not. In fact, there are very few examples where HCA presents a fairer, clearer picture than FV. It is very difficult to face the constant truth of FV; it also leads to better long term decisions and more disciplined management.

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