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Accounting and Reporting
Accounting Policies
Well-managed institutions have written and consistently applied accounting policies for commitments to originate mortgage loans that will be held for resale and to sell mortgage loans under mandatory delivery and best efforts contracts, including approved valuation methodologies and procedures to formally approve changes to those methodologies. The methodologies should be reasonable, objectively supported, and fully documented. Procedural discipline and consistency are key concepts in any valuation measurement technique. Institutions should ensure that internal controls, including effective independent review or audit, are in place to provide integrity to the valuation process. Therefore, institutions' practices should reflect these concepts to ensure the reliability of their valuations of derivative loan commitments and forward loan sales commitments.
Derivative Loan Commitments
Institutions should account for derivative loan commitments at fair value on the balance sheet, regardless of the manner in which the intended sale of the mortgage loans will be executed (e.g., under a best efforts contract, a mandatory delivery contract, or the institution's own securitization). Institutions should report each fixed, adjustable, and floating derivative loan commitment as an "other asset" or an "other liability" in their regulatory reports based upon whether the individual commitment has a positive (asset) or negative (liability) fair value.6
With respect to floating derivative loan commitments, because the interest rate on such a commitment "floats" on a daily basis with market interest rates, the fair value of a floating derivative loan commitment approximates zero as long as the creditworthiness of the borrower has not changed. However, as with other derivative loan commitments, institutions must report the entire gross notional amount of floating derivative loan commitments in their regulatory reports.
Commitments to originate mortgage loans that will be held for investment purposes and commitments to originate other types of loans are not within the scope of FAS 133 and, therefore, are not accounted for as derivatives.7 Institutions should report the unused portion of these types of commitments, which are not considered derivatives, as "unused commitments" in their regulatory reports.
Forward Loan Sales Commitments
Institutions should account for forward loan sales commitments for mortgage loans as derivatives at fair value on the balance sheet. Each forward loan sales commitment should be reported as an "other asset" or an "other liability" based upon whether the individual commitment has a positive (asset) or negative (liability) fair value.8
Netting of Contracts
For balance sheet presentation purposes,9 institutions may not offset derivatives with negative fair values (liabilities) against those with positive fair values (assets), unless the criteria for "netting" under GAAP have been satisfied.10 In addition, institutions may not offset the fair value of forward loan sales commitments against the fair value of derivative loan commitments (the pipeline) or mortgage loans held for sale (warehouse loans). Rather, forward loan sales commitments must be accounted for separately at fair value, and warehouse loans must be accounted for at the lower of cost or fair value (commonly referred to as "LOCOM"),11 with certain adjustments to the cost basis of the loans if hedge accounting is applied.
Hedge Accounting
Institutions should follow the guidance in FAS 133 when applying hedge accounting to their mortgage banking activities. If the FAS 133 qualifying criteria are met, institutions may apply:
- Fair value hedge accounting in a hedging relationship between forward loan sales commitments (hedging instrument) and fixed-rate warehouse loans (hedged item), or
- Cash flow hedge accounting in a hedging relationship between forward loan sales commitments (hedging instrument) and the forecasted sale of the warehouse loans and/or the loans to be originated under derivative loan commitments (forecasted transaction).12
If an institution does not apply hedge accounting, either because the FAS 133 hedge criteria are not met or the institution chooses not to apply hedge accounting, forward loan sales commitments should be treated as nonhedging derivatives. If an institution does not apply hedge accounting, the institution will account for its warehouse loans at the lower of cost or fair value. Because nonhedging forward loan sales commitments are accounted for at fair value through earnings, such an approach causes volatility in reported earnings if the fair value of the warehouse loans increases above their cost basis. In this situation, the volatility is a result of recognizing the full amount of any decline in the fair value of the forward loan sales commitments in earnings while not adjusting the carrying amount of the warehouse loans above their cost basis.
Income Statement Effect
Unless cash flow hedge accounting is applied, institutions should include the periodic changes in the fair value of derivative loan commitments and forward loan sales commitments in current period earnings. Institutions should report these changes in fair value in either "other noninterest income" or "other noninterest expense," but not as trading revenue, in their regulatory reports. However, an institution's decision on whether to report the changes in fair value in its regulatory reports in an income or expense line item should be consistent with its presentation of these changes in its general-purpose external financial statements (including audited financial statements)13 and should be consistent from period to period.
6 In preparing Reports of Condition and Income (Call Reports), fixed, adjustable, and floating derivative loan commitments should not be reported as unused commitments in Schedule RC-L, Derivatives and Off-Balance Sheet Items, because these commitments must be reported as derivatives in this schedule.
In preparing NCUA 5300 Call Reports (5300 Call Reports), fixed, adjustable, and floating derivative loan commitments should not be reported as unused commitments on Schedule G, Off-Balance Sheet Commitments and Contingent Assets and Liabilities (instead, refer to instructions, page 1a, line 13).
For Thrift Financial Report (TFR) purposes, fixed, adjustable, and floating derivative loan commitments should be included when reporting outstanding commitments in Schedule CC, Consolidated Commitments and Contingencies. For Schedule CMR, Consolidated Maturity/Rate, refer to the instructions as various types of derivative loan commitments have differing reporting guidelines.
7 See FAS 133, paragraph 10(i).
8 Regardless of whether the underlying mortgage loans will be held for investment or for resale, commitments to purchase mortgage loans from third parties under either mandatory delivery contracts or best efforts contracts are derivatives if, upon evaluation, the contracts meet the definition of a derivative under FAS 133. Institutions should report loan purchase commitments that meet the definition of a derivative at fair value on the balance sheet.
9 FAS 133 does not provide specific guidance on financial statement presentation (i.e., where the fair value of derivatives or the changes in the fair value of derivatives should be classified).
10 When an institution has two (or more) derivatives with the same counterparty, contracts with positive fair values and negative fair values may be netted if the conditions set forth in FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts (FIN 39), are met. Those conditions are as follows: 1) each of the parties owes the other determinable amounts; 2) the reporting party has the right to set off the amount owed with the amount owed by the other party; 3) the reporting party intends to set off; and 4) the right of setoff is enforceable at law. In addition, without regard to the third condition, fair value amounts recognized for derivative contracts executed with the same counterparty under a master netting arrangement may be offset.
11 See Statement of Financial Accounting Standards No. 65, Accounting for Certain Mortgage Banking Activities (FAS 65), paragraph 4.
12 See FAS 133, paragraphs 20–21, and related FAS 133 guidance for hedging instruments, hedged items, and forecasted transactions that qualify for fair value and cash flow hedge accounting.
13 See footnote 9 above.