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Example¹⁹
ABC Mortgage Institution
(Best efforts contracts and no application of fair value hedge accounting)

The Agencies developed this simplified example to provide an institution that has a limited number of derivative loan commitments general guidance on one approach that may be used to value such commitments.²⁰ This example also illustrates the regulatory reporting requirements for derivative loan commitments and forward loan sales commitments.

The guidance in this example is for illustrative purposes only as there are several ways that an institution might estimate the fair value of its derivative loan commitments. A second approach to valuing derivative loan commitments is described in Derivative Loan Commitments Task Force Illustrative Disclosures on Derivative Loan Commitments, a practice aid developed by staff of the American Institute of Certified Public Accountants (AICPA) and a task force comprising representatives from the financial services, mortgage banking, and public accounting communities.²¹ As indicated in the body of the interagency advisory, an institution must consider the guidance in FAS 133, FAS 107, EITF 02-3, and SAB 105 in measuring and recognizing derivative loan commitments and forward loan sales commitments. In addition, institutions should be aware that the SEC or the FASB may issue additional guidance in the future that may alter certain aspects of this example.

Background
ABC Mortgage Institution (ABC) enters into fixed, adjustable, and floating derivative loan commitments to originate mortgage loans that it intends to sell. The institution accounts for the commitments as derivative financial instruments as required under FAS 133.

ABC enters into best efforts contracts with a mortgage investor under which it commits to deliver certain loans that it expects to originate under derivative loan commitments (i.e., the pipeline) and loans that it has already originated and currently holds for sale (i.e., warehouse loans). ABC and the mortgage investor agree on the price that the investor will pay ABC for an individual loan with a specified principal amount prior to the loan being funded. Once the price that the mortgage investor will pay ABC for an individual loan and the notional amount of the loan are specified, and ABC is obligated to deliver the loan to the investor if the loan closes, the contract represents a forward loan sales commitment. Under FAS 133, ABC accounts for these forward loan sales commitments as derivative financial instruments.

At December 31 of a given year, the notional amounts of ABC's mortgage banking derivative loan commitments and forward loan sales commitments are as follows:

Market interest rates have changed throughout the time period that ABC's derivative loan commitments and forward loan sales commitments have been outstanding. Some of the fixed-rate commitments are at rates above current market rates while others are at rates at or below current market rates. All of ABC's adjustable-rate commitments are at rates below current market rates.

Based on its past experience, ABC estimates a pull-through rate of 70 percent on its fixed-rate commitments for which the locked-in rate is above current market rates (i.e., 70 percent of the commitments will actually result in loan originations) and a pull-through rate of 85 percent for its fixed-rate commitments for which the locked-in rate is at or below current market rates. ABC also estimates a pull-through rate of 85 percent for all of its adjustable-rate commitments that are below market rates.

The pull-through rate assumptions in this example have been simplified for illustrative purposes. In determining appropriate pull-through rates, institutions must consider all factors that affect the probability that derivative loan commitments will ultimately result in originated loans. Therefore, institutions are expected to have more granularity (i.e., stratification) in their application of pull-through rate assumptions to their derivative loan commitments.

Discussion of ABC's Approach to Valuing Derivative Loan Commitments and Forward Loan Sales Commitments
ABC estimates the fair value of its derivative loan commitments using the best information available in the circumstances because quoted market prices are not available. In this case, ABC uses valuation techniques that take into account current secondary market loan pricing information.²³ ABC had noted the appropriate reference price for the underlying loans on the day that each derivative loan commitment was given to a borrower and assigned an initial fair value of zero to each loan commitment consistent with the guidance in SAB 105 and EITF 02-3. At the end of the month, ABC compares the current reference price of each underlying loan with its initial reference price and calculates the price difference. ABC then calculates the fair value of these derivatives by multiplying the price difference by the estimated pull-through rate. This approach is illustrated in Table 2 below.

As illustrated in Table 2, ABC excludes time value from its fair value estimate methodology due to the short-term nature of the derivative loan commitments. As the exclusion of time value is not appropriate for all fair value estimates, an institution must consider the terms of its specific agreements in determining an appropriate estimation methodology.

In the example in Table 2, ABC estimated the initial reference price of the underlying loan to be originated under the commitment, excluding the value of the associated servicing rights, to be $100,000. That is, at the date it entered into the fixed derivative loan commitment with the borrower, ABC estimated it would receive $100,000, excluding the value of the associated servicing rights, if the underlying loan was funded and sold in the secondary market on that day. Because this amount is equal to the notional amount of the loan, ABC would not experience a gain or loss on the sale of the underlying loan (before considering the effect of the loan origination fees and costs associated with the loan). As such, the fair value of this derivative loan commitment would be zero, and there would not be any unrealized gain or loss at the inception of the derivative loan commitment. This may not be true for all derivative loan commitments.

ABC defers all unrealized gains and losses at the inception of its derivative loan commitments until the underlying loans are sold. ABC's policy is based on the short-term nature of its derivative loan commitments and was adopted in order to not accelerate the timing of gain recognition. As this practice may not be appropriate for all derivative loan commitments or other derivatives initially accounted for under EITF 02-3 and due to the lack of authoritative guidance in this area, institutions should consult with their accounting advisors concerning the appropriate accounting for their specific agreements.

After applying the methodology described above to individual derivative loan commitments, ABC aggregates the fair values of the derivative loan commitments by type (i.e., fixed, adjustable, and floating) and by whether the commitments have above, at, or below market rates. The fair values of the fixed derivative loan commitments with above market rates, adjusted for the appropriate pull-through rate, total $21,000 [C], which represents an asset. The aggregate fair value of the fixed derivative loan commitments that have at or below market rates, adjusted for the appropriate pull-through rate, sums to ($31,000) [D], which represents a liability. For the adjustable derivative loan commitments, the aggregate fair value, adjusted for the pull-through rate, is approximately ($2,000) [E], which is also a liability. The fair value of the floating derivative loan commitments approximates zero.

ABC also estimates the fair value of its forward loan sales commitments outstanding at the end of the month using a similar methodology as that described above. Based upon this information, ABC determines that the estimated fair value of the forward loan sales commitments related to its derivative loan commitments and warehouse loans with above market rates is approximately ($45,000) [F], which represents a liability, because current market interest rates for comparable mortgage loans are lower than the rates in effect when the derivative loan commitments were initiated. (Consequently, current offered delivery prices for similar commitments are greater than the delivery prices of ABC's existing forward loan sales commitments. Therefore, the change in the fair value of ABC's forward loan sales commitments since they were entered into represents a loss.) The fair value of ABC's forward loan sales commitments related to its derivative loan commitments and warehouse loans with at or below market rates is estimated to be $50,000 [G], which is an asset.²⁴

Regulatory Reporting
The following table illustrates the regulatory reporting requirements for the derivative-related dollar amounts cited in the example.

As illustrated in Table 3, depending upon particular market circumstances, individual derivative loan commitments and forward loan sales commitments may have either positive or negative fair values, which ABC properly reports gross as assets or liabilities on its balance sheet. In addition, for regulatory reporting purposes, ABC consistently reports the periodic changes in the fair value of its derivative contracts in "other noninterest expense" in its income statement. Alternatively, ABC could have chosen to consistently report these fair value changes in "other noninterest income" in its regulatory reports.

¹⁹ This example uses the definitions and concepts presented in the body of the "Interagency Advisory on Accounting and Reporting for Commitments to Originate and Sell Mortgage Loans" (interagency advisory). Reference should be made to the interagency advisory for clarification of the terms and concepts used in this example.

²⁰ Estimating fair values when quoted market prices are unavailable requires considerable judgment. Valuation techniques using simplified assumptions may sometimes be used (with appropriate disclosure in the financial statements) to provide a reliable estimate of fair value at a reasonable cost. See FAS 107, paragraphs 60-61.

²¹ The practice aid is available at www.aicpa.org/download/members/div/acctstd/Illustrative_Disclosure_on_Derivative_Loan_Commitments.pdf - PDF 369k (PDF Help)

²² Alpha references in Table 1 and the text of this example refer to the "Reference" column in Table 3.

²³ In general, source data for secondary market loan pricing information may include, for example, quotations from rate sheets; brokers; or electronic systems such as those provided by third-party vendors, market makers, or mortgage loan investors. When secondary market loan pricing information that includes the value of servicing rights is used, the fair value of the derivative loan commitments ultimately must exclude any value attributable to servicing rights.

²⁴ The absolute value of the fair value of the forward loan sales commitments is greater than the absolute value of the fair value of the related derivative loan commitments because the forward loan sales commitments also apply to, and act as an economic hedge of, ABC's warehouse loans. ABC accounts for its warehouse loans at the lower of cost or fair value in accordance with FAS 65. In this example, ABC does not apply hedge accounting to its warehouse loans.

²⁵ Because derivative loan commitments are in certain respects similar to options, they are reported with "Over-the-counter written options" for regulatory reporting purposes.