Financial Institution Letters
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Derivative Loan Commitment
For the purpose of this advisory, the term derivative loan commitment refers to a lender's commitment to originate a mortgage loan that will be held for resale. Notwithstanding the characteristics of a derivative set forth in FAS 133, these commitments to originate mortgage loans must be accounted for as derivatives by the issuer under FAS 133 and include, but are not limited to, those commonly referred to as interest rate lock commitments.
In a derivative loan commitment, the lender agrees to extend credit to a borrower under certain specified terms and conditions in which the interest rate and the maximum amount of the loan 2 are set prior to or at funding. Under the agreement, the lender commits to lend funds to a potential borrower (subject to the lender's approval of the loan) on a fixed or adjustable rate basis, regardless of whether interest rates change in the market, or on a floating rate basis. In a typical derivative loan commitment, the borrower can choose to:
- "Lock-in" the current market rate for a fixed-rate loan (i.e., a fixed derivative loan commitment);
- "Lock-in" the current market rate for an adjustable-rate loan that has a specified formula for determining when and how the interest rate will adjust (i.e., an adjustable derivative loan commitment); or
- Wait until a future date to set the interest rate and allow the interest rate to "float" with market interest rates until the rate is set (i.e., a floating derivative loan commitment).
Derivative loan commitments vary in term and expire after a specified time period (e.g., 60 days after the commitment date). Additionally, derivative loan commitments generally do not bind the potential borrower to obtain the loan, nor do they guarantee that the lender will approve the loan once the creditworthiness of the potential borrower has been determined.
Forward Loan Sales Commitment
For the purpose of this advisory, the term forward loan sales commitment refers to either (1) a mandatory delivery contract; or (2) a best efforts contract that, upon evaluation under FAS 133, meets the definition of a derivative.
Mandatory Delivery Contract
A mandatory delivery contract is a loan sales agreement in which an institution commits to deliver a certain principal amount of mortgage loans to an investor at a specified price on or before a specified date. If the institution fails to deliver the amount of mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a pair-off fee, based on then-current market prices, to the investor to compensate the investor for the shortfall. Variance from the originally committed principal amount is usually permitted, but typically may not exceed 10 percent of the committed amount.
All loan sales agreements must be evaluated to determine whether they meet the definition of a derivative under FAS 133.3 A mandatory delivery contract has a specified underlying (the contractually specified price for the loans) and notional amount (the committed loan principal amount), and requires little or no initial net investment. Additionally, a mandatory delivery contract requires or permits net settlement or the equivalent thereof as the institution is obligated under the contract to either deliver mortgage loans or pay a pair-off fee (based on the then-current market prices) on any shortfall on the delivery of the committed loan principal amount. Since the option to pay a pair-off fee accomplishes net settlement, it is irrelevant as to whether the mortgage loans to be delivered are considered readily convertible to cash.4 Based on these characteristics, a mandatory delivery contract meets the definition of a derivative at the time an institution enters into the commitment.
Best Efforts Contract
For the purpose of this advisory, the term best efforts contract refers to a loan sales agreement in which an institution commits to deliver an individual mortgage loan of a specified principal amount and quality to an investor if the loan to the underlying borrower closes. Generally, the price the investor will pay the seller for an individual loan is specified prior to the loan being funded (e.g., on the same day the lender commits to lend funds to a potential borrower). A best efforts contract that has all of the following characteristics would meet the definition of a derivative:
- An underlying (e.g., the price the investor will pay the seller for an individual loan is specified in the contract);
- A notional amount (e.g., the contract specifies the principal amount of the loan as an exact dollar amount or as a principal range with a determinable maximum amount5);
- Requires little or no initial net investment (e.g., no fees are exchanged between the seller and investor upon entering into the agreement or a fee that is similar to a premium on other option-type contracts is exchanged); and
- Requires or permits net settlement or the equivalent thereof (For example: the seller is contractually obligated to either deliver the loan to the investor if the loan closes or pay a pair-off fee, based on then-current market prices, to the investor to compensate the investor if the loan closes and is not delivered. Since the option to pay a pair-off fee accomplishes net settlement, it is irrelevant as to whether the loan to be delivered is considered readily convertible to cash.).
An institution may enter into one of several types of arrangements with an investor to govern the relationship between the institution and the investor and set the parameters under which the institution will deliver individual mortgage loans through separate best efforts contracts. Such an arrangement might include, for example, a master agreement or an umbrella contract. These arrangements may specify an overall maximum principal amount of mortgage loans that the institution may deliver to the investor during a specified time period, but generally they do not specify the price the investor will pay for individual loans. Further, while these arrangements may include pair-off fee provisions for loans to be sold under individual best efforts contracts covered by the arrangements, the seller is neither contractually obligated to deliver the amount of mortgages necessary to fulfill the maximum principal amount specified in the arrangement nor required to pay a pair-off fee on any shortfall. Because these arrangements generally either do not have a specified underlying or determinable notional amount or do not require or permit net settlement or the equivalent thereof, the arrangements typically do not meet the definition of a derivative. As discussed above, an individual best efforts contract governed by one of these arrangements may, however, meet the definition of a derivative.
As the terms of individual best efforts contracts and master agreements or umbrella contracts vary, institutions must carefully evaluate such contracts to determine whether the contracts meet the definition of a derivative in FAS 133.
2 In accordance with the Background Information and Basis for Conclusions in Statement of Financial Accounting Standards No. 149 (FAS 149), the notional amount of a derivative loan commitment is the maximum amount of the borrowing. See FAS 149, paragraph A27.
3 See FAS 133, paragraph 6, for the characteristics of a financial instrument or other contract that meets the definition of a derivative.
4 See FAS 133, paragraph 57(c)(1), for a description of contracts that have terms that implicitly or explicitly require or permit net settlement.
5 The use of a maximum amount as the notional amount of a best efforts contract is consistent with the loan commitment discussion in the Background Information and Basis for Conclusions in FAS 149. See FAS 149, paragraph A27.