Specialized Accounting for Mortgage Bankers

Mortgage banking’s core function is originating mortgage loans to sell them into the secondary market, not to hold them as long-term investments. This originate-to-distribute model creates a distinct financial reporting environment. The main activities of originating, selling, and servicing loans generate specific assets and liabilities not found on most company balance sheets.

The accounting complexity stems from this business cycle. The time between a loan’s origination and its sale exposes the banker to interest rate risk, as the loan’s value can change with market fluctuations. When a loan is sold, the banker often retains the right to service it, creating a separate intangible asset that must be valued. Managing risk and valuing these assets requires specific accounting treatments to accurately reflect the company’s financial position.

Accounting for Loans Held for Sale

A mortgage banker’s primary inventory consists of loans originated with the intent to sell, classified on the balance sheet as Loans Held for Sale (LHFS). Accounting Standards Codification (ASC) 948 dictates that these loans are measured using the Lower of Cost or Market (LOCOM) approach. Under this method, loans are recorded at their original cost, and at each reporting date, this cost is compared to the current market value.

Cost is determined as the loan’s principal balance, adjusted for any net deferred origination costs. Market value is determined by outstanding purchase commitments from investors or by current market prices for similar loans. If the market value of a loan portfolio is lower than its cost, the mortgage banker must record a write-down, which is recognized as a charge to earnings.

As an alternative to LOCOM, mortgage bankers can irrevocably elect the Fair Value Option for their LHFS. When this option is chosen, the loans are recorded at their fair value at every reporting date, with any changes in fair value flowing directly through the income statement as unrealized gains or losses. This method can more accurately reflect the economic reality of the business, as it aligns the accounting with how the loans are managed.

Loan origination fees are recognized as an adjustment to the gain or loss on the sale of the loan. Direct loan origination costs, such as appraiser and credit report fees paid to third parties, are deferred and recognized as part of the loan’s cost. For example, a $300,000 loan with $3,000 in direct costs and a $1,000 origination fee has an initial cost basis of $302,000. If its market value falls to $301,000, a $1,000 write-down is recorded under LOCOM.

Accounting for Mortgage Servicing Rights

When a mortgage banker sells a pool of loans, it often retains the right to service those loans for a fee. This contractual right is a distinct asset known as a Mortgage Servicing Right (MSR). Under ASC 860, an MSR is recognized as an asset on the balance sheet at its fair value on the date the related loans are sold. The MSR’s initial fair value is considered part of the proceeds from the sale, directly impacting the total gain or loss.

After initial recognition, the mortgage banker must choose an irrevocable method for subsequent measurement for each class of MSRs: the amortization method or the fair value method. The choice depends on the company’s risk management strategy.

Under the amortization method, the MSR is amortized over the estimated life of the underlying loans in proportion to the projected net servicing income. This method requires a regular assessment for impairment. If the carrying value of the MSR exceeds its current fair value, an impairment loss is recognized in earnings. A valuation allowance is established for the impairment, which can be recovered if the fair value later increases, but not above the original carrying amount.

Alternatively, a company can elect the fair value method. The MSR is remeasured to its fair value at every balance sheet date, and all changes in fair value are reported directly in earnings. This method is often chosen by companies that actively manage the interest rate risk of their MSR portfolio with derivatives, as it allows for a natural offset in the income statement between the MSR’s value and the hedging instrument’s value.

The fair value of an MSR is sensitive to changes in interest rates. When rates fall, borrowers are more likely to refinance, which shortens the expected life of the loan and reduces future servicing fees, thus lowering the MSR’s value. Conversely, when rates rise, refinancing slows, and the MSR’s value increases.

Hedging and Risk Management Activities

The mortgage banking business model creates significant exposure to interest rate risk. This risk exists from the moment a loan rate is promised to a borrower—an interest rate lock commitment (IRLC)—through the period the loan is held for sale. A rise in interest rates between when a rate is locked and when the loan is sold will decrease the loan’s market value, resulting in a lower gain or a loss on the sale.

To mitigate this, mortgage bankers engage in hedging activities using derivative financial instruments, most commonly forward sale commitments. These are contracts to sell a specified amount of loans at a future date for a predetermined price. By locking in a future sales price, the banker is protected against a decline in the value of their LHFS and their pipeline of unclosed loans.

For accounting purposes, both IRLCs and forward sale commitments are considered derivatives under ASC 815 and must be recorded on the balance sheet at fair value. Most mortgage bankers account for these derivatives as free-standing instruments measured at fair value, with changes reported in current earnings. This approach is simpler than applying special hedge accounting rules and achieves a similar economic result.

The goal of the hedging strategy is to achieve a net neutral position. For example, if interest rates rise, the fair value of the LHFS will fall, creating an unrealized loss. Simultaneously, the value of the forward commitment to sell loans at a now-above-market price will increase, creating a gain. When both are reported in earnings, they largely offset, insulating the company’s income from interest rate volatility.

Financial Statement Presentation and Disclosures

On the balance sheet, Loans Held for Sale are reported as a separate line item within current assets. Mortgage Servicing Rights are presented as a separate intangible asset. Derivative instruments used for hedging are shown at their fair value, with assets and liabilities presented separately.

The income statement reflects the core operations of the business. The primary revenue source is “Gain on sale of loans,” which includes the premium on the sale, the initial fair value of MSRs, and the net effect of origination fees and costs. Other income lines include servicing fee income, changes in the fair value of MSRs, and the net gain or loss from hedging activities.

Footnote disclosures provide context for the financial statements. According to ASC 820, extensive disclosures are required for valuation methods, assumptions, and hedging activities. These disclosures provide transparency into the company’s risk management and market exposure and include:

• The valuation method for LHFS (LOCOM or fair value).
• The valuation method for MSRs (amortization or fair value).
• A roll-forward of the MSR balance from the beginning to the end of the period.
• Key assumptions used in determining the MSR fair value, such as prepayment speeds and discount rates.
• The fair value of derivative instruments and their location on the balance sheet.
• The location and amount of gains and losses from derivative instruments on the income statement.