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Home > Bank Resources > Bank Resources Publications > SRC Insights > 2005 > Third Quarter

SRC Insights: Third Quarter 2005

Is Your Bank Correctly Reporting Derivative Mortgage Products?

by Andrea Anastasio, Capital Markets Analyst

On May 3, 2005, the Federal Reserve, OCC, FDIC, OTS, and NCUA issued interagency guidance to clarify the accounting and reporting requirements for commitments to originate mortgage loans that will be held for resale and commitments to sell mortgage loans under mandatory delivery and best efforts contracts. The regulators have found that banks may not be correctly reporting these items on their call reports. The Federal Reserve System’s guidance was issued as SR letter 05-10.1

Commitments to originate mortgage loans that will be held for resale are derivatives, and the fair value of these derivatives must be reported on the balance sheet. The guidance refers to these commitments as derivative loan commitments. All loan sale agreements, including both mandatory delivery and best efforts contracts, must be evaluated under Financial Accounting Standards Board Statement 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), to determine whether they meet the definition of a derivative. The guidance refers to best efforts and mandatory delivery contracts that qualify as derivatives under FAS 133 as forward loan sales commitments. All forward loan sales commitments should be reported at fair value on the balance sheet.

A derivative loan commitment is created when a bank makes a mortgage commitment to a customer and it also intends to sell the loan to a third party once the loan is funded. These commitments include, but are not limited to, interest rate lock commitments. A derivative loan commitment is in place from the time the commitment is made until the loan is funded. Once the loan is funded, it is no longer a derivative loan commitment.

Therefore, if at the end of the calendar quarter, a bank has mortgage loans in its pipeline that it intends to sell, the notional amount of the loans should be reported as over-the-counter written options on Schedule RC-L of the call report. Additionally, the fair value of the derivative should be included in other assets or other liabilities on the balance sheet, depending on whether it has a positive (asset) or negative (liability) value at the end of the calendar quarter.

Derivative Loan Commitments

Item Call Report Schedule Line Item

Notional Amount of the Mortgage Loans

Schedule RC-L
(Derivatives and Off-Balance-Sheet Items) 		12.d.(1), Column A and
14, Column A

Fair Value of the Derivative

Schedule RC-L

15.b.(1) or (2), Column A

Schedule RC-F (Other Assets)
or Schedule RC-G (Other Liabilities) 		5.d.
or 4.d.

A mandatory delivery contract is a loan sale 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 mortgages necessary to fulfill the commitment by the specified date, it is obligated to pay a pair-off fee to compensate the investor for not following through on the commitment.

A best efforts contract is 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 borrower closes. Under this type of agreement, the institution is required to pay a pair-off fee only if the loan closes and the bank fails to deliver it to the investor; if the loan does not close, no pair-off fee is required.

For a mandatory delivery contract or a best efforts contract to qualify as a derivative, it must possess all four of the following characteristics.

Mandatory Delivery Contract Best Efforts Contract

An underlying, i.e., the price the investor will pay for the loans

An underlying, i.e., the price the investor will pay the seller for the individual loan

A notional amount: the committed loan principal amount

A notional amount: the principal amount of the loan as an exact dollar amount or as a principal range with a determinable maximum amount

Requires little or no initial net investment

Requires little or no initial net investment

Requires or permits net settlement or the equivalent thereof as the seller is contractually obligated to either deliver mortgage loans or pay a pair-off fee on any shortfall on the delivery of the committed loan principal amount

Requires or permits net settlement or the equivalent thereof, as the seller is contractually obligated to either deliver the loan to the investor if the loan closes or pay a pair-off fee to compensate the investor if the loan closes and is not delivered

If a mandatory delivery contract or best efforts contract meets all four of the above criteria, the notional amount should be reported as a forward contract on Schedule RC-L, and the fair value of the derivative should be included in the other assets (positive value) or other liabilities (negative value) on the balance sheet.

Forward Loan Sales Commitments

Item Call Report Schedule Line Item

Notional Amount of the Mortgage Loans

Schedule RC-L
(Derivatives and Off-Balance-Sheet Items)

12.b., Column A and
14, Column A

Fair Value of the Derivative

Schedule RC-L

15.b.(1) or (2), Column A

Schedule RC-F (Other Assets)
or
Schedule RC-G (Other Liabilities) 		5.d.

or
4.d.

The forward loan sales commitments are in place from the time the mortgage commitments are made to customers until the loans are sold to the third party. Therefore, it is possible that the same loan will be included in the total derivative loan commitments (over-the-counter written options) as well as the total forward loan sales commitments (forward contracts).

A fair value that is based on current mortgage interest rates in the market, not on interest rate(s) incorporated in the derivative loan commitment(s), must be assigned to all derivative loan commitments and forward loan sales commitments. There are several methods outlined in the guidance, including valuation techniques based on estimated expected future cash flows, observable prices of other current market transactions, or other source data such as quotations from rate sheets.

When determining the fair value of the derivative, institutions also need to give consideration to the predicted “pull-through” rate, which is the probability that a derivative loan commitment will ultimately result in an originated loan. Institutions are urged to have discussions with their auditors to ensure the integrity of their valuation process.

The guidance also contains additional details and examples that are helpful in clarifying some of the more complicated concepts associated with derivative mortgage products. Institutions that sell mortgage loans in the secondary market are encouraged to review the accounting and reporting requirements covered in the guidance to ensure that they are in compliance. Incorrect call report filings are subject to examiner criticism, and failure to comply with GAAP requirements in regulatory reports may be viewed as an unsafe and unsound practice.

If you have any questions about the accounting and reporting for commitments to originate and sell mortgage loans, please contact your institution’s central point of contact or assigned manager at the Reserve Bank.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.