Hedging, Fair Value, & the IRLC
1- Every mortgage lender experiences market risk.
The interest rate environment is continuously moving up and down. Each rate movement impacts the value of a mortgage lender’s assets and commitments. This interest rate movement causes a mortgage lender to experience market risk from when the lender issues an interest rate lock commitment (IRLC) to a customer until the loan held for sale (LHFS) is sold. The IRLC protects the consumer from market risk while simultaneously exposing the mortgage lender to market risk. If the rates move up, the future loan revenue is less, and the lender may lose money unless a hedging mechanism is created to protect the amount of future revenue.
The most common hedging strategy deployed by mid-sized mortgage companies is to sell forward TBA-MBS commitments to protect the IRLC risk exposure and then receive a mandatory delivery commitment to protect the LHFS risk exposure until it is sold. The purpose of the hedge is to preserve the future gain on sale by establishing a transaction that exhibits the same degree of value change but in the inverse direction relative to a mortgage loan. The secondary marketing department adds enough mark-up into the lock commitment issued to a customer so that the future gain on sale revenue plus or minus the hedging activity will generate enough revenue so that the mortgage company makes a profit.
6- Every mortgage lender must assess the ASC 820 calculation's reasonableness.
The cash flow value of the IRLC is adjusted by the market movement change in the TBA-MBS short position to reflect the recordable value for the derivative asset or the derivative liability. The derivative asset value of the IRLC net cash flow value from the AICPA model may be 75bp, plus or minus the hedge position change. If the hedge is a 1% loss, then the derivative asset should have an offsetting value of approximately 1.75% resulting from the offsetting value change plus the net cash flow value of the IRLC. At the very least, all of the computational elements must be presented in the audit or interim financial footnotes so the reader can follow the bread crumb trail to understand the math behind the derivative asset and derivative liability amounts.
7- Author's Note about Fair Value and IRLC A note about volatility. If interest rates rise quickly creating a value increase in the short position, the IRLC market change loss may be more than the cash flow value of the IRLC, resulting in the IRLC reported as a derivative liability. And a note about complexity. This topic may generate an emotional response as a more advanced awareness of this topic reveals a necessary change in past practice. The information presented above has passed the scrutiny of the scholarly community and the review by Ph.D. CPAs that are not invested in a prior conclusion. Citations are omitted given the informal structure of this publication. While I am confident the IRLC valuation method presented in this paper is the most accurate method, the ultimate fair value measurement of a Level 3 input is the Certified Public Accountant's representation that the financial statements are presented fairly upon signing the audit report.
© Copyright 2020 Dr. Andy Schell, CPA/CFF, CMB,
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