top of page
Journal: Blog2
  • Dr. Andy Schell, Ph.D., DBA, CPA, CMB

IRLC Supplement 12-31-20

Although this article was originally released at the end of 2020 to address the tremendous market volatility during 2020, the principles discussed remain true today.

Dr. Andy Schell’s

Mortgage Accounting White Paper Series

IRLC Fair Value 2021 Supplement


Hedging, Fair Value, Market Value, and the IRLC

By: Dr. Andy Schell, D.BA, Ph.D.c, MSML, MBA, CPA/CFF, CMB

© Copyright by Dr. Andy Schell, 2021

Reproduction without Permission Prohibited

Published: March 2, 2021


1 - Net Cash Flow Update as of 12-31-20

2 - A Note About Arbitrary Adjustment.

3 - A Note about IRLC Fair Value Calculation.

4 - Response to Questions.

5 - About the Author


In January 2021, Loan Vision released Dr. Schell’s white paper that addressed several topics, including the IRLC Fair Value. This March 2, 2021, white paper provides a valuation update based on 12-31-20 secondary margins common among mortgage companies.

As noted in the January white paper, the IRLC fair value assessment is significantly influenced by its future net cash flow. The future net cash flow is impacted by the future gain on sale revenue. If the future revenue is greater than in prior years, as is the case as of 12-31-20, then the value of the IRLC will be higher than in previous years.

The purpose of this supplement white paper is to identify how the year-end 2020 IRLC value has increased and to respond to questions that surfaced as readers absorbed the first IRLC fair value white paper.

Net Cash Flow Update as of 12-31-20

Most warehouse lenders and CPA auditors should expect the IRLC’s Derivative Asset to be elevated when comparing a net cash flow fair value assessment relative to 12-31-19. If the value of the IRLC was 75bp in 2019, then the 2020 value may be 170 bp. The maximum value of the 12-31-20 IRLC is approximately 170bp before adjusting for market value change. After the market value change is applied to the IRLC net cash flow value, the result will likely be as high as 220bp. It is unlikely for the value to exceed 250bp unless gain on sale revenue is 600bp.

As an example, the analysis demonstrates the actual calculation of an IMB’s IRLC value is presented. The hedge advisor report is used to assign pipeline amounts and pull-thru values by status code. The actual total commission and total cost per loan for the year-end 12-31-20 are used as cost inputs.

The model value of the IRLC is 1.54% before adjusting for the market value change in the hedge position. Recall that the market adjustment of the IRLC is off-set by the change in the value of the TBA-MBS short position, assuming the hedging activity is properly deployed. In this case, the actual hedge position MTM is a loss of 323,847.02. When the IRLC value of 1.54% is applied to the locked pipeline amount and then adjusted by the hedge loss, the derivative asset's value is $1,253,219.88 or 2.08% of the locked pipeline.

For year-end 2020, the increased value in the derivative asset resulted from the atypically increased gain on sale. If the gain on sale was normalized and reduced to approximately 3%, the IRLC value drops to less than 1% before hedge adjustment. The IMB’s derivative asset value is driven by the following values including, gain on sale, pull-thru, commission, total costs, and the change in value of the hedge.

There is no “rule of thumb” to identify the value of the IRLC without consideration of the embedded value drivers noted here.

A Note About Arbitrary Adjustment

It is never appropriate for the CPA Auditor to use the unadjusted hedged advisor’s reflection of the IRLC’s market value. As noted in the January 2021 white paper, there is no market value for the IRLC. The IRLC fair value must be assessed through the ASC820 fair value methodology, including applying the AICPA net cash flow model depicted here. This AICPA SSVS model is used as a valuation tool to identify the intangible asset’s value, including the derivative asset, for a range of valuation services, including litigation support.

Likewise, it is never appropriate for the warehouse line lender to arbitrarily reduce the derivative asset value when the AICPA net cash flow valuation model establishes its value and the audit report presents the model inputs and outputs. This computational disclosure enables the FDIC warehouse line lender and investors or any other financial statement user to make an informed decision when accepting the audit report’s presentation of the IRLC fair value. Adjusting the audit report value places the FDIC lender in the position of valuation expert of the IRLC level 3 input, which may be beyond the scope of the lender’s credit assessment expertise.

The warehouse lender's reliance upon the CPA audit report is an acceptable standard when addressing regulatory scrutiny, provided the CPA’s report includes the details outlined here. If the warehouse line bank’s borrower hires a CPA firm that does not provide sufficient computation detail to examine the IRLC fair value, then the warehouse lender should establish CPA firm presentation standards that are required to be implemented by all IMB borrowers when hiring a CPA auditor.

A Note about IRLC Fair Value Calculation

IRLC Characteristics

The IRLC is an interest-sensitive firm commitment subject to market risk, which exposes the mortgage company to hidden financial risk. The components of the IRLC and the valuation efforts to quantify the mortgage company’s hidden risk exposure are complicated and sometimes controversial. The current accounting methods used to value the IRLC pipeline create challenges for investors and warehouse lenders that receive CPA audits of IMBs because of variability and possible misapplication of ASC 820 measurement techniques, which may overstate the value of the IRLC pipeline loans. The key point to identify is that the IRLC is labeled a derivative under ASC815 to force market change risk presentation. The IRLC is not a loan and not a security. There are always conversion costs to consider, and the amount of the conversion cost is greatest when the IRLC is first issued.

IRLC Lifecycle

Any valuation model considers the reality of the IRLC lifecycle such that each IRLC has a different value, and the value of the IRLC rises over its life cycle. A new IRLC has yet to incur conversion cost, thus the value is lower than an IRLC the day before closing. On the day before closing, when all costs except for LO commission are incurred, the IRLC is at its highest value. This raises a caution about the LO compensation only method.

LO Commission only Direct Cost Model Fallacy

The LO direct commission cost model applies commission as the only conversion cost. The IRLC conversion costs are incurred as the IRLC status codes are completed. The last significant conversion cost is LO compensation. The only time that commission is the only conversion cost is when the IRLC is clear to close, which is the few days before closing. At month-end, how many IRLC will close the next day? The answer is, very few. All of the applications that could close did close, thus the pipeline is weighted with new IRLCs and more unincurred conversion costs, thus the new IRLC value is lower. Applying commission as the only conversion cost for the entire pipeline at month-end is virtually certain to over-state the IRLC value.

Conversion Cost Application

The conversion cost model that includes all direct costs, some indirect costs, and an allocation of conversion cost based on the pipeline status codes is likely to approximate the net cash flow model result. The cash flow value of the IRLC adjusted by the market movement change in the TBA-MBS short position will reflect the most accurate fair value of the IRLC. In the valuation of both the IRLC and the MSR, or any Level 3 inputs, the proper disclosures of the inputs used to value the derivative asset are essential and should follow the presentation content outlined in ASC 820-10-50-2bbb irrespective of the required applicability.

The CPA’s opinion

The fundamental factor that defines the value of the IRLC / derivative asset is the independent CPA auditor’s willingness to sign the audit report, which represents to the public that the financial statements, including the value of the IRLC, are fairly presented in all material respects. Research has demonstrated that public company investors typically ignore Level 3 amounts, like the IRLC value, presented on the financial statements due to the variability and unreliability of Level 3 measurement computations.

IRLC Value Calculation Dynamics

Investors and warehouse lenders should consider the IRLC calculation dynamics when reviewing mortgage company audited financial statements. It is possible for a CPA auditor not to understand all of the ASC 820 fair value measurement complexities and present the IRLC / derivative asset in a fashion that increases the mortgage company’s profit and capital above an amount that an informed fair value assessment would apply.

Response to Questions

Question 1

In March 2020, closed loan values fell dramatically. What is the value of the pipeline when the market for the LHFS collapses?

Answer 1

When markets cease to function, all valuation methodologies are suspended. The Black Scholes option pricing model specifically requires the presence of rational markets for output precision. When uncertainty leads to chaotic markets, the anticipation of future market normalcy and the resulting future cash flow may be applied; nevertheless, a significant discount is appropriate.

Question 2

What is the basis for the 75bp value presented in the January 2021 white paper?

Answer 2

The white paper presented the IRLC value based on the net cash flow approach with normalized product margins, not the abnormal margin IMB’s experienced in 2020 due to the supply and demand-driven increase in revenue. Presented above is the same calculation based on 12-31-20 revenue levels and reflects IRLC value of 154bp and total derivative asset of 208bp.

Question 3

The white paper discussed the buyer’s costs as the basis for fair value assessment and identified the seller’s costs as irrelevant to the buyer. If the seller’s costs are irrelevant, then what is the amount of LO comp input needed? Answer 3

In an MSR assessment, the value of the net future cash flows is calculated using the market’s servicing costs input. Many of the MSR calculation variables are estimable given the underly cash flow drivers, If the MSR buyer has actual servicing costs that are lower than the market assumption, then in this circumstance, the net future cash flows will be higher, and the MSR IRR value will be higher.

When fair value measurement is applied to the IRLC, the buyer's net future cash flow is established using the future revenue less the buyer’s (market) conversion cost relative to the IRLC lifecycle. The buyer is not focused on the seller’s costs. If the seller is a retail operation and the hypothetical buyer has an overseas platform, the cost structure difference is likely to provide distorted results. This is where a CPA's independent judgment is applied to identify the fair value given the circumstances addressed in the audit. The CPA will note that the IRLC’s unobservable inputs are significantly more dramatic than with the MSR, which is why it is essential to include the expansive disclosure of the fair value computational elements within the audit report.

The CPA will note that the IRLC’s unobservable inputs are significantly more dramatic than with the MSR, which is why expansive disclosure of the computational elements within the audit report is essential.

No valuation model is perfect short of an actual sale of the pipeline. In an M&A transaction, the buyer will typically leave the seller’s pipeline to wind down for the seller's benefit. The buyer knows the IRLC pull-thru is at risk if any branch quits during the transition. If an LO leaves and takes the IRLC to another company, what is the value of a canceled or expired IRLC? Zero.

Question 4

The white paper suggests that the seller’s costs may be aligned with the status code silos irrespective of period or product costs to determine cash flow value. Does this mean that the cost allocation should occur without aligning the product cost or period cost concept?

Answer 4

Yes. Period costs are not relevant to the buyer cost allocation. If the new IRLC incurs future costs in 45 days, those costs are considered for valuation purposes irrespective of the costs incurred in a subsequent month. The concept of product cost is more applicable, provided the product costs include all direct costs and indirect costs.

As an example, if the seller’s locked pipeline has 400 basis points of embedded gross revenue and incurs 150 of LO cost and 100 basis points in other direct costs and 25 bp of indirect costs, then the value of the IRLC is 125bp only when the IRLC lifecycle aligns with this cost allocation calculation. A new IRLC may be worth 25bp because all conversion costs are yet to be incurred. An IRLC associated with a loan that will close tomorrow may be worth 250bp, given that the only remaining cost is LO commission. In all cases, regardless of how GAAP might consider product or period costs in a manufacturing operation, the key concept is that a knowledgeable buyer knows that the measurement of the IRLC value depends upon pull-thru probability and the recognition of unincurred costs (conversion costs) based on the IRLC lifecycle, and that value is the IRLC’s value.

© Copywrite 2020 Dr. Andy Schell, Ph.D.c, D.BA, MBA, CPA/CFF, CMB,

All rights reserved, Unauthorized reproduction is prohibited.

About: Dr. Andy Schell, PhD.c, D.BA, MSML, MBA, CPA/CFF, CMB

Dr. Schell is CEO, Managing Partner, and Co-Founder of Mortgage Banking Solutions and MBS Financial Services ("MBS"), based in Austin, Texas. He is known for his ability to turn "vision into reality" and "chaos into order" as he finds creative solutions to address his clients' challenges. He primarily supports regulated depositories in mortgage finance and sophisticated independent mortgage lenders to address revenue stability, technology enhancement, and Workflow Efficiency. Andy is a finance guy, a CPA, (there is a difference), and a musician. The combination of his creativity, experience, and education enables him to create business strategies that will lead to his client's success.

Dr. Schell's finance experience began trading marketable securities in 1980 at a Dallas, Texas-based Wall Street firm and then continued throughout his career spanning four decades. His finance activities include trading Mortgage-Backed Securities and Options on T-Bond Futures as a risk management tactic, directing the $35 billion securities settlement activities for Bank of America, and supporting the bank's quantitative assessment of implied volatility for the Monte Carlo simulation model. His finance education began with a bachelor's degree in banking and finance and continued at the SMU graduate school of banking and the University of Chicago's options trading program.

Dr. Schell's accounting expertise is equally expansive, including a master's in accounting, a CPA certificate licensed in Texas with public accounting experience in Dallas, and a doctorate in business strategy with a doctoral dissertation on the value of financial derivatives. He is also a Certified Mortgage Banker awarded from the Mortgage Bankers Association in addition to holding the designation as a Certified Public Accountant licensed in Texas.

Dr. Schell's 40 years of experience, professional designations, CPA/CFF, CMB, and academic credentials, including a terminal degree that established the title Doctor Schell, collectively provide the foundation for him to authoritatively address the topics presented in this white paper. Other white papers and articles by Dr. Schell are available directly at

To find out more information on MBS Services, please click HERE

Find more information at:

(512) 501-2812

Doctor Schell the Profit DoctorT

Doctor Schell the Profit DoctorTM

Recent Posts

See All

The earth is flat. Unclosed loan value? By Andy Greer, CPA October 27, 2021 The earth is flat! Our industry values unclosed

Hedging Explained: by Trading Places

In the 1983 movie Trading Places, Louis Winthrope (Aykroyd) and Billy Ray Valentine (Murphy) attempt to “get rich quick” while at the same time putting the bad guys in the “poor house” through a serie

bottom of page