The increase in the 10-year treasury yield from 1.5% to 3.6% since the beginning of the year has resulted in the closure of about a dozen non-bank mortgage lenders, who have either shut down operations or sold significant assets to other entities. With the possibility of a recession looming, some financial institutions could be under significant pressure without adequate liquidity. As we saw with Silicon Valley Bank (SVB), if these lenders were forced to sell certain loans, it could be the nail in their coffin. In this piece, let’s uncover the risk in classifying loans as held for investment (HFI).
Accounting Classification Implications for Financial Reporting
When SVB was confronted with selling its treasury bonds to meet liquidity needs from a run on the bank, it had to reclassify investments classified as held to maturity (HTM) to available for sale (AFS). This resulted in a nearly $2 billion loss recognized in earnings. This was because the investments were not marked to market, and the significant drop in value was not reflected in earnings. Similarly, financial institutions that originate mortgage loans can also elect held-for-long-term-investment (HFI) for loans if one can attest, they have the ability and intent to hold to maturity or payoff.
CECL Provisioning and Its Impact on Financial Statements
Electing to classify the loans as HFI also requires the company to recognize an estimate of lifetime losses of their loans upfront as the loan is originated. This is referred to as Current Expected Credit Losses (CECL) provisioning. Lenders use empirical data to estimate how many of these loans will default and then subtract the CECL provision amount from their bottom line. Increasing rates and elevated credit risk could be a perfect storm for the value of these loans.
Valuation of Loans Held for Long-Term Investment (HFI)
Companies that elect to account for loans as HFI are required to disclose the estimated fair value in their footnotes. Public companies may only value these loans at quarter-end, and typically these valuations do not go through audit scrutiny until the year-end audit. For private companies, the value of these loans may not be reviewed until year-end. These loans are usually valued with an internal discounted cash flow (DCF) model or obtained from a third-party valuation specialist such as Compass Analytics, Situs AMC, and DebtEx.
The Rise of HFI Loans and Their Impact on Originators’ Balance Sheets
As the demand from aggregators slowed down, originators were forced to hold more of these loans on the balance sheet. The loans that went into HFI were usually loans that the lender did not see a viable exit (sale or placed into securitization) for or bought back from the GSEs and Ginnie Mae. Some lenders specifically place these loans in the HFI bucket to eliminate the market value fluctuation associated with these loans. As rates rose, the loans have become less attractive because newer originated loans paid more in interest. Although the economy remains resilient, the probability of credit default is also expected to increase when mortgage holders are no longer able to afford their monthly payments.
Managing Risks Associated with HFI Loans
Holders of HFI Loans must consider the following points to avoid a crisis:
Is the risk and uncertainty associated with HFI loans buried in your financial statements?
If the risk and uncertainty associated with HFI loans are not transparently disclosed in a company’s financial statements, it could lead to surprises for investors or regulators down the line, potentially damaging the company’s reputation or financial stability.
How often are you valuing HFI loans? How comfortable are you if they are internally marked vs. third-party pricing?
Failing to regularly and accurately value HFI loans could lead to an inaccurate understanding of a company’s financial health, potentially leading to poor investment decisions or regulatory non-compliance.
Does your cash forecast include the impact of mark-to-market on HFI loans?
If a company does not include the impact of mark-to-market on HFI loans in its cash forecast, it could face liquidity problems if it suddenly needs to sell these loans due to a market downturn.
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What cushion do you have until you must sell some of your HFI loans?
If a company does not have enough cushion to hold onto HFI loans until they can be sold at a reasonable price, it may be forced to sell at a loss, potentially leading to financial instability or even insolvency.
Do you include the impact of valuing HFI loans in covenants monitoring such tangible net worth (equity) and leverage ratio?
Not including the impact of valuing HFI loans in covenants monitoring means a company may not be aware of potential breaches of those covenants, which could lead to regulatory non-compliance or other legal problems.
How effective are your hedges on your HFI portfolio?
If a company’s hedges on its HFI portfolio are not effective, it could face losses if interest rates rise or credit risk increases, potentially leading to financial instability or insolvency.
If interest rates keep rising and credit risk increases, the value of HFI loans will continue to decline. In an economic downturn, the value of these loans may face even more downward pressure. Therefore, it’s crucial for non-bank mortgage lenders to effectively manage the risks associated with HFI loans by including their value in cash forecasts and covenant monitoring. Seeking assistance in addressing these potential issues before they become problems can help lenders ensure the stability of their operations.