Obscure Item in Tax Bill Costs Banks Billions and Increases Borrowing Costs
The tax proposal changes the way taxes are treated
The tax bill is rolling through the senate at a record pace. It is a huge bill with tons of moving parts, so there are bound to be unintended consequences. The recent iteration contains a provision that would nail banks. It appears accidental, but will have a major impact on lenders and the costs would ultimately be passed on to both commercial and residential borrowers.
The Mortgage Bankers Association put out the following press release and call to action:
"This provision would have severe, unintended consequences resulting in higher costs for borrowers and diminished access to credit, caused when servicers of all shapes and sizes are forced to exit the business because they can't or won't operate under this new rule. It would also negatively impact trillions of dollars of mortgage servicing rights held by small community banks, non-bank lenders, regional and large banks and commercial and multifamily lenders. MBA calls on members of the Senate to address this provision without further delay, before the bill gets to the Senate floor."
What is in the tax bill that is so different? The proposed tax bill changes the way mortgage servicing rights are treated. Why is this such a big deal? This could mean when billions of tax dollars must be paid now as opposed to recognized over the life of the servicing right.
What are mortgage service rights?
Mortgage service rights (MSR) refer to a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect the mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principal to the mortgage lender. In return for this assistance, the servicer is compensated with a specific fee outlined in the contract established at the beginning of the agreement.
Why is this an important market function?
Mortgage Servicing rights are an asset to the owner of such rights. The asset is the future servicing fee collected over the life of the loan. The mortgage servicing rights are bought and sold by banks. A bank typically is unable to hold every loan it originates, so it sometimes sells off the mortgage and the servicing rights to free up capital to make additional loans. There is a heightened demand for quality servicing rights due ot the stable future cash flows. Many investors, funds, etc. buy these rights for the cash flow streams.
How are taxes currently collected on mortgage servicing rights?
Currently, taxes are "prorated" based on the current cash flow of the servicing right. For example, in a mortgage servicing contract you could get payments over a 30-year period. Only the income generated each year is recognized in that year. The taxes are commensurate with the income.
How will they be collected going forward?
The tax proposal changes the way taxes are treated. Under the Senate bill, according to the MBA and other groups, lenders would have to pay taxes upfront, based on the projected income from the servicing. That mismatch between when the income is taxes and when it's actually received could cause lenders that lack the wherewithal to pay upfront to abandon servicing altogether, the trade group says.
How will this impact borrowers?
For Texas-based non-bank lender Georgetown Mortgage LLC, the change would mean about a $1 million increase in taxable income this year – even though the actual cash from servicing a typical loan comes in over five or six years – said Michael Jones, the company's chief financial officer.
Taxes would be paid now as opposed to over a much longer period when the revenue was received. This increase in taxes must be paid by someone. Banks are running on thin margins in the mortgages business and therefore this increase, no doubt, would be passed on to consumers.
Though the intent of this tax bill was likely not to increase mortgage borrowing coasts, the way the bill is currently written would result in unintended consequences, which ultimately the borrowers will absorb.