Purchased mortgage portfolios: initial recognition and effective interest rate

A refinance company's balance sheet is built from portfolios bought from banks and finance companies, often at a premium (when the loans carry a rate above current market rates) or at a discount. The purchase price, not the outstanding principal, is the starting point: the loans are recognised at fair value plus transaction costs, and the premium or discount is spread through a new effective interest rate computed by the buyer from its own estimate of the loans' cash flows. Carrying purchased loans at the originator's principal balance, or amortising the premium straight-line, misstates interest income every year. In addition, performing purchased loans (not credit-impaired) start in Stage 1, so a 12-month ECL allowance is recognised on day one even though the price already reflects credit risk; this day-one loss surprises many new refinance businesses.

Is each purchased portfolio recognised at the price paid (fair value) plus directly attributable transaction costs (legal, due diligence specific to the deal, stamp or registration fees), rather than at the originator's outstanding balance? Is any difference between price and fair value at initial recognition (for example a related-party purchase at an off-market price) identified and treated under IFRS 9 and IFRS 13? Is the EIR computed by the buyer at purchase date from its own estimated cash flows over the expected life, including prepayments but excluding ECL? Are the loans assessed for SPPI and the held-to-collect business model at the buyer's level? Has each loan been checked for credit-impairment at purchase date, so that credit-impaired loans follow the POCI model (BANK-022) and others start in Stage 1 with a day-one 12-month ECL? Is the purchase date (when the company becomes party to the contractual provisions) used rather than the cut-off date for cash flows?

1. Recognise the purchased loans when the company becomes party to their contractual provisions, normally the legal transfer or completion date.
2. Confirm that the seller has derecognised the loans or, from the buyer's side, that the buyer has obtained the contractual rights to the cash flows without the seller retaining substantially all risks and rewards; if the seller keeps substantially all of them (for example through full recourse), the buyer has a receivable from the seller, not the mortgages (see BANK-090).
3. Classify the loans: amortised cost if they pass SPPI and are held to collect, which is typical for a refinance company.
4. Measure them initially at fair value plus directly attributable transaction costs; in an arm's-length purchase the price paid is normally the best evidence of fair value.
5. Allocate the price to individual loans or homogeneous pools on a reasonable basis so that the EIR can be applied and loans can be tracked through staging and derecognition.
6. Determine for each loan whether it is credit-impaired at purchase; if so, apply the POCI model (BANK-022).
7. For loans that are not credit-impaired, compute an EIR that discounts estimated future cash flows (considering prepayments, but not ECL) exactly to the initial carrying amount, recognise interest at that EIR, and recognise a 12-month ECL allowance at initial recognition through profit or loss.

Initial carrying amount = purchase price (fair value) + transaction costs. The premium or discount relative to principal, together with transaction costs, is not recorded as a separate asset or liability but is absorbed through the EIR. The EIR is the buyer's own rate, which will differ from the contractual rate on the loans: below the contractual rate when bought at a premium, above it when bought at a discount. Accrued interest purchased is part of the price and is collected, not recognised as income. If the price differs from fair value (for example a purchase from a shareholder at an off-market price), the day-one difference is accounted for under the IFRS 9 initial-recognition requirements and may be an equity transaction with the shareholder. Subsequently: amortised cost = opening amount + interest at EIR - cash received, less the loss allowance.

Disclose: (1) the accounting policy for purchased loan portfolios, including the treatment of premiums, discounts and transaction costs; (2) the carrying amount of purchased portfolios by originator type or vintage where relevant to understanding concentration; (3) new purchases during the year in the ECL allowance reconciliation and in the gross carrying amount movement; (4) the amount of unamortised premium or discount where it is significant to understanding interest income; (5) significant judgments in estimating cash flows used for the EIR, including prepayment assumptions; (6) the fair value of the loan portfolio and its level in the fair value hierarchy.

• Recording loans at the originator's outstanding principal and booking the premium paid as a separate intangible or prepaid asset
• amortising the premium straight-line over the contractual term
• using the loans' contractual rate as the EIR
• expensing deal-specific legal and due diligence costs that are transaction costs, or capitalising general overheads that are not
• treating accrued interest bought as interest income
• assuming no ECL is needed at purchase because the price already reflects credit risk
• treating every purchased loan with any arrears as POCI, or none of them