Demystifying the Valuation of Mortgage Servicing Rights

Urum Urumoglu
January 21, 2010 | COMMENTS

Yes, the legal, accounting and operational issues surrounding the valuation of mortgage servicing rights (MSR) can be overwhelming, confusing and contradictory. But let's take a practical look at MSR valuation, its context, components and discount method.

The best place to start is simply to address why MSR valuations are necessary, beyond the fact that auditors and regulators now demand them.

Context for MSR valuations
In 1995, MSR emerged as an issue via Statements of Financial Accounting Standards (SFAS)-122. Before then, non-financial institutions that originated mortgages and financial institutions that were net mortgage lenders did not compare easily to institutions that obtained mortgage servicing rights through other channels.

Though financial statements became more comparable and generally increased the capital of entities dominated by retail production, confusion arose over:

• what MSR value to use on the balance sheet
• how to assess MSR value for future accounting periods
• how to manage the changes in MSR value

Much of the murkiness disappeared with SFAS-156 and SFAS-157, though there remains a significant variation in published values due to valuation techniques and accounting elections.

Creating mortgages produces MSR. Many financial institutions retain the servicing for the mortgages they originate. Accordingly, they continue to own both the loan and the servicing rights. Mortgage originators can also sell mortgages and retain the servicing rights. In these cases, they continue to manage the payments for the purchaser for a fee. This also enables them to continue to collect allowable charges (like late fees) and reimbursable expenses.

MSR creates revenue
MSR can produce significant servicing revenue over the life of a loan. This income is attractive if the servicer can control its cost to fulfill the contractual obligations. Of particular interest to credit unions is the ability to maintain contact with the borrower for the life of the loan, which provides the opportunity to cross-sell other products and services to members.

If an institution retains the MSR, then SFAS 140/156 states that it must:

• stratify servicing assets within a class based on one or more of the predominant risk characteristics of the
  underlying mortgages; these characteristics may include mortgage type, size, interest rate, origination date, term
  and geographic location
• recognize the MSR on financial statements at fair value
• elect the ongoing method of accounting for the changes in the MSR, choosing from either:
  • fair value measurement (a.k.a., mark-to-market accounting): choosing this method is irrevocable; see below for
    more information
  • amortization: amortize the MSR in proportion to, and over the period of, estimated net servicing income or net
    servicing loss; this requires assessing the MSR for impairment based on fair value at each reporting date; electing
    amortization permits a one-time reclassification to fair value at the beginning of the fiscal year

Establishing the fair value of MSR
Under either of the above accounting methods, the servicing rights must be valued at inception and at reporting dates. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

An ongoing question regarding MSR is what would a willing buyer pay for the servicing? Of course it depends on who the buyer is and the delinquency and prepayment experience of the loans.

Though a secondary market exists for MSR, it significantly lacks the liquidity of the underlying mortgages since servicing sales involves multiple loans and classes and carries legal obligations to the investor. When loans are sold to FNMA or FHLMC with the seller retaining the servicing rights, control of the MSR rests with FNMA and FHLMC, and thus requires their respective approvals before servicing can be sold. With no actively traded market for servicing rights, the establishment of values requires models that use market information to influence assumptions.

Value can be determined in a similar fashion to valuing securities. By determining the present value of the net cash flows, a dollar value can be reached. The discounted cash flow model is a commonly accepted approach for regulators and Generally Accepted Accounting Principles (GAAP).

Income and expenses
The servicing income streams include monthly servicing fees, all ancillary income and the use of idle funds. The servicing expenses include the cost to handle the payment management, escrow management, borrower communication, investor communication, investor advances, collection activity and foreclosure.

Prepayments dramatically drive the servicing income streams and servicing outflows. It is important to understand that during volatile interest rate environments, valuation may change significantly. Because mortgages contain call options that can be exercised by the borrower, values of servicing rights are heavily affected by future events and economic environments that are unknown at the time of valuation and can change at any given time.

Any event, such as falling interest rates, that causes borrowers to refinance or prepay their loans causes the value of the servicing rights to decline, as do events that cause increases in delinquencies and foreclosures. On the other hand, rising interest rates, which tend to slow the rate of refinancing and prepayments, increase the value of the servicing.

Impact of prepayments
Because of the impact on values, it is very important to understand how prepayments affect the MSR. There are two frequently used measurements of prepayments, the constant prepayment rate (CPR) and the public securities association (PSA). While the ways they measure prepayments differ, each reflects the rate of payment with a specific number. The higher the number, the faster the prepayment. The lower the number, the slower the prepayment. Both indexes are widely reported. For example, the Securities Industry and Financial Markets Association publishes a dealer survey of long-term prepayment expectations for mortgage-backed securities by coupon and year of issue. It also reflects national geographic dispersion.

As part of the valuation, investors need to be aware that servicing portfolios may prepay differently than national prepayment speeds, just as specific mortgage pools prepay at different rates. Servicers should always use their actual prepayment experience to temper national prepayment data.

Calculating MSR
The proper calculation of MSR can affect income, pricing, investments and risk management decisions. Even though a wide range of assumptions affect the value of servicing rights, prepayment speed is the most critical for valuing MSR. The level of interest rates, general health of the employment sector and the current loan to value strongly influence the incentive and ability for the borrower to refinance.

Generally the volatility of MSR values is lower for those that elect the amortization accounting method over the fair value measure accounting method. Servicers that desire to manage the change in value risk of the MSR by using derivatives should elect the fair value measure accounting method to avoid the hassles of hedge accounting.

The recent crisis of confidence in the mortgage process has sent more borrowers to credit unions to originate and service their mortgages. As credit unions create and retain more mortgages, servicing valuation grows in importance. Setting the proper assumptions is very important for calculating the “fair value” rather than an institution-specific value. The most critical assumptions – prepayment speeds, discount rate, servicing cost and delinquency – should be supported by and based on market conditions.

Urum Urumoglu, is Senior Director of Mortgage Services, at Balance Sheet Solutions, LLC. Contact the author at Urum@balancesheetsolutions.org or 800-782-2431, ext 2799.