Abstract
This research examines whether the fair value of mortgage servicing rights (MSRs) based on managerial inputs (Level 3) better reflects the cash flow and risk characteristics of the underlying assets than the fair value of MSRs based on market inputs (Level 2). Using mortgage servicing fees as a proxy for the underlying cash flows, we find that the valuation multiples for MSRs based on Level 3 inputs are more positively associated with the persistence of future servicing fees compared with the fair value of MSRs based on Level 2 inputs. We also document that only the valuation multiples based on Level 3 fair values are negatively associated with proxies for risk factors. Our results suggest that, although unobservable inputs are subject to managerial discretions, managers can generate higher quality fair value estimates than market inputs due to their information advantage, especially when the market for the underlying asset is inactive.
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Notes
In light of the financial crisis that began in 2007, the Financial Accounting Standards Board (FASB) released staff position papers FAS 157-3 and 157-4, recognizing that additional guidance was required for the adoption of fair value accounting during periods when a market was not active or the transactions associated with an asset or liability are not orderly. Consistent with the conjectures in Ryan (2008), the FASB acknowledged that “multiple valuation techniques” might be the most appropriate way to determine fair values and that the determination of prices and market conditions used to generate prices “depends on the facts and circumstances and requires the use of significant judgment.”
See Sect. 2 for detailed literature review.
Although our sample is small, these 82 banks comprise over 85% of the US market for mortgage servicing rights.
Thirteen banks always classify their MSR assets as Level 2 for the entire 4 years.
Fifty-two percent of our sample firms disclose sources of changes in mortgage servicing rights during a given year. Based on the available disclosures, more than 95% of the servicing rights are derived from loans originated but subsequently sold with servicing rights retained.
Banks that intend to originate and service mortgages but do not intend to hold the mortgage portfolio usually have the intention of selling their conforming loans (those under $417,000) to Freddie Mac or Fannie Mae. Twenty-five basis points is the industry standard for conforming loan portfolios sold to Freddie/Fannie.
“Adequate compensation” is determined by the market level costs of servicing plus a normal profit margin. Since the majority of the servicing costs incurred are upfront investments in resources required to engage in the servicing, “adequate compensation” is often manifested in the form of fixed costs per loan. Therefore servicing rights may generate a net liability when the outstanding principal balance drops to a certain level (usually $20,000–$30,000). Banks only report a net asset or liability amount for all servicing portfolios in the regulatory report. In our sample, all banks report net MSR assets across all quarters.
Please see "Appendix" for an example of the accounting for MSRs under both fair value and lower of amortized cost or market.
The price of servicing is often expressed as a multiple of the servicing strip. For example, a 25 basis point strip of MSRs priced at 100 basis points has a multiple of 4.
Revenues from servicing follow a “cash flow” process. The remittance agreement between the servicer and the mortgage acquirer determines the flow, as most agreement are based on actual payments from the homeowner to the servicer. Traditional agreements do not require the servicer to make upfront payments of interest and principal to the acquirer.
Based on the disclosed information, most of the MSR assets are derived from banks’ own loan originations where loans are sold with servicing rights retained. If banks tend to originate loans with local borrowers, then refinances within a state where a bank locates would be correlated with the prepayment risk of the underlying servicing portfolios.
Information related to state level refinances is acquired from Federal Financial Institutions Examination Council (FFIEC) website.
There is no readily available measure for the liquidity of the MSR market. Since the revenue generated from the MSR assets is similar to an interest only strip receivable, we contend that the bond market liquidity is likely to be more relevant than the equity market liquidity.
Buttimer and Lin (2005) explain that MSR servicers incur significant upfront costs building computing and customer-service infrastructure. The costs of servicing and the “adequate compensation” are mainly fixed. Therefore expected future servicing revenue is the most important valuation factor.
Because the bank-level servicing fee persistence is an estimated variable, we use quartile rank to minimize the estimation noise. Our results are robust to alternative ranking choices such as tercile, quintile, or decile ranking.
For presentation and interpretation clarity, we run the regressions for the two subsamples separately. We obtain the same results if we estimate the regressions for the pooled sample with three-way interaction terms.
We obtain the same results if we combine the two subsamples and run pooled regressions with three-way interactions. Moreover, we find that the three-way interaction term is significantly positive, suggesting Level 3 fair value is statistically more sensitive to the risk characteristics of the underlying service portfolios than Level 2 fair value.
Fair value of the servicing asset is determined as described in Section 2, pp. 10–13.
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Acknowledgments
The authors thank Patricia Dechow (editor), Cathy Shakespeare, Bradley Hendricks, an anonymous referee, Kris Allee, Anne Beatty, Gopal Krishnan, Heibatollah Sami, Andrew Van Buskirk, Dan Russomanno, and the seminar participants at the 2012 RAST Conference, The Ohio State University, Lehigh University, Pennsylvania State University, and the 2011 American Accounting Association Annual Meeting for their helpful comments and suggestions. We are grateful for the excellent research assistance provided by Dun Liu, Michelle Fan, and Austin Sudbury. We also thank Urum Urumoglu of Balance Sheet Solutions, LLC and Eric Nokken of Wilary Winn Inc. for sharing their knowledge of the mortgage servicing market and related accounting issues with us.
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Appendix: Accounting for mortgage servicing rights
Appendix: Accounting for mortgage servicing rights
Note: This example is drawn from a presentation by Erik Nokken and his staff at Willary Winn, available at the following website: http://www.wilwinn.com/assets/documents/2005-fi-conference.pdf. We have made modifications to this example for simplicity to highlight issues that are relevant to our research.
(1) Company A originates a 15- year $150,000 mortgage and sells the loan, with servicing retained. Sale is at par, and the contractually-specified servicing rate is .25 %. Estimated fair values are $150,000 for the cash proceeds from the loan and $1,200Footnote 18 for the servicing asset. The sale should be recorded at relative fair value as follows:
Allocation | Value | Fair value | Amount |
|---|---|---|---|
Loans sold | $150,000 | 99.2 % | $148,810 |
Servicing asset | 1,200 | 00.8 % | 1,190 |
$151,200 | $150,000 |
Net proceeds | $150,000 |
Carrying amount | |
Of loans | (148,810) |
Gain on sale | $1,190 |
JE1 | Loans | $150,000 | ||
Cash | $150,000 | |||
JE2 | Cash | $150,000 | ||
Loans | $148,810 | |||
Gain on sale | $1,190 | |||
JE3 | MSR | $1,190 | ||
Loans | $1,190 |
(2) Assume Company A chooses Lower of Amortized Cost or Market accounting for its MSR and estimates amortization on a straight line basis and the fair value at the end of the first month is higher than the amortized cost value. The following entries are made at the end of month one:
JE4 | Cash | $31.25($150,000 × 0.0025/12) | ||
Servicing Revenue | $31.25 | |||
JE5 | Servicing costs | $4.17 | ||
Cash | $4.17 | |||
JE6 | Amortization expense | $6.61 (1190/15 years/12 months) | ||
MSR | $6.61 | |||
(3) Now assume Company A chooses FV accounting for its MSR. Based on the model, FV of the MSR is now $1,210. We would repeat JE 4 and JE 5 from (2) above and adjust the value of the MSR asset.
JE7 | |
MSR | $20.00 |
Other income | $20.00 |
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Altamuro, J., Zhang, H. The financial reporting of fair value based on managerial inputs versus market inputs: evidence from mortgage servicing rights. Rev Account Stud 18, 833–858 (2013). https://doi.org/10.1007/s11142-013-9234-y
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DOI: https://doi.org/10.1007/s11142-013-9234-y