MSR Impairment Testing and Initially Booking MSRs

SFAS 157 will have a profound impact for all holders of MSRs, not just those few firms who elected Fair Value reporting under SFAS 156. The Fair Value methodology is the standard disclosure for SFAS 140 Impairment Testing of MSRs. Therefore, every holder of MSRs must employ a newly defined Fair Value method for Impairment Testing of their MSRs.

In addition to new procedures for Impairment Testing, mortgage companies will also need to alter their methods for initially booking MSRs. SFAS 156 requires that MSRs be booked at Fair Value and no longer at Relative Fair Value, which involves a cost accounting component. Both of these previously established Fair Value disclosures are likely to undergo significant adjustments once mortgage companies are compliant with the new definition of Fair Value under SFAS 157.

We’ll briefly describe some of the new concepts in SFAS 157 and then present some of the implications for adapting your MSR valuation methodologies to be SFAS 157 compliant.

 

Significant New Concepts of Fair Value in SFAS 157:

o Exit Price
o Market-Based vs. Entity-Specific Valuation
o Fair Value Hierarchy
o Principal (or Most Advantageous) Market
o Highest and Best Use Analysis
o Blocking Factor
o Expanded Disclosure and Model Input Assumptions

Exit Price:
The definition of Fair Value from SFAS 157 is “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.”

In addition, the historical standard fair value market conditions apply:
o An orderly transaction
o Arm’s length transaction with disinterested parties involved
o No transaction costs (Broker fees)
o Includes transportation costs (Recording fees)

An important distinction that SAFS 157 makes is that the Exit Price is not the Entry Price or the cost to acquire the asset. The example one leading accounting firm uses is the market dynamics of purchasing a new car. The buyer pays $50K for the new car, but as soon as he drives off the showroom floor, the now slightly new car could be sold for $40K. The Exit Price of the slightly new car is now substantially discounted to reflect the reality of this market’s dynamics. This Exit Price of $40K is what the new Fair Value standard requires the users to disclose even though the cost of the new car was $50K. This has tremendous implications for mortgage companies.

Under SFAS 156, MSRs must be initially booked at their Fair Value, regardless of whether the mortgage company has elected to adopt the Fair Value method for reporting MSRs on a go-forward basis or utilize the long-standing LOCOM (Lower of Cost or Market) disclosure. The initial MSR Fair Value must be the Exit Price. For many mortgage companies that have been complying with the Relative Fair Value methods for initially booking MSRs, this will cause some significant changes to both their accounting practices as well as their business practices.

Mortgage companies will need to:
Regularly review Flow, AOT, SRPs, and Co-issue Servicing multiples.
Maintain MSR valuation assumptions consistent with current market Bulk and Flow pricing.
Understand the implications of the migration from Flow MSR to Bulk MSR pricing.
Utilize a widely accepted software model that can demonstrably replicate MSR market prices.

Bye, Bye MSR Impairment Cushion?
Does this mean that newly originated (off the show room new car) MSRs will be priced more consistently with Bulk (slightly older new car) MSRs in the future? If a mortgage company must test for impairment one calendar quarter after origination and interest rates and economic conditions haven’t changed significantly, then the Fair Value derived from the impairment test needs to be very close to the amortized initial book basis in order to avoid challenging how the MSR asset was initially booked. This impairment test will, if done in a manner consistent with SFAS 157, be consistent with Bulk MSR valuations methods, assumptions, and market execution.

As a result, a currently common accounting practice — that of initially booking the MSRs at values significantly below Fair Value and therefore creating a cushion against future impairment — will be jeopardized. MIAC believes that changing the initial booking of MSRs to Fair Value could have a dramatic effect on the mortgage banking industry.

One likely consequence of this change will be that a much larger number of mortgage companies will elect to hedge their impairment risk in their MSRs. Whether they set up distinct MSR hedging programs or utilize other mark-to-market balance sheet assets, they will surely need more effective risk management solutions.

More MSR Hedging?
Another likely consequence is that more mortgage companies will migrate to the SFAS 156 Fair Value disclosure for their MSRs on an ongoing balance sheet basis. If the initial accounting cushion is removed and LOCOM restricts their ability to write up their Fair Value gains, then more mortgage companies will be motivated to adopt Fair Value disclosure of their MSRs. They won’t want to hedge a LOCOM asset and not be able to write up their assets when the hedges decline in value.

Also, the market value declines in MSRs won’t be disclosed as “impairments”, a meaningful distinction for the readers of these financial statements. Moreover, without the burdens of FAS 133 effectiveness testing, setting up simple MSR hedging programs can be viable solutions for addressing their earnings volatility concerns.

Market-Based vs. Entity-Specific Valuation:
For holders of publicly traded fixed-income securities, the Market-Based vs. Entity-Specific valuation will have no impact. However, for holders of MSRs, a frequent point of clarification in the current valuation practice is whether a particular valuation represents a market valuation or an “economic” valuation. A common practice in MSR valuations is for the holder of the MSRs to value the assets’ “economic” value or the Entity-Specific valuation. An economic valuation generally means an entity-specific, or to some degree entity-specific, valuation where input pricing assumptions are derived from the company’s own experience with the MSR asset.

The particular parameters or input assumptions that are often made entity-specific are:
o T&I Multipliers
o Marginal Costs to Service various loan products
o Escrow Earnings Rates
o Geographic adjustments to prepayments or delq/FCL behavior
o Prepayment behavior
o Delq/FCL behavior
o Entity-Specific OASs
o Entity-Specific Aggregation Levels

Inconsistencies in any of these input assumptions with market consensus assumptions will result in MSR valuations differing from a market price. Clearly, an independent third-party MSR valuation or an appropriate comparison to benchmark Generic Servicing Assets (GSAsTM) pricing will provide an important independent verification of the input pricing assumptions.

Fair Value Hierarchy:
One of the most important components of the new SFAS 157 standard is the new hierarchy associated with the disclosure. If a Fair Value was derived from a market source with a higher level of reliability, then this reliability level is now included in the financial statement. Fair Values will be categorized as Level 1, 2 or 3 Fair Values.
Here is a brief summary of the definitions of the fair value levels.

Level 1:
- Market Observable: Quoted Price

Level 2:
- Observable market data other than Level 1 inputs
o Quoted prices for similar assets or liabilities in active markets
o Quoted prices for identical or similar assets or liabilities in inactive markets
o Inputs other than quoted prices that are directly observable (e.g. interest rates, yield curves, default rates)
o Inputs derived principally from or corroborated by market data by correlation or other means (market corroborated inputs). Example: royalty rates, prices per square foot or valuation multiples.
- Adjustments may vary depending on facts and circumstances. Example: condition and/or location of the asset. Significant adjustments may render the fair value measurement a Level 3 measurement

Level 3:
-Unobservable inputs:
Inputs derived through extrapolation or interpolation that cannot be corroborated by market data
o Other entity-specific inputs [historical or projected financial data (revenue, earnings, cash flow,etc.) that are not derived from market data]
o Unobservable inputs reflect the reporting entity's own assumptions about the assumptions that market participants would use.
o In developing unobservable inputs, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions.
o The reporting entity must not ignore information about the market participant assumptions that is reasonably available without undue cost and effort.

In the loan origination market, MSRs could be classified as Level 1 Fair Values. Flow and co-issue servicing prices are committed contractual prices from an arms length buyer. In an AOT trade, the MSR value can be directly derived from the total price minus the MBS price. And there is readily available SRP information, which would be argued is a market observable quoted price. Mortgage companies should be able to argue successfully that these MSR prices are a Quoted Price, and therefore, Level 1 Fair Values.
Clearly, Bulk MSRs aren’t going to be classified as Level 1 Fair Values because no quoted prices exist. MIAC estimates that approximately 1% to 3% of the entire mortgage servicing assets will trade in the bulk market within a year. These trades are nearly always brokered and everyone would agree that there is no quoted price for a bulk MSR asset.

The MIAC process for independent third-party pricing of a particular portfolio of Bulk MSRs is to map the representative portfolio components to similar benchmark servicing assets, where price discovery can be formalized. The similar assets that MIAC uses as benchmark instruments are the Generic Servicing Assets (GSAsTM).

The MIAC GSAs undertake a regular virtual auction process with the largest MSR market participants and are priced by MIAC on a daily basis. GSA’s daily prices are published on MIAC’s web site, www.MIACAnalytics.com and a representative sample is published daily at www.nationalservicingnews.com and on a weekly basis at www.americanbanker.com. MIAC believes that GSAs will serve an important role in helping mortgage companies establish Fair Values for MSRs. In subsequent MIAC publications, MIAC will elaborate further on how GSAs can be used in future issues.

The SFAS 157 also states that “the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.” The cost of a GSA subscription is insignificant and their prices are easily available. MIAC believes that the GSA pricing will continue to gain wide acceptance in the mortgage banking industry and address this SFAS 157 requirement.

Principal (or Most Advantageous) Market:
Highest and Best Use Analysis:
Blocking Factor:

All of these SFAS 157 requirements are related to the market execution mechanisms for selling MSRs. The Fair Value measurement must include a disclosure of the assumptions surrounding the market execution mechanisms. Once the assumed market transaction procedures are disclosed, the MSR holders will not need to regularly update these descriptions of the market practices. In addition to a detailed description of the auction procedures, standard representations and warranties, prepayment lock-out protection, due diligence procedures, and MSR transfer mechanics need to be described and their effect on the Fair Value need to be quantified. Independent third-party MSR valuation firms will typically provide this disclosure description and analysis.

Moreover, the MSR holders most likely will be required to obtain an independent third-party description of the standard market practices and an analysis that the assumed market transaction practices represent the Highest and Best Use of the asset. The analysis of Highest and Best Use of the asset will include a justification of whether the asset “would provide maximum value to market participants principally through its use in combination with other assets as a group (highest and best use is “in-use”)” or “principally on a standalone basis (highest and best use is “in-exchange”)”.

Because MSR acquirers typically assume their marginal cost to service a new portfolio in their bidding process, expect to leverage cross-selling opportunities in their ancillary income assumptions, and often assume different success rates with their retention programs, an “in-use” valuation will likely be the practice of MSR holders.

The statement also allows MSR holders to disclose their in-use fair values as adjustments to in-exchange fair values. The statement indicates, “The in-use valuation premise might be incorporated in the fair value of the asset through adjustments to the value of the asset in-exchange.” Clearly, the new Fair Value disclosures will make more explicit the valuation premises to readers of their financial statements.

Expanded Disclosure and Model Input Assumptions:
SFAS 157 will require that the much wider scope of the model input assumptions be disclosed, including the primary components of the valuation models such as the term structure model parameters, prepayment model parameters and types, the source and magnitude of the discount rates or spreads, and the mechanics for assumption and price discovery. Particular scrutiny will likely be placed on the “unobservable inputs (Level 3)”. For changes in these inputs, the statement will require a reconciliation of the effects on the Fair Value due to changes in the significant inputs and changes “in the observability of significant inputs”. Moreover, the “Valuation Techniques” must be categorized as “market approach”, “income approach”, or “cost approach”.

Conclusions:
MIAC believes that SFAS 157 will have sweeping implications directly for how the Fair Value of MSRs are derived and disclosed. The world of running an internal black-box MSR valuation model will soon be replaced with new parlance such as Exit Price and Fair Value Hierarchy. With SFAS 156 requiring the MSRs to be initially booked at Fair Value, whether a buyer and holder of MSRs or a seller of MSRs, both parties will need to fully understand the implications of how the new SFAS 157 Fair Value standard will affect their business practices. The implementations of this new standard will be complex and challenging and, for those most attuned to the details, will represent an opportunity to structure their business practices to most successfully benefit from this brave new world.

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