Servicing ownership shared by two or more parties in violation of servicing contracts should not be included in the fair value of servicing of either the buyer or the seller. (FNMA and FHLMC servicing contracts contain prohibitions against splitting the ownership of servicing.) Servicing owned by two or more affiliated companies should have formal servicing agreements in place that specifically allow the split ownership of servicing.
Sub-Servicing
If an institution has contracted with an outside third party to do the servicing (i.e., the institution owns the servicing rights but the outside third party is servicing the loans for the institution under a sub- servicing contract with the institution), the sub-servicing arrangement should be ignored with regard to deriving fair market value since this is only pertinent for “economic value” purposes and these loans should be included in the fair value.
If an institution performs sub-servicing for another entity but does not own the servicing rights, these loans should not be included in the fair value.
Credit Enhancement Fees
Under certain Federal Home Loan Bank mortgage partnership finance programs, the institution earns a credit enhancement fee. This credit enhancement fee should not be capitalized as part of the carrying value of MSR and should not be included in the fair value of MSR. It should be treated as an interest- only strip. See the Accounting section.
D. MSR Market Data
Institutions may use broker surveys and peer group surveys (PricewaterhouseCoopers quarterly survey, Interagency Regulatory quarterly survey, Mortgage Industry Advisory Corporation (MIAC), etc.) to gauge (a) individual assumptions used in the fair value and (b) multiples for comparative purposes. However, survey data is not a substitute for fair value. Further, multiples3 cannot be used as a substitute
for fair value since they are not reflective of individual servicing portfolio characteristics. Multiples are only a general indicator of price.
OTS participates in interagency MSR surveys and subscribes to various servicing sites (e.g., MIAC, etc.) that provide pricing on both generic servicing assets and newly originated MSR. These sources are general in nature, but can be consulted in the examiner’s review of MSR valuations. Contact National Mortgage Banking Specialists or Regional Capital Markets Examiners for access to these surveys. When using any kind of market survey, the user must be careful to ascertain whether data and values are for seasoned MSR or newly created MSR since there can be material differences.
3 The multiple represents the ratio between: (a) Fair value of MSR as a percentage of the unpaid principal balance of the loans serviced for
others and (b) servicing fee received by the servicer. For example, an institution services $100,000 loans and the fair value of the servicing
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E. IO Trust transactions
The cash flow stream for a trust IO is similar to the MSR income. Some institutions use these values and changes in value as additional support (i.e., benchmarks) for the assumptions used in their internal models.
F. Flow Sales/Purchases
Servicers review the prices required for flow purchases/sales as an indication of value for newly created MSR. It is important to note, however, this method is applicable only to new MSR production values and can be limited to a specific servicer operation.
Transfers of MSR
An institution can retain the right to service mortgages it has originated and sold, acquire servicing in bulk acquisitions, or acquire servicing from third-party production flow. Co-issue is also another means of acquiring servicing.The number of servicing sales and the dollar volume of servicing purchased and sold constitute a significant part of the mortgage banking business. The factors driving servicing transfers include an institution’s:
• Need to achieve economies of scale.
• Need to produce an immediate increase in current earnings through servicing sales. • Need to realize accounting profits through servicing swaps.
• Inability or lack of interest to service loans or a particular mortgage product.
Sales of Servicing Rights
Management should periodically assess its strategic decisions to retain or sell servicing. Institutions normally sell servicing in a bulk sale or released servicing as individual loans or pools of loans. Bulk sales generally occur in the secondary market and involve aged servicing. Loans sold servicing released are often sold on a flow basis. Flow refers to an institution selling loans under a master commitment as loans are produced or pools are formed. Any sales of servicing involving Freddie Mac and Fannie Mae require prior approval from these agencies. Another loan flow arrangement is an assignment of trade (AOT) wherein the seller of the servicing assigns a forward sale commitment of MBS to the buyer of the servicing. Another flow arrangement is through use of correspondents. The seller delivers the loan
to the buyer, who is then responsible for delivering the MBS to the broker/dealer. Such arrangements carry the risk that the seller cannot meet the commitment.
Bulk Purchases of Servicing Rights
Bulk mortgage loan servicing purchases are an investment opportunity for institutions that maintain adequate capacity and are efficient in their existing servicing operation. An institution needs to evaluate such MSR acquisitions for the risks and earnings potential along with comparison to alternative
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investments. Management should document the evaluation, which should include an analysis of the economic value of the servicing rights, including key assumptions, judgments, and estimates.
Documentation allows for proper management communication, review, and approval of key assumptions and judgments. Internal procedures should establish an effective due diligence process for institutions to evaluate a portfolio for possible acquisition. The institution should also perform a due diligence review on site. Initially, a due diligence review should corroborate the portfolio characteristics placed in the bid offering. An institution’s review should address:
• Interest rates on the loans in the portfolio. • Overall servicing income and ancillary income.
• Credit quality of the servicing portfolio and the ability of the institution to bear any additional risks.
• Type and complexity of loans in the servicing portfolio. • Operational costs incurred in servicing the portfolio. • Seller’s conformity with investor requirements.
Because most investors require the buyer of the servicing to maintain all origination and servicing warranties, it is important to ensure that the seller has serviced the loans according to those guidelines. An institution should address any issues arising from the due diligence during the purchase contract negotiations.
When pursuing a bulk acquisition, an institution should determine the fair value of servicing assets to assist in the bidding process. It is beneficial for the institution to calculate the return on investment (ROI) and return on equity (ROE). The economic value or ROE is unique to each servicer because of the inherent differences in each servicer’s ability to optimize servicing revenues and costs. The ROE is calculated by using the fully allocated costs of servicing and includes both income taxes and any debt used to finance the acquisition. The ROI is calculated using a required pretax rate of return or discount rate without debt leveraging. ROI is appropriate for determining the fair value of servicing and thus the resulting price to be paid or received for bulk purchases and sales of servicing. ROE is appropriate for internal analysis and planning purposes for bulk purchases and sales since it provides an effective measure of the potential impact to the bottom line.
An institution’s documentation of a bulk acquisition should include original expectations for the life of the net revenue stream and the valuation assumptions used to determine the purchase price of the MSR. These records should support the initial carrying amount of each bulk acquisition. Management should continuously monitor prepayment speeds and other assumptions and document their effect upon each portfolio.