A better way to value mortgage assets.

Author:Healy, Tom

In the old days, valuations of mortgage loans and mortgage servicing rights (MSRs) were often accepted, more or less, at face value. There was a presumption that the analysts knew what they were doing and were coming up with reasonable assessments of value. Those days are over.

Examiners and auditors bolstered by new Financial Accounting Standards Board (FASB) pronouncements, as well as the prospect of having valuation changes flow through the income statement, have increased the scrutiny of both the input and the output of valuation models. This has caused a good amount of angst in the valuation community. Technology can help relieve that angst.

There are tremendous uncertainties surrounding the valuation of mortgage-related assets. Analysts need to concern themselves with a wide variety of difficult-to-define (no less defend) borrower behaviors such as prepay propensities, as well as the probability and consequence of borrowers going into default. Additionally, they must confront the fickleness of the capital markets--those that might buy these assets.

Underlying all of these vagaries is the problem of discerning the appropriate discount rate/yield requirement to be used to calculate a net present value of the projected cash flows. All of these assumptions need to be well-documented and disclosed in financial statements.

FAS 159, combined with advances in information technology (IT), now provides an easier way to accomplish fair-market valuations. FAS 159 defines three different levels of valuation:

* Level 3 -- unobservable inputs (i.e., typical cash-flow models);

* Level 2 -- quoted prices for similar assets (e.g., backing into loan prices based on comparable securities prices); and

* Level 1 -- quoted prices, in active markets, for identical assets at the measurement date.

The lower levels (levels 2 and 3) are generally not allowed where level 1 pricing is available. While level 3 pricing has been the norm in this market, advances in information technology now allow for level 2 and even level 1 pricing of most of these loan and servicing assets. This not only increases the accuracy of these fair values, but also reduces dramatically modeling validation efforts and disclosure requirements. This is true for both mortgage loans and mortgage servicing rights.

Mortgage loans

Mortgage loans are originated and sold as either conforming or nonconforming product.

Conforming loans tend to have as their principal secondary market the securities...

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