A new study on valuing servicing rights: a study of the valuation of mortgage servicing rights finds that servicing valuations differ based on some non-servicing-related factors. These can include company size or incentive compensation plans.

Author:Cochran, Robert J.
Position:COVER REPORT: SERVICING
 
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WHY STUDY MORTGAGE SERVICING RIGHTS (MSR) VALUATION CHARACTERISTICS?

Prior to 1995 and the issuance of the MSR accounting and valuation rules, a significant difference existed between the treatment of purchased mortgage servicing rights (PMSR) and servicer-originated mortgage servicing rights (OMSR). The new rules were contained in Statement of Financial Accounting Standard Number 122 (SFAS No. 122) and its successor, Statement of Financial Accounting Standard Number 125 (SFAS No. 125) (now SFAS No. 140).

Those in the industry prior to 1995 will remember that a mortgage banker purchasing PMSR recognized that purchase, at cost, as an asset on the servicer's balance sheet, while an originating mortgage banker did not reflect OMSR on its balance sheet.

Although the method of acquisition of a servicing portfolio should not affect its fair value, the different accounting treatments afforded PMSR and OMSR created a material difference in the financial statements of a mortgage banker. First, an originating mortgage banker that retained servicing did not reflect the value of the OMSR on its balance sheet. Second, the income statement was affected, since the unrecorded value of the OMSR resulted in a dollar-for-dollar reduction of the gain recognized on the sale of the loan.

The principal reason for the different accounting treatments of PMSR and OMSR was the belief that the amount paid for the PMSR objectively measured the value, because it resulted from an arm's-length negotiation between self-interested parties. On the other hand, the accounting regulators believed that OMSR values were too subjective to measure reliably.

The different accounting treatments for PMSR and OMSR contributed to what the industry called "portfolio churning." Portfolio churning occurred when a firm sold an originated servicing portfolio (OMSR), recognizing a gain from the transaction equal to the cash received (since no cost was assigned to the OMSR), and then, subsequently, purchased a similar servicing portfolio. Such portfolio churning allowed the seller/purchaser to both recognize a gain from the sale of the OMSR and, at the same time, recognize the value of the PMSR on its balance sheet.

Portfolio churning negatively affected mortgage lenders due to a reduction in the economic value of the servicing asset. Not only did transaction costs reduce the lifetime value of the servicing asset, the need for back-office personnel to handle repetitive transfers increased costs and decreased the long-term profitability of the servicer. Additionally, the mortgage lending industry suffered a serious loss of public confidence due to the high volume of servicing errors caused by multiple servicing transfers.

Many industry observers also felt that the exclusion of the fair value of OMSR from the balance sheet, for those not involved in churning, understated an originating servicer's balance sheet. These reasons, among others, caused the Mortgage Bankers Association (MBA) in 1992 to urge the Financial Accounting...

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