Background
and Purpose The purpose of this advisory
letter is to highlight concerns and provide guidance regarding mortgage
banking activities, primarily in the valuation and hedging of mortgage-servicing
assets (MSAs). While the number of institutions with significant exposure
to mortgage banking assets is limited, mortgage banking is a growing
business line for many institutions. Mortgage production volume increased
significantly over the past two years as interest rates fell to record
lows and refinancing activity reached an all-time high. Many borrowers
have been attracted to new lending products by innovative, low-cost
lending programs, widespread use of automated underwriting, and increased
competition among banks, thrifts, and other financial institutions.
This high volume of mortgage activity exposes institutions to a number
of risks. This guidance focuses on risks associated with valuation
and modeling processes, hedging activities, management information
systems, and internal audit processes in connection with mortgage
banking.
1Servicing is inherent in all financial assets; it becomes
a distinct asset or liability only when contractually separated from
the underlying financial assets by sale or securitization of the assets
with servicing retained or by a separate purchase or assumption of
the servicing. To help manage the interest-rate, liquidity, and credit
risks inherent in mortgages, many institutions sell these loans into
the secondary market (e.g., to the Federal National Mortgage Association,
Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks,
and private-sector issuers and investors). In such mortgage loan sales,
institutions often retain the servicing and recognize MSAs, which
are complex and volatile assets subject to interest-rate risk. MSAs
can become impaired when interest rates fall and borrowers refinance
or prepay their mortgage loans. This impairment can lead to earnings
volatility and erosion of capital, if the risks inherent in the MSAs
have not been properly hedged.
Institutions are expected to follow Financial Accounting
Standards Board Statement No. 140, “Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities” (FAS 140),
when accounting for MSAs. In summary, FAS 140 requires the following
accounting treatment for servicing assets (including MSAs):
2
- initially record servicing assets at fair value, presumably
the price paid if purchased, or at their allocated carrying amount
based on relative fair values if retained in a sale or securitization;3
- amortize servicing assets in proportion to, and over
the period of, estimated net servicing income; and
- stratify servicing assets based on one or more of
the predominant risk characteristics of the underlying financial assets,
assess the strata for impairment based on fair value, and report them
on the balance sheet at the lower of unamortized cost or fair value
through the use of valuation allowances.
Fair value is defined in FAS 140 as the amount
at which an asset could be bought or sold in a current transaction
between willing parties, that is, other than in a forced or liquidation
sale. Quoted market prices in active markets for similar assets provide
the best evidence of fair value and must be used as the basis for
the measurement, if available. If quoted market prices are not available,
the estimate of fair value must be based on the best information available.
The estimate of fair value must consider prices for similar assets
and the results of valuation techniques to the extent available.
Examination Concerns The banking agencies expect institutions involved
in mortgage-servicing operations to use market-based assumptions that
are reasonable and supportable in estimating the fair value of servicing
assets. Although consolidation in the mortgage-servicing industry
has reduced the number of MSA purchase and sale transactions, a significant
volume of MSAs continue to be traded, which can provide an indication
of comparable fair value for similar assets. Specifically, bulk, flow,
and daily MSA/loan pricing activities observed in the market should
be evaluated to ensure that an institution’s MSA valuation assumptions
are reasonable and consistent with market activity for similar assets.
Many financial institutions also use models to estimate the fair value
of their MSAs and substantiate their modeled estimate of MSA fair
value by comparing the model output to general or high-level peer
surveys. Such a comparison, however, is often performed without adequate
consideration of the specific attributes of the institution’s own
MSAs. The following concerns have been noted in recent examinations
of mortgage banking activities; examiners should consider these items
as an indication that additional scrutiny is necessary:
- The use of unsupported prepayment speeds, discount
rates, and other assumptions in MSA valuation models. Assumptions
are unsupported when they are not benchmarked to market participants’
assumptions and the institution’s actual portfolio performance across
each product type.
- Questionable, inappropriate, or unsupported items
in the valuation models. Examples include retention benefits,4 deferred tax benefits, captive reinsurance premiums, and income
from cross-selling activities. The inclusion of these items in the
MSA valuation must be appropriate under generally accepted accounting
principles (GAAP) and must also be consistent with what a willing
buyer would pay for the mortgage-servicing contract. For example,
when the inclusion of retention benefits as part of the MSA valuation
is not adequately supported with market data, such inclusion will
result in an overstatement of reported mortgage-servicing assets,
and therefore will be deemed an unsafe and unsound practice.
- Disregard of comparable market data coupled with
overreliance on peer group surveys as a means of supporting assumptions
and the fair value of MSAs. Management may use survey data for comparative
purposes; however, it is not a measure of or substitute for fair value.
- Frequent changing of assumptions from period to period
with no compelling reason for the change, and undocumented policies
and procedures relating to the MSA valuation process and oversight
of that process.
- Inconsistencies in MSA valuation assumptions used
in valuation, bidding, pricing, and hedging activities as well as,
where relevant, in mortgage-related activities in other aspects of
an institution’s business.
- Poor segregation of duties from an organizational
perspective between the valuation, hedging, and accounting functions.
- Failure to properly stratify MSAs for impairment-testing
purposes. FAS 140 requires MSAs to be stratified based on one or more
of the predominant risk characteristics of the underlying mortgage
loans. Such characteristics may include financial asset type, size,
interest rate, origination date, term, and geographic location. Institutions
are expected to identify a sufficient number of risk characteristics
to adequately stratify each MSA and provide for a reasonable and valid
impairment assessment. Stratification practices that ignore predominant
risk characteristics are a supervisory concern.
- Inadequate amortization of the remaining cost basis
of MSAs, particularly during periods of high prepayments. Inadequate
amortization often occurs because prepayment models are not adequately
calibrated to periods of high prepayments. When these models underestimate
runoff, the amount and period of estimated net servicing income are
overstated.
- Continued use of a valuation allowance for the impairment
of a stratum of MSAs when repayment of the underlying loans at a rate
faster than originally projected indicates the existence of an impairment
for which a direct write-down should be recorded.
- Failure to assess actual cash-flow performance. The
actual cash flows received from the serviced portfolio must be established
in order to determine the benefit of MSAs to the institution.
- Failure to validate or update models for new information.
Inaccuracies in valuation models can result in erroneous MSA values
and affect future hedging performance. Models should be inventoried
and periodically revalidated, including an independent assessment
of all key assumptions.
Risk-Management Activities The banking agencies expect institutions
to perform mortgage banking operations in a safe and sound manner.
Management should ensure that detailed policies and procedures are
in place to monitor and control mortgage banking activities, including
loan production, pipeline (unclosed loans) and warehouse (closed loans)
administration, secondary-market transactions, servicing operations,
and management (including hedging) of mortgage-servicing assets. Reports
and limits should focus on key risks, profitability, and proper accounting
practices.
MSAs possess interest rate-related option characteristics
that may weaken an institution’s earnings and capital strength when
interest rates change. Accordingly, institutions engaged in mortgage
banking activities should fully comply with all aspects of their primary
federal regulator’s policy on interest-rate risk.
5 In addition, institutions with significant mortgage banking operations
or mortgage-servicing assets should incorporate these activities into
their critical planning processes and risk-management oversight. The
planning process should include careful consideration of how the mortgage
banking activities affect the institution’s overall strategic, business,
and asset/liability plans. Risk-management considerations include
the potential exposure of both earnings and capital to changes in
the value and performance of mortgage banking assets under expected
and stressed market conditions. Furthermore, an institution’s board
of
directors should establish limits on investments in mortgage banking
assets and evaluate and monitor such investment concentrations (on
the basis of both asset and capital levels) on a regular basis.
During examinations of mortgage banking activities, examiners
should review mortgage banking policies, procedures, and management
information systems to ensure that the directors, managers, and auditors
are adequately addressing the following matters.
Valuation and Modeling Processes
- Comprehensive documentation standards for all
aspects of mortgage banking, including mortgage-servicing assets. In particular, management should substantiate and validate the initial
carrying amounts assigned to each pool of MSAs and the underlying
assumptions, as well as the results of periodic reviews of each asset’s
subsequent carrying amount and fair value. The validation process
should compare actual performance to predicted performance. Management
should ensure proper accounting treatment for MSAs on a continuing
basis.
- MSA impairment analyses that use reasonable and
supportable assumptions. Analyses should employ realistic estimates
of adequate compensation,6 future revenues, prepayment speeds, market-servicing costs,
mortgage-default rates, and discount rates. Fair values should be
based upon market prices and underlying valuation assumptions for
transactions in the marketplace involving similar MSAs. Management
should avoid relying solely upon peer group surveys or the use of
unsupportable assumptions. The agencies encourage institutions to
obtain periodic third-party valuations by qualified market professionals
to support the fair values of their MSAs and to update internal models.
- Comparison of assumptions used in valuation models
to the institution’s actual experience in order to substantiate the
value of MSAs. Management should measure the actual performance
of MSAs by analyzing gross monthly cash flows of servicing assets
relative to the assumptions and projections used in each quarterly
valuation. In addition, a comparison of the first month’s actual cash
received on new MSAs to the projected gross cash flows can help validate
the reasonableness of initial MSA values prior to the impact of prepayments
and discount rates. “Economic value” analysis is a critical tool in
understanding the profitability of mortgage-servicing to an institution;
however, it is not a substitute for the estimation of the fair value
of MSAs under GAAP.
- Review and approval of results and assumptions
by management. Given the sensitivity of the MSA valuation to changes
in assumptions and valuation policy, any such changes should be reviewed
and approved by management and, where appropriate, by the board of
directors.
- Comparison of models used throughout the company
including valuation, hedging, pricing, and bulk acquisition. Companies
often use multiple models and assumption sets in determining the values
for MSAs depending on their purpose (pricing versus valuation). Any
inconsistencies between these values should be identified, supported,
and reconciled.
- Appropriate amortization practices. Amortization
of the remaining cost basis of MSAs should reflect actual prepayment
experience. Amortization speeds should correspond to and be adjusted
to reflect changes in the estimated remaining net servicing income
period.
- Timely recognition of impairment. Institutions
must evaluate MSAs for impairment at least quarterly to ensure amounts
reported in the call report7 or TFR8 are accurately stated. Institutions
will generally be expected to record a direct write-down of MSAs when,
and for the amount by which, any portion of the unamortized cost of a
mortgage-servicing asset is not likely to be recovered in the future.
Mortgage Banking Hedging
Activities
- Systems to measure and control interest-rate risk. Hedging activities should be well developed and communicated to
responsible personnel. Successful hedging systems will mitigate the
impact of prepayments on MSA values and the effects of interest-rate
risk in the mortgage pipeline and warehouse.
- Approved hedging products and strategies. Management
should ensure appropriate systems and internal controls are in place
to oversee hedging activities, including monitoring the effectiveness
of hedging strategies and reviewing concentrations of hedge instruments
and counterparties.
- Hedge accounting policies and procedures. Institutions
should ensure their hedge accounting methods are adequately documented
and consistent with GAAP.
Management Information Systems
- Accurate financial reporting systems, controls,
and limits. At a minimum, the board should receive information
on hedged and unhedged positions, mark-to-market analyses, warehouse
aging, valuation of MSAs, various rate shock-scenario and risk exposures,
creation of economic value, and policy exceptions whenever material
exposure to MSAs exists.
- Systems that track quality-control exceptions. With many institutions processing record volumes of mortgages, transaction
risk has increased. Quality-control reports should be analyzed to
determine credit quality, loan characteristics and demographics, trends,
and sources of problems. Sound quality-control programs are also beneficial
in the early detection of deteriorating production quality and salability,
as well as in the prevention and detection of fraudulent activities.
- Systems that track and collect required mortgage
loan documents. As a seller in the secondary market, it is important
for institutions to ensure that their mortgage products are salable
and comply with investor requirements. Management should ensure adequate
control processes are in place for both front-end-closing and post-closing
loan documents. If mortgages are not properly documented, an institution
may be forced to hold unsold mortgages for extended periods or repurchase
mortgages that have been sold. Further, management should ensure that
adequate analyses are performed and allowances are established for
estimated probable losses arising from documentation deficiencies
on closed loans.
- Systems that monitor and manage the risks associated
with third-party-originated loans. Institutions often originate
loans through broker and correspondent channels. Management should
ensure prudent risk-management systems are in place for broker and
correspondent approvals and ongoing monitoring, including controls
on the appraisal and credit-underwriting process of third-party-originated
loans. Adequate due diligence of third-party relationships is necessary
to help prevent the origination of loans that are of poor credit quality
or are fraudulent. Delegated underwriting to brokers or correspondents
warrants close supervision from senior management.
Internal Audit
- Adequate internal-audit coverage. Because
of the variety of risks inherent in mortgage banking activities, internal
auditors should evaluate the risks of and controls over their institution’s
mortgage banking operations. They should report audit findings, including
identified control weaknesses, directly to the audit committee of
the board or to the board itself. Board and management should ensure
that internal-audit staff possesses the necessary qualifications and
expertise to review mortgage banking activities or obtain assistance
from qualified external sources.
Summary In supervising mortgage banking operations, the primary
objective of the banking agencies is to ensure that institutions implement
satisfactory policies, procedures, and controls addressing the risks
inherent in mortgage banking activities. Institutions with significant
exposures to mortgage-related assets, especially MSAs, should expect
greater scrutiny of their mortgage-related activities during examinations.
The banking agencies may also require additional capital for institutions
that fail to exercise the sound practices set forth in this advisory.
Issued jointly by the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, the Office
of the Comptroller of the Currency, and the Office of Thrift Supervision
Feb. 25, 2003 (SR-03-4).
