Magazine article Mortgage Banking

Servicing Valuations and SOX

Magazine article Mortgage Banking

Servicing Valuations and SOX

Article excerpt

THE SERVICING COLUMN BY MARY Bruce Batte and Janis Ulsch in the August 2004 issue of Mortgage Banking stated that the Sarbanes-Oxley Act (SOX), among other external influences, has resulted in "lenders need[ing] far more meaningful servicing compliance monitoring." I couldn't agree more. But it is important to note that the impact of SOX extends well beyond operational compliance. A basic tenet of Sarbanes-Oxley is that management must attest to the accuracy of, as well as control over, its financial reporting. This has tremendous implications on servicing valuations.


The balance-sheet value of the mortgage servicing asset (MSA) must be affirmed as "accurate" by senior management. Accurate, in this context, is synonymous with "fair value." Since fair value is defined in FAS 140 as the "amount at which an asset can be bought or sold in a current transaction between willing parties," it is important that modeled value be benchmarked to secondary market transactions. This presents some challenges.

The secondary market for traditional servicing is much less liquid than it has been historically. This has resulted in more reliance on modeled values. As interest rates have stabilized--and, in fact, inched up--model values have escalated. These higher modeled values appear not to be completely reflected in the trades that are being completed. Reconciling the modeled values with market values requires diligent discussions with servicing brokers that trade these assets on an ongoing basis.

There are many new products and servicing types, and rapid growth in some old, historically less popular products. This is the result, in part, of the end of the refinance boom and the concomitant increase in competition for a smaller pie of mortgage originations. This situation is exacerbated by ever more creative securitization executions. These less-traditional products/tranches include interest-only loans, hybrid adjustable-rate mortgages (ARMs), negative-amortization loans, home-equity lines of credit (HELOCs), alternative-A, loans with prepay penalties, subprime, 125s, seconds and servicing tranches that include excess servicing or those that include waterfall payments (i.e., a particular tranche that does not receive cash payments until a superior tranche has received its).

Additionally, many new products include one or more of these traits and many times allow the borrower to choose which payment option he or she will use on a monthly basis.

These products may not be handled well by older valuation models that have not kept up with the inherent optionality and nonlinearity inherent in these new product cash flows. Additionally, setting assumptions (i.e., predicting borrower behavior) on these more exotic products must rely more on intuition and less on historical, empirical data. As of yet, there is little statistically significant data on these products to use for forecasting purposes.

The resultant modeled values need to be benchmarked against secondary market transactions for loans (pure servicing trades are rare) to reverse engineer market prepay and credit assumptions. Once again, discussions with your broker/trader can shed a good amount of light on how the market views these products. Information on comparable trades that occurred servicing-released and servicing-retained can provide tremendous insight into the fair value of these servicing rights. …

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