Fair-value accounting and MSRs: current accounting rules require that mortgage loan servicing rights be recorded at fair value. A recently published study examines whether or not that measurement principle is being met

Mortgage Banking, Dec, 2007 by Robert J. Cochran, Edward N. Coffman, David W. Harless

A study published in the June-July 2007 issue of Bank Accounting and Finance, by Robert J. Cochran, Edward N. Coffman and David W. Harless, examines the question of whether publicly traded mortgage banking firms record their mortgage loan servicing rights (MSRs) in accordance with current accounting rules. Current accounting rules require that MSRs be recorded at their fair value. [??] The Financial Accounting Standards Board (FASB) first introduced the concept of fair value with respect to MSRs in 1995 with the issuance of its Statement of Financial Accounting Standard (SFAS) No. 122, "Accounting for Mortgage Servicing Rights, which was an amendment of FASB Statement No. 65." Since then, the FASB has issued four additional standards (SFAS Nos. 125, 140, 156 and 157) and two exposure drafts (Nos. 1201-100 and 1250-001) that reinforced the fair-value measurement objective with respect to MSRs. [??] Fair value is defined as the value at which an asset would trade hands in an arm's-length transaction between knowledgeable parties. Fair value is a measurement objective that the FASB has embraced with respect to a wide range of financial assets and liabilities. [??] In many cases, fair value is readily determined by reference to highly liquid markets. In other cases, such as with MSRs, highly liquid markets do not exist. Where highly liquid markets do not exist, other techniques are to be used to determine fair value. [??] The various standards that address the measurement of fair value for those assets and liabilities for which highly liquid markets do not exist provide little guidance as to what other measurement techniques are appropriate. In an effort to provide additional guidance for how to measure fair value, the FASB issued SFAS No. 157, "Fair Value Measurements" in September 2006 (effective for fiscal years beginning after November 2007).

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SFAS No. 157 recognizes three techniques for determining fair value: the market approach, income approach and cost approach. SFAS No. 157 states, "The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). The measurement is based on the value indicated by current market expectations about those future amounts. Those valuation techniques include present value techniques; option-pricing models, such as the Black-Scholes-Merton formula (a closed-form model) and a binomial model (a lattice model), which incorporate present value techniques; and the multi-period excess earnings method, which is used to measure the fair value of certain intangible assets."

The income approach, as identified in SFAS No. 157, is the method most commonly used by mortgage banking firms to value their MSRs. The statement is clear that when using the income approach, the inputs to the models used are to be "assumptions market participants would use in pricing the asset." Use of firm-specific assumptions that differ from marketplace assumptions would result in a calculation of investment value. "[I]nvestment value reflects value to a particular investor (buyer or seller), and is often considered from the perspective of that investor as a basis for making investment (buy and sell) decisions," states Exposure Draft No. 1201-101.

Investment value is not fair value, and is not an appropriate measure at which to recognize MSRs. Determination of fair value requires that mortgage banking firms (servicers) make many estimates relative to the servicing portfolio being valued.

The problem faced by mortgage banking firms that originate and sell mortgage loans while retaining the servicing is that marketplace assumptions regarding the variables that must be estimated are not published. There are no empirical benchmarks that allow for the conclusion that the inputs used are marketplace assumptions rather than firm-specific assumptions. As such, there are no empirical benchmarks to conclude that the values recognized in the financial statements are fair value and not investment value.

Our 2007 study referred to earlier that was published in Bank Accounting and Finance is the second study in a series that examines the capitalization of MSRs by publicly traded mortgage banking firms. Our first study in 2004, published in Research in Accounting Regulation, identified the firm characteristics that influenced the level (measured in basis points) at which firms capitalized MSRs.

The study found that, in addition to servicing-related firm characteristics, certain non-servicing-related firm characteristics (e.g., firm size, debt level, level of incentive compensation) also influenced the level of MSR capitalization.

The study found that, all else being equal, larger firms capitalized MSR at lower levels (an income-decreasing accounting position) than did smaller firms. It also discovered that firms with higher debt-to-equity ratios and firms that relied more heavily on incentive compensation capitalized MSRs at higher levels (an income-increasing accounting position) than did firms with lower debt-to-equity ratios and firms that relied less on incentive compensation.