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6.3 Recognition and measurement of servicing rights
Publication date: 30 Sep 2020 (updated 28 Feb 2022)
us Transfers of financial assets guide
Servicing rights become distinct assets or liabilities that require separate accounting treatment when they are contractually separated from the underlying financial assets and provide compensation to the servicer that is either:
- More than adequate (resulting in a net servicing asset)
- Less than adequate (resulting in a net servicing liability)
ASC 860 prescribes a uniform approach to the accounting for servicing of all types of financial assets under which a net servicing asset or liability is recognized for each servicing contract. ASC 860 permits fair value accounting or an amortization method, under which servicing rights are accounted for at the lower of amortized cost or fair value.
There is diversity in practice concerning the applicable GAAP guidance for servicing and subservicing contracts deemed to have just adequate compensation. See Question TS 6-2 for additional information.
6.3.1 Separate recognition of servicing rights
ASC 860 describes when a servicing right should be accounted for separately.
Excerpt from ASC 860-50-25-1
An entity shall recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations:
- A servicer’s transfer of any of the following, if that transfer meets the requirements for sale accounting:
- An entire financial asset
- A group of entire financial assets
- A participating interest in an entire financial asset, in which circumstance the transferor shall recognize a servicing asset or a servicing liability only related to the participating interest sold.
- Subparagraph superseded by Accounting Standards Update No. 2009-16
- An acquisition or assumption of a servicing obligation that does not relate to financial assets of the servicer or its consolidated affiliates included in the financial statements being presented.
Example 1 (see paragraph 860-50-55-20) illustrates accounting for a sale of receivables with servicing obtained by the transferor.
Excerpt from ASC 860-50-25-2
A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor’s balance sheet shall not recognize a servicing asset or a servicing liability.
Excerpt from ASC 860-50-25-3
A servicer that recognizes a servicing asset or servicing liability shall account for the contract to service financial assets separately from those financial assets.
Excerpt from ASC 860-50-25-4
An entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held to maturity in accordance with Topic 320 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced.
A servicing asset or servicing liability should be recognized when a company undertakes an obligation to service financial assets (i.e., the acquisition or assumption of the right to service a financial asset from a third party). Servicing rights related to failed sales (i.e., secured borrowings) or transfers to SPEs that are consolidated under ASC 810, would not qualify for separate recognition under ASC 860.
In accordance with ASC 860-50-55-4, if an entity transfers a participating interest in a financial asset that qualifies for sale accounting, the entity should record a servicing asset for the portion of the loan it sold. The assumption that the entity would service the loan because it retains part of the participated loan does not affect the requirement to recognize a servicing asset.
Recognition of servicing assets or servicing liabilities for revolving-period receivables shall be limited to the servicing for the receivables that exist and have been transferred. As new receivables are transferred into the revolving-period structure, rights to service those receivables should be recognized, to the extent the transfers to the structure meet the conditions for sale accounting.
Question TS 6-1 further clarifies the scope of transactions that are subject to ASC 860.
Question TS 6-1
Would ASC 860 apply if a broker were to bring a bank and a borrower together in a brokered loan transaction and simultaneously enter into a servicing contract with the bank upon origination of the loan?
Would ASC 860 apply if a broker were to bring a bank and a borrower together in a brokered loan transaction and simultaneously enter into a servicing contract with the bank upon origination of the loan?
PwC response
Yes. ASC 860 applies to any separate purchase or assumption of a servicing contract, regardless of whether a transfer of financial assets is connected to it, as outlined in ASC 860-50-30-1.
6.3.2 Initial measurement of servicing assets and liabilities
ASC 860-50-30 discusses some of the critical considerations when determining the initial measurement of a servicing asset or a servicing liability that qualifies for separate recognition. The guidance establishes that servicing contracts for which the servicer’s benefits of servicing are expected to more than adequately compensate the servicer will result in a servicing asset and contracts for which the benefits of servicing are not expected to adequately compensate the servicer will result in a servicing liability. The determination of adequate compensation considers the margin that would be demanded in the marketplace based on expected costs to serve; it does not vary based on the servicer’s own specific servicing costs. Servicing contracts that entitle the servicer to benefits equal to adequate compensation do not result in the recognition of a servicing asset or liability.
ASC 860 requires that separately recognized servicing rights be measured initially at fair value. ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Measurements of the fair value of servicing rights may consider the present value of expected cash flows, including both future inflows of servicing revenues and outflows of costs related to servicing. See TS 6.3.5 for a discussion of fair value measurements of servicing rights.
6.3.2.1 Determining whether a servicer is adequately compensated
A servicer of financial assets receives revenues from contractually specified servicing fees and other ancillary sources of income, including float and late charges. This income represents the benefits of servicing. In most cases, servicing contracts are structured such that the benefits of servicing are expected to more than adequately compensate the servicer for performing the servicing. The ASC Master Glossary defines benefits of servicing and adequate compensation. The determination of the adequacy of compensation is done on a contract by contract basis with no aggregation of contracts.
Definitions from ASC Master Glossary
Benefits of Servicing: Revenues from contractually specified servicing fees, late charges, and other ancillary sources, including float.
Adequate Compensation: The amount of benefits of servicing that would fairly compensate a substitute servicer should one be required, which includes the profit that would be demanded in the marketplace. It is the amount demanded by the marketplace to perform the specific type of servicing. Adequate compensation is determined by the marketplace; it does not vary according to the specific servicing costs of the servicer.
Adequate compensation is a market concept and should be made independent of the servicer’s internal cost structure. A servicer’s level of compensation should be compared to the level of compensation demanded by current market prices (i.e., the cost to service that servicers of similar assets would assume when buying the servicing in the marketplace, plus the profit margin they would demand).
Because the determination of a servicing asset or liability is based on the compensation demanded by the marketplace to perform the servicing, a company’s actual costs to service are irrelevant in determining whether a servicing asset or liability should be recorded. An efficient servicer could end up recording a liability, even if it can profitably perform the servicing below the contractually specified fee or "adequate compensation." Likewise, an inefficient servicer may be able to establish an asset, even though its actual cost to service may be higher.
The types of assets being serviced will impact the amount required to adequately compensate the servicer. ASC 860-50-30-7 provides an example that addresses these differences by distinguishing between the amount of effort that would be required to service a home equity loan from a credit card receivable or a small business administration loan. Some entities look to proxies, such as subservicing contracts, to help determine what adequate compensation, including a reasonable profit margin, would be for different assets being serviced.
The actual servicing costs and fees are recorded in the income statement as they are incurred or earned. Changes in the fair value of the servicing asset/liability are recorded in the income statement as they occur or through amortization. As a result, the income statement reflects the servicing contracts’ actual yield, including any efficiencies/inefficiencies in the entity’s own operations.
If a servicer is not adequately compensated by marketplace standards, a servicing liability should be recorded at fair value, even though the contractually specified fee may cover the servicing costs of that particular servicer. A contractual provision establishing the amount to be paid to a replacement servicer should not be utilized as the sole basis for determining fair value of servicing in the marketplace. However, that contractual provision would be a relevant provision for evaluating the overall fair value of the servicing contract.
If a servicer’s internal servicing costs exceed its compensation, a servicing liability should not be recorded as long as (1) the compensation represents what a substitute servicer would demand in the market, and/or (2) the servicer has the ability to sell its servicing rights to a substitute servicer, or to subcontract the servicing without incurring a loss. In these cases, the servicer’s internal servicing costs in excess of its servicing revenues should be recognized as a period cost during the term of the servicing contract. If, however, a servicer is contractually precluded from transferring its servicing rights or unable to subcontract the servicing without incurring a loss, a liability (at the time the servicing contract is entered into or assumed) equal to the unfavorable commitment for the contract’s remaining term should be recorded using a market-based cost assumption.
Question TS 6-2 discusses which standard should be applied when measuring revenue from a servicing contract.
Question TS 6-2
Does the recognition and measurement of revenue attributable to a servicing contract (relating to financial assets, such as residential mortgage loans) fall within the scope of ASC 606 or ASC 860?
Does the recognition and measurement of revenue attributable to a servicing contract (relating to financial assets, such as residential mortgage loans) fall within the scope of ASC 606 or ASC 860?
PwC response
ASC 860-50 addresses when a servicer of financial assets should record a servicing asset (or obligation), and directs how a servicer should account for the asset (or liability) in subsequent periods. However, other than requiring a servicer to disclose certain information about fees earned during the reporting period that relate to servicing assets or liabilities, the guidance is silent regarding the accounting for those fees by the servicer. Similarly, the guidance does not explicitly address subservicing fees; ASC 860-50 refers only to servicing contracts and related assets/liabilities.
There is diversity in practice concerning the applicable GAAP guidance for servicing and subservicing contracts deemed to have just adequate compensation. Servicing and subservicing contracts with more or less than adequate consideration fall within the scope of ASC 860 and are thus exempted from ASC 606, Revenue for Contracts with Customers. Although there is diversity in practice concerning servicing contracts with adequate compensation, revenue recognition patterns are likely similar under both standards and both standards require similar disclosures concerning amounts and significant assumptions. Entities with servicing contracts that contain incentive features and other unique revenue patterns should carefully consider the appropriate revenue recognition model.
6.3.3 Subsequent measurement of recognized servicing rights
ASC 860-50-35 provides guidance on the measurement attribute for servicing assets and servicing liabilities subsequent to initial recognition.
Excerpt from ASC 860-50-35-1
An entity shall subsequently measure each class of servicing assets and servicing liabilities using either of the following methods:
- Amortization method. Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date.
- Fair value measurement method. Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur.
Excerpt from ASC 860-50-35-1A
A servicing asset may become a servicing liability, or vice versa, if circumstances change.
6.3.4 Classes of servicing assets and servicing liabilities
Different elections for subsequent measurement can be made for different classes of servicing assets or servicing liabilities. Entities must elect and apply one of the methods for each "class" of servicing assets and servicing liabilities.
ASC 860-50-35-5 requires that classes of servicing assets and servicing liabilities be identified based on one or both of the following: (a) the availability of market inputs used to determine the fair value of servicing assets or servicing liabilities and/or (b) an entity’s method for managing the risks of its servicing assets or servicing liabilities. The number of classes will affect a company’s disclosures because a number of the disclosures are required by class of servicing assets and servicing liabilities. See FSP 22.7 for information on the disclosure of servicing assets and servicing liabilities.
There is not a uniform approach mandated by GAAP for identifying classes of servicing assets or servicing liabilities. An entity may consider grouping them by the nature of the assumptions underlying the fair value of the servicing assets or servicing liabilities (e.g., prepayment and default rates). The fair value of servicing assets or servicing liabilities is generally determined using valuation models that incorporate a number of different assumptions because quoted market prices for servicing rights are generally not available.
In other cases, a company may find it more appropriate to base the grouping on its risk management strategies. The risks of servicing assets and servicing liabilities will often differ among asset types, and companies may manage those risks separately. A company may use derivative financial instruments or available-for-sale (AFS) securities to economically hedge the risks, or may not hedge the risks at all. As a result, a company’s method for defining classes may differ depending on the complexity of its risk management strategies. Factors such as the nature of the collateral, fixed or floating interest rates, commercial or consumer loans, credit quality, and tenor (which all impact customer prepayment rates) may influence how an entity manages its risk exposure and, ultimately, how it defines its classes.
If the right to service a new class of financial assets is contractually undertaken, the election of a subsequent measurement method for the new class should be documented on the date on which the company acquires that right.
6.3.5 Fair value measurement method
The fair value election is irrevocable and can be made at the beginning of any fiscal year. For example, if a calendar year-end company elects to subsequently account for Class A servicing assets at fair value on January 1, 20X1, the company cannot change to the amortization method in any subsequent period. However, this does not prevent the company from electing to subsequently value its Class B servicing assets at amortized cost. If the fair value election is made, changes in the fair value of servicing rights should be recognized in earnings at each reporting date.
When the fair value measurement method is elected, it is beneficial for that election to be supported by concurrent documentation or a pre-existing documented policy for automatic election. As the fair value method can be elected at the beginning of any fiscal year, "concurrent" would mean that a company documents its election at the beginning of the fiscal year in which it applies the fair value method to that specific class of servicing assets or servicing liabilities.
The fair value measurement method requires an entity to measure classes of servicing assets or servicing liabilities at fair value at each reporting date, with changes in fair value recorded in earnings in the period during which they occur. ASC 860 does not define how fair value must be measured. An entity should look to ASC 820 for guidance on how to measure the fair value of servicing assets and liabilities.
Under ASC 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The basis for a fair value measurement is the market price at which a company would sell or otherwise dispose of assets or transfer liabilities (i.e., an exit price), not the market price that an entity pays to acquire assets or assume liabilities (i.e., not an entry price). ASC 820 further requires that the price used be based on the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Refer to FV 4 for additional information.
ASC 820 requires that an entity maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs that reflect quoted prices in active markets for identical assets or liabilities are the best evidence of fair value. Markets that provide quoted prices may include exchange, dealer, and principal-to-principal markets. Quotation and pricing services may also provide observable price quotations. However, there is no exchange market that provides both price quotations and an active market in servicing rights.
Care should be exercised when evaluating quoted prices to ensure that the prices used are representative of the servicing rights being valued. Prices can vary significantly based on the underlying characteristics of the loans. Quoted prices for newly-originated individual servicing rights on agency-conforming mortgage loans may be more readily available than quoted prices for other types of mortgage loans, which may require the use of alternative valuation methods.
The fair value of the servicing assets or liabilities should represent the difference between the benefits of servicing and adequate compensation. The initial measure for servicing may be zero if the benefits of servicing are just adequate to compensate the servicer for its responsibilities.
If quoted prices are not available, the estimate of fair value should be based on the best information available, given the circumstances. Often, in these cases, the prices of similar assets and liabilities represent the best information. If neither quoted market prices for the servicing assets or liabilities nor quoted market prices for similar servicing assets or liabilities are available, fair value should be estimated using other valuation techniques. These may include a present value of estimated future cash flows, option-pricing models, matrix pricing, option-adjusted spread models, or fundamental analysis. Regardless of the valuation technique used, the fair value of servicing assets or liabilities should represent the present value of a stream of cash flows, composed primarily of the servicing fees collected by the servicer, net of cash outflows that would be used by a market participant for performing the administrative tasks of servicing (e.g., collecting cash from borrowers, paying real estate taxes and hazard insurance, and remitting cash to third parties) and a market profit margin. It should also include all fees contractually due to the servicer (e.g., late payment fees). In determining the exact stream of cash flows that will be collected by the servicer (and, therefore, the fair value of the servicing rights), the amount and timing of cash flows are forecasted based on a number of assumptions.
The assumptions used in the model should be reasonable and supportable. All available evidence should be considered when estimating expected future cash flows. When servicing rights are valued using discounted cash flow analyses, the assumptions used in the valuation (primarily prepayment speeds, discount rate, delinquency and default rates, escrow earnings rates and the cost to service) should be consistent with the assumptions that would be used by a market participant independently evaluating the same portfolio of servicing for purchase.
In many situations, assumptions that market participants would use in computing the fair value of servicing rights are not available due to a limited number of market participants, imperfect information, or other conditions. In such cases, companies will likely need to estimate expected cash flows related to servicing activities using their own historical cash flow experience as a basis for formulating assumptions. ASC 820 allows this approach only to the extent that an entity can demonstrate that its own assumptions provide a reasonable proxy for market participant assumptions. It is also important to evaluate the nature of the cash flows that are included in the computation to ensure that they are consistent with the types of cash flows that a market participant would use to determine fair value.
For mortgage servicing rights, information regarding assumptions used can be obtained from independent servicing brokers in the market and from other sources, such as peer and industry group surveys. In addition, many mortgage servicers engage external third-party appraisers to provide estimates of fair value of their mortgage servicing rights.
Estimated future net servicing income includes estimated future cash inflows and outflows related to servicing. Estimates of cash inflows or servicing revenues should include servicing fees and other ancillary revenue, including float and late charges. Estimates of cash outflows or servicing costs should include direct costs associated with performing the servicing function and appropriate allocations of other costs. Estimated future servicing costs should be determined on a market value basis.
Critical assumptions used to determine estimated fair value generally include servicing fee to be earned, prepayment and default rates, discount rate, cost of servicing, float income, ancillary fees, default estimates, interest income on escrow and principal and interest balances, inflation factors, and interest paid on escrows.
6.3.5.1 Servicing fee to be earned
The servicing fee to be earned is equal to the contractual servicing fee retained after the financial asset is sold.
The ASC Master Glossary defines contractually specified servicing fee.
Definition from ASC Master Glossary
Contractually Specified Servicing Fee: All amounts that, per contract, are due to the servicer in exchange for servicing the financial asset and would no longer be received by a servicer if the beneficial owners of the serviced assets (or their trustees or agents) were to exercise their actual or potential authority under the contract to shift the servicing to another servicer. Depending on the servicing contract, those fees may include some or all of the difference between the interest rate collectible on the financial asset being serviced and the rate to be paid to the beneficial owners of those financial assets.
6.3.5.2 Prepayment and default rates
Prepayment and default rates are used to estimate the length of the life of the servicing right and timing of the estimated cash flows. Because many factors impact prepayment activity, predicting the actual cash flows of a financial instrument can be complex. Therefore, the factors outlined in Figure TS 6-1 are typically considered when determining or assessing prepayment assumptions for mortgage loans.
Figure TS 6-1
Factors to consider when determining or assessing prepayment assumptions
Factors to consider when determining or assessing prepayment assumptions
Consideration |
Impact |
Current interest rates |
Lower interest rates provide borrowers incentive to refinance. |
Loan to value ratio |
Some homeowners may, despite low interest rates, be unable to refinance their loans because they have little or no equity in their homes due to declining property values. |
Regional demographics |
Certain areas of the country have historically experienced higher prepayment rates than others. This partly stems from local demographics. For instance, a particular area may be more transient than other parts of the country. |
Entity experience |
Actual experience of the entity compared to others in the same geographic and/or demographic area. |
In the mortgage servicing industry, two measurements of prepayment activity are commonly used: (1) the Securities Industry and Financial Markets Association’s Prepayment Speed Assumption (PSA) model and (2) Constant Prepayment Rate (CPR).
Prepayment estimates such as PSA and CPR are available from a wide variety of services, including several investment banks and information services.
Third-party prepayment models are also used to estimate prepayments. These models often provide prepayment speeds that better approximate actual prepayment activity than the static PSA or CPR prepayment rates. Entities may also use internally-developed prepayment speeds that are simply client-specific estimates of the timing of prepayments for a loan pool. More often than not, these vectors are derivatives of a standard CPR rate with either a ramp-up or ramp-down period of prepayments designed to reflect unique expected prepayment performance in a newly originated loan pool or to reflect unique current market conditions.
The objective should always be to use prepayment estimates that accurately reflect the loans that are underlying the servicing rights being evaluated, and that are representative of market participant assumptions. In cases involving pools of geographically dispersed mortgages, this measure may be based on national prepayment estimates. Estimates other than national prepayment estimates might be used in cases when an entity can demonstrate that loans differ from a geographically dispersed pool of mortgages.
6.3.5.3 Float income
Income is earned on balances held in trust by servicers from the date a loan payment is received from the borrower to the date funds are forwarded to investors. The benefit of this float accrues to the servicer through interest earned or a reduced cost of funds.
6.3.5.4 Ancillary fees
Ancillary fees are those fees that a mortgage servicer receives in addition to the contractual servicing fee. These fees typically consist of late fees, but may also include telephone payment fees, third-party promotional fees, charges for lost coupon books, as well as other fees.
6.3.5.5 Costs of servicing
Servicing costs represent the expenses borne by the servicer for performing functions outlined in the servicing agreement and include the costs associated with processing payments, managing delinquent and defaulting loans, and monitoring and administering escrow accounts. The costs represent the servicer’s legal obligations under the contractual agreement.
6.3.5.6 Income/expense on escrow and trust balances
Many mortgage bankers use escrow and principal and interest balances as compensating balances for borrowings. These balances provide interest savings and are typically considered a benefit of servicing. In addition, several states in the US require mortgage servicers to pay interest to borrowers on amounts escrowed throughout the life of the loan, and this cost is typically considered a cost related to servicing.
6.3.5.7 Inflation factors and discount rate
Given the longer-dated life of typical servicing contracts, an inflation or similar factor is typically used in calculating estimated future costs of servicing.
A discount rate is a rate at which the expected cash flows are discounted to arrive at the present value of net servicing cash flows. This rate should reflect the risk profile of the servicing cash flows, consider relevant market conditions and be consistent with discount rates used by market participants in fair valuing servicing rights.
6.3.5.8 Recapture of Mortgage Servicing Rights (MSRs)
The definition of a recapture is when a loan underlying Mortgage Servicing Rights (MSRs) is prepaid, and the loan is refinanced with the servicer and thus “retained.” When this happens, servicing fees lost from the prepaid loan will be recaptured through the economics of the new lending arrangement (and potentially subsequent transactions associated with the new loan).
When a bid on a pool of MSRs is submitted, the value of recapture is considered. The considerations on what is included in the value of the bid include 1) cash flows from the existing servicing contract and 2) the ability or the potential to use the relationship with the borrower to retain the customers for a new MSR.
Question TS 6-3
Is the recapture part of the MSR asset?
Is the recapture part of the MSR asset?
PwC response
ASC 860-50-35-17 states that an “entity shall not consider the estimated future net servicing income from the new mortgage loan in determining how to amortize any capitalized cost… the mortgage servicing asset represents a contractual relationship between the servicer and the investor in the mortgage loan, not between the servicer and the borrower.” As such, we believe that the MSR unit of account is the contractual arrangement between the servicer and the investor, and the recapture right is not a part of the value of the MSR.
6.3.6 Amortization method
If an entity elects the amortization method for subsequent measurement of the servicing rights, the initial carrying value (i.e., the Day 1 fair value) is amortized over the expected period of estimated net servicing income or loss and assessed for impairment or increased obligation at each reporting date.
Servicing assets are to be amortized in proportion to, and over the period of, estimated net servicing income. Servicing liabilities are to be amortized in proportion to, and over the period of, estimated net servicing loss.
Companies often determine the amount of the servicing asset (liability) to be amortized during a given period by calculating the undiscounted net servicing income (loss) for the period, divided by the total estimated undiscounted net servicing income (loss). The resulting percentage represents the amount of the originally recorded servicing asset (liability) to be amortized during the period. This is sometimes referred to as the "expected over expected cash flow" or "proportionate to income" methodology when a given period’s amortization rate is equal to the ratio of that period’s expected net cash flow over the total expected net cash flow for the life of the servicing asset or liability. For this purpose, the same estimated undiscounted cash flows used in the fair value calculation should be used. This expected over expected cash flow methodology is only one example of an amortization method. Other methods may be appropriate.
Example TS 6-1 demonstrates the application of the amortization requirement.
EXAMPLE TS 6-1
Amortization of servicing assets or servicing liabilities
Amortization of servicing assets or servicing liabilities
A servicer of residential mortgages has the following specifications for a portion of a loan portfolio:
- Total undiscounted net servicing income (contractual revenues less the servicer’s internal servicing costs) is estimated to be $290,000.
- The initial fair value recorded for the servicing asset is $160,000.
The undiscounted net servicing income to be received in years one through five is estimated at $23,200, $22,475, $21,750, $21,025, and $20,300, respectively. (For simplicity, only the first five years are shown here; the total net undiscounted income of $290,000 includes all years comprising the weighted-average term of the loan pool.)
What amortization amounts should be recorded in years one through five?
Analysis
The following table shows the amortization amounts the servicer should record in years one through five.
Year |
Servicing asset carrying value |
Cumulative amortization percentage (A) = (D) / $290K |
Cumulative amortization expense (B) = (A) * $160K |
Current period amortization expense (C) = current year (B) – prior year (B) |
Net servicing income per year* |
Cumulative net servicing income* (D) |
Total estimated net servicing income* |
$160,000 |
— |
— |
— |
— |
— |
$290,000 |
|
1 |
147,200 |
8.00% |
$12,800 |
$12,800 |
$23,200 |
$23,200 |
|
2 |
134,800 |
15.75 |
25,200 |
12,400 |
22,475 |
45,675 |
|
3 |
122,800 |
23.25 |
37,200 |
12,000 |
21,750 |
67,425 |
|
4 |
111,200 |
30.50 |
48,800 |
11,600 |
21,025 |
88,450 |
|
5 |
100,000 |
37.50 |
60,000 |
11,200 |
20,300 |
108,750 |
* Amounts are undiscounted
The estimates of undiscounted cash flows should be updated for actual experience at each valuation date.
6.3.6.1 Assessing servicing assets and liabilities for impairment
If an entity elects the amortization method, it must evaluate and measure impairment for each class of recognized servicing assets. Similarly, an entity must evaluate each class of recognized servicing liabilities for an increase in the servicing obligation.
Stratification of classes of servicing assets and liabilities
ASC 860 requires that servicing assets subsequently measured using the amortization method be evaluated for impairment based on a stratification of the predominant risk characteristics of the underlying financial assets, which may include interest rates, type of asset, term, origination date, and geographic location. ASC 860 does not require that the most predominant risk characteristic or more than one predominant risk characteristic be used to stratify the servicing assets for purposes of evaluating and measuring impairment.
A servicer must exercise judgment when determining how to stratify servicing assets (i.e., when selecting the most appropriate characteristic(s) for stratification). While the guidance is not prescriptive, historically, servicers have often used interest rates as a predominant risk characteristic to stratify servicing assets and liabilities.
In addition, as discussed in ASC 860-50-35-14, once an entity determines the predominant risk characteristics it will use in identifying stratums, that decision should be applied consistently unless significant changes in economic facts and circumstances clearly indicate a change is warranted. Any change should be accounted for prospectively as a change in accounting estimate under ASC 250, Accounting Changes and Error Corrections.
An entity may use different stratification criteria for the purposes of ASC 860 impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge under ASC 815.
Measurement of impairment or increased obligation
Impairment should be recognized through the use of a valuation allowance for each individual stratum for the amount by which the amortized cost of the servicing asset exceeds fair value for that stratum. The fair value of servicing assets that have not been recognized are not used in the evaluation of impairment. Subsequent increases in fair value can be recorded by reducing the valuation allowance up to an amount that results in the servicing asset being carried at its remaining amortized cost. Therefore, although subsequent increases in fair value can be recognized by reducing the valuation allowance, such adjustments are limited to the remaining amortized cost of the asset.
The carrying value of a servicing liability should be evaluated subsequently for increases in the fair value of the servicing liability. If there is an increase in the fair value of a stratum of servicing liabilities, the servicer should revise its earlier estimates and recognize the increased obligation and a charge to earnings. Subsequently, reductions in the fair value of the servicing liability can be recognized in earnings to the extent of previously recorded charges to earnings.
Example TS 6-2 demonstrates the application of the impairment requirement when applying the amortization method for subsequent measurement.
EXAMPLE TS 6-2
Analysis of measurement of servicing assets
Analysis of measurement of servicing assets
Servicer Corp elected the amortization method to subsequently measure its Class A servicing assets. Servicer Corp determined that the Class A servicing assets contained two stratum with the following characteristics as of 12/31/x9.
- Stratum A has an amortized carrying value of $22,019,877 and a fair value of $21,641,291.
- Stratum B has an amortized carrying value of $18,038,444 and a fair value of $18,987,622.
What is the impairment amount that Servicer Corp should record as of 12/31/x9?
Analysis
Servicer Corp should record an impairment on Stratum A of $378,586 (the excess of the fair value over the amortized carrying value). No impairment should be recorded on Stratum B as the fair value exceeded the carrying value as of 12/31/x9. An entity is not permitted to net stratum with a fair value in excess of amortized carrying value against stratum with a fair value that is below the amortized carrying value.
6.3.7 Distinguishing servicing assets from interest-only strips
ASC 860 requires separate accounting for rights to future income that exceed contractually specified servicing fees. These rights are not considered servicing assets; they are interest-only (IO) strips. Interest spreads in addition to a contractual servicing fee should be evaluated to determine whether a separate IO strip should be recorded.
An IO strip should be assessed to determine whether it should be accounted for as a derivative in its entirety or contains an embedded derivative under the guidance in ASC 815 (see DH 3.2.12 for additional information). If not, ASC 860-20-35-2 specifies that such assets should be measured like investments in debt securities classified as available-for-sale or trading under ASC 320. Given the prepayment exposure, an investor typically would not recover substantially all of its recorded investment and therefore the impairment and income recognition provisions of ASC 325-40 would apply.
Absent a contractually specified servicing fee, if the servicer would lose the entire difference between the rate received and the rate passed through to the investor upon termination or transfer of the servicing contract, the entire interest spread represents the contractually specified servicing fee. Otherwise, the contractually specified servicing fee represents only the fee that would be forfeit by the servicer if the servicing contract were terminated.
If the servicer were to determine that it has no servicing fee (i.e., that no interest spread would be lost upon termination or transfer of the servicing contract, and that there is no contractually specified servicing fee), then the right to receive the interest spread should be treated as an IO strip and the obligation to service should be evaluated as a servicing liability. Question TS 6-4 and Question TS 6-5 address how this guidance should be applied.
Question TS 6-4
Can an entity bifurcate the servicing fee it receives under a servicing contract into a base servicing fee and interest only strip?
Can an entity bifurcate the servicing fee it receives under a servicing contract into a base servicing fee and interest only strip?
PwC response
It depends. An entity should account separately for rights to future interest income from the serviced assets that exceed the contractually specified servicing fees. Under ASC 860-50-25-7, whether a right to future interest income from serviced assets should be accounted for as an interest only strip, a servicing asset, or a combination thereof, depends on whether a servicer would continue to receive that amount if a substitute servicer began to service the assets.
Therefore, an entity will need to determine whether it would continue to receive a portion of the right to future interest income from the serviced assets if servicing was shifted to another servicer. This will often require a legal interpretation of the servicing contract and how the contractually specified servicing fee is defined.
If it is determined that the entire right to future interest income from serviced assets would shift to another servicer, then the total amount received would be considered the contractually specified servicing fee and the entity would not be able to bifurcate the fees received into a servicing asset and an interest only strip.
Question TS 6-5
Bank Corp originated a portfolio of mortgage loans and transferred them in their entirety to a third party in a transfer that is accounted for as a sale. As part of the transaction, Bank Corp undertakes an obligation to service the loans. After the transfer, Bank Corp enters into a subservicing agreement with a third party.
Bank Corp’s benefit from servicing exceeds its obligation under the servicing contract. Can Bank Corp account for the difference between the servicing fees it is receiving and the subservicing fees it is paying to the subservicer as an interest only strip?
Bank Corp originated a portfolio of mortgage loans and transferred them in their entirety to a third party in a transfer that is accounted for as a sale. As part of the transaction, Bank Corp undertakes an obligation to service the loans. After the transfer, Bank Corp enters into a subservicing agreement with a third party.
Bank Corp’s benefit from servicing exceeds its obligation under the servicing contract. Can Bank Corp account for the difference between the servicing fees it is receiving and the subservicing fees it is paying to the subservicer as an interest only strip?
PwC response
No. ASC 860-50-55-11 is explicit that in such cases, the transferor should account for the two transactions separately. Although theoretically the difference between the contractual fees to be received and to be paid might equal a fixed percentage of principal, the transactions are with different parties and should be accounted for separately. First, the transferor should account for the transfer of mortgage loans in accordance with the guidance in ASC 860-20 on transfers that qualify for sale accounting. The obligation to service the loans should be initially recognized and measured at fair value. Second, the transferor should account for the subcontract with the subservicer by recognizing the expenses as the services are provided.
For agency loan sales (e.g., FNMA, FHLMC, GNMA), the interest spread exceeding contractually specified servicing fees (excess servicing), should be treated as part of the mortgage servicing right. The seller can generally control the amount of excess servicing created in agency loan sales by buying up or down the standard guarantee fee and as a result, this excess servicing fee is part of the contractual arrangement with the agencies and is specifically related to the servicing function. An agency excess IO market has developed where the excess is split and becomes a separately traded CUSIP instrument. For non-agency loan sales and securitizations, the servicing fee to be earned is limited to the amount contractually stated in the loan sale contract (i.e., the seller cannot control the amount of excess by buying up or down the guarantee fee). Any cash flows retained in excess of the contractual servicing fee specifically stated in the loan sale contract are considered part of the transferor’s interests and must be accounted for in accordance with the guidance in ASC 860-20-35-2.
Example TS 6-3 illustrates the application of ASC 860 to servicing obtained on transferred financial assets.
EXAMPLE TS 6-3
Application of ASC 860 to servicing obtained on transferred financial assets
Application of ASC 860 to servicing obtained on transferred financial assets
Bank Corp is in the business of originating, securitizing, and selling residential mortgages. From time to time, depending on market conditions and its investment strategy, Bank Corp will sell certain loans it originated.
Bank Corp is evaluating several securitization structures for a $100 million pool of residential mortgages for sale in the secondary market as shown in the following table.
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1 No servicing asset or liability is recorded as the servicer is just adequately compensated.
2 A servicing liability is recorded as the contract's fair value is negative due to contractually specified servicing fee of zero.
3 The gain in Scenario 3 is lower as the servicing contract with just adequate compensation is not separately recorded. The revenue from this contract would be reflected over time.
Assuming the requirements for sale accounting are met, how would Bank Corp record its (1) sale of the securitized mortgage loans, (2) servicing asset or liability, (3) interest only strip, and (4) recourse and put obligations under each scenario?
Analysis
Scenario 1
Bank Corp would record the following entry under scenario 1.
Dr. Cash |
$100,000 |
|
Dr. Servicing asset |
$2,700 |
|
Cr. Loans |
$100,000 |
|
Cr. Recourse obligation |
$65 |
|
Cr. Put option |
$35 |
|
Cr. Gain on sale of loans |
$2,600 |
Scenario 2
Bank Corp would record the following entry under scenario 2.
Dr. Cash |
$100,000 |
|
Dr. Servicing asset |
$1,200 |
|
Dr. Interest only strip |
$1,500 |
|
Cr. Loans |
$100,000 |
|
Cr. Recourse obligation |
$65 |
|
Cr. Put option |
$35 |
|
Cr. Gain on sale of loans |
$2,600 |
Scenario 3
Bank Corp would record the following entry under scenario 3.
Dr. Cash |
$100,000 |
|
Dr. Interest only strip |
$2,550 |
|
Cr. Loans |
$100,000 |
|
Cr. Recourse obligation |
$65 |
|
Cr. Put option |
$35 |
|
Cr. Gain on sale of loans |
$2,450 |
Scenario 4
Bank Corp would record the following entry under scenario 4.
Dr. Cash |
$101,500 |
|
Dr. Interest only strip |
$1,500 |
|
Cr. Loans |
$100,000 |
|
Cr. Recourse obligation |
$65 |
|
Cr. Put option |
$35 |
|
Cr. Servicing liability |
$300 |
|
Cr. Gain on sale of loans |
$2,600 |
6.3.8 Hedging considerations
Companies may hedge the interest rate and prepayment risks associated with servicing rights using derivative financial instruments and investment securities. Instruments typically used to hedge servicing rights include interest rate floors, caps, swaps and swaptions, agency mortgage-backed securities forward contracts, Treasury and Eurodollar futures contracts, and options on futures contracts.
ASC 815 requires that all derivatives be recognized as assets or liabilities on the statement of financial position and measured at fair value. Under the amortization method, the related servicing assets and liabilities need to be recognized at the lower of amortized cost and market value. Income statement volatility exists when the fair value changes in the derivatives are recognized in earnings while only adverse changes in the fair value of the servicing assets or servicing liabilities are recognized.
As a result, entities might consider applying ASC 815 hedge accounting provisions to hedge the fair value of their servicing rights accounted for under the amortization method. However, the application of hedge accounting under ASC 815 is complex. That is why ASC 860 allows servicing assets and liabilities to be subsequently recognized at fair value under the fair value measurement method. This method reduces income statement volatility and the difficulty of achieving hedge accounting for such transactions.
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