A well-designed system for managing servicing assets will have as an essential function the analysis of risk. This analysis will include determining "predominant risk characteristics" for accounting purposes as well as determining which segments should be hedged, sold, or subserviced.
The system should assist management in determining which loans may profitable to service. Those that are less profitable should be considered for sale or for subservicing; those that are most profitable may indicate a servicing niche.
The system should also provide for a high degree of sensitivity analysis. In determining the risk associated with segments of the portfolio, sensitivity analyses will be critical.
As the reliance on the servicing-asset management system grows, the importance of an accurate and detailed servicing valuation will also expand. Among the most common valuation techniques are discounted cash flow (the most widely used) and option-adjusted pricing models.
A company must understand the economic value versus the fair-market value of the servicing rights. An economic value represents the value to the company if loans are serviced internally. This value may be materially different from what buyers may be willing to pay in the market.
Before any hedging considerations can be made, a company must determine its risk tolerance - the dollar amount of losses it is willing to absorb. Once a threshold has been determined, hedging can be considered. There are various types of hedges, such as internal (servicing sales, production) and market-based (options, floors, swaps). Internal hedges may be accounting- driven. For example, many companies use a "conservative" fair-market value at the time the servicing right is capitalized.
The most common market-driven hedges include CMT floor interest rate swaps. A system must be able to analyze what information and what values are used for accounting purposes in contrast to what is used for economic decisions. It is imperative to have the analytical capabilities, since all of the typical hedges in the market require active management.
The smarter companies are evaluating their options for a servicing-asset management system. Some companies are not focusing on the big risk picture and are simply looking for an accounting tool. It is not a question of whether to have a system, but whether to buy, build, or outsource.
The decision depends on factors such as organization size, budget constraints, and internal resources. As part of the decision process, a company should spend adequate time developing system requirements such as ease of use, flexibility, maintenance, and concise, timely management reporting.
The risks presented by the new accounting standard FAS 122 - on top of the long-standing foreclosure, repurchase, and regulatory risks - dramatize the necessity for a comprehensive system.
Most companies will likely be interested in purchasing an existing fully integrated system. Companies will have the flexibility of analyzing portfolios or segments of portfolios without coordination of third parties.
In addition, when a company licenses a system, it incurs no development costs, and it should choose one that requires only limited technical support from the vendor.
However, the vendor's depth of resources should be evaluated. For example, KPMG has developed and licenses a servicing-asset management system that incorporates all of the requirements outlined here.
The only drawback in purchasing a system is the initial capital outlay. Therefore, most companies that decide not to purchase will most likely be ones that do not have large servicing assets. They may change their minds as the servicing asset grows.
Although building a system internally many seem like a viable option at first glance, this option quickly disintegrates as one considers all of the operational implications. A company that believes it can go with the bare basics may find itself at a competitive disadvantage.
In fact, many large organizations that initially intended to build are now buying. If a company has the resources, the right combination of skills, and the time, it may consider building internally.
Software development requires significant resources and capabilities, including:
*Overall system design, architecture, and overall planning.
*Test of system software and programming languages.
*Comprehensive understanding of generally accepted accounting principles and tax requirements.
*Development of reporting requirements.
*Interface design and development.
*Alpha and beta testing.
*Dedicated project management and dedicated programmers.
*System updates and maintenance for FAS changes and tax regulatory changes.
*Acceptance by accountants for accounting and tax purposes.
*Coordination and buyoff from all internal departments (accounting, finance, tax, treasurer).
Those companies that decide against both building and buying will turn to outsourcing, a standard practice for many mortgage servicers. Processes such as insurance and tax reporting are often outsourced. In addition, many companies outsource portfolio valuations (most often to meet regulatory requirements) and hedging analytics.
Mr. Oliver is a partner of KPMG Peat Marwick and co-director of its mortgage and structured finance group in Washington. Ms. Kogler is senior manager of the group.