The interest rate environment has produced the lowest mortgage rates in 20 years, with record refinances and prepayments. This activity has rewritten the financial statements for mortgage companies over the last two years and focused accountants and regulatory bodies on the accounting for mortgage servicing rights. The major accounting issues for mortgage servicing rights are:

* The amount initially capitalized.

* The amortization of amounts capitalized.

* The re-evaluation of carrying amounts for financial statement and regulatory reporting purposes.

Servicing Rights

Mortgage servicing rights are the rights to servicing specific mortgage loans. The components of mortgage servicing rights are contractual service fees and excess service fees.

What are PMSRs, ESFRs, and OMSRs? PMSRs -- purchased mortgage servicing rights -- are considered intangible assets, and are created when an entity purchases the rights to service specific loans.

PMSR acquisitions can be made in their entirely, through the purchase of a company or substantially all of its assets (in bulk purchases), or in conjunction with the purchase of a loan from a correspondent, (i.e flow purchase) when a definitive plan is in place to sell the loans. Bulk PMSRs may include both the normal and excess service fee components whereas flow PMSRs represents only the normal service fee component.

ESFRs -- excess servicing fees receivable -- are considered tangible assets and are created when loans are sold and the servicing rights are retained by the seller. ESFRs represent the excess service fee spread, i.e. difference between the yield on the loans less the security pass through rate, the normal service fee rate and the guaranty fee, if any.

Originated mortgages servicing fee rights -- OMSRs -- are the normal service fees for the loans either originated by the institution or acquired through the wholesale market and don't qualify as a purchase under accounting rules.

What Should Be Capitalized

The accounting literature states the amount to be capitalized for PMSR is the portion of the purchase price which represents the cost of acquiring the servicing right, not to exceed the present value of estimated net servicing revenues (the present value of estimated future service revenue, including ancillary revenue less the present value of expected future servicing costs).

FAS 65 requires capitalization of the cost associated with chasing the right to service a loan if a definitive plan exists to sell the loan.

A definitive plan includes estimates of purchase and sale prices, and a commitment to re-sell the loan or related mortgage-backed security. If the PMSRs are acquired through flow purchases, the amount capitalized must be reduced by any gain on sale of the loan that is incurred.

ESFR is capitalized for the amount of the present value of the excess service fees spread over (he estimated life of the mortgage loans. ESFR creates a noncash gain on the sale of a loan.

Accounting rules prohibit the capitalization of any originated servicing rights; these amounts are considered part of the basis in the loan which then impacts the gain or loss once the loans are sold.

How to Amortize

PMSRs and ESFRs are both amortized for accounting purposes in proportion to and over the period of estimated net servicing income.

Therefore, if you receive 15 percent of your estimated net servicing income in the first year, 15% of your purchase price should be amortized. However, the amortization must be reevaluated in light of changes in prepayments activities.

When the assets are capitalized, a number of assumptions are made. The primary assumptions relate to prepayment speeds, servicing costs and discount rates.

The re-evaluation of PMSRs and ESFRs for significant changes in the underlying assumptions is necessary to determine whether the amortization should be adjusted or the asset should be written down. The major issues in the re-evaluation process are: 1) What prepayment speed is appropriate and 2) What level of aggregation is appropriate?

The Discounted Approach

Through their recent regulations, the Office of Comptroller of the Currency, Federal Deposit Insurance Corp., and Federal Reserve Board require institutions to use the discounted approach for regulatory reporting purposes when re-evaluating the carrying amount of PMSRs.

The Office of Thrift Supervision requires the use of the discounted approach if the institution wishes to include its PMSRs in regulatory capital. The discount rates used must be no lower than those used as of the purchase date (i.e., the original discount rate).

The PMSR asset is compared to the estimated future net servicing revenues to determine if an impairment of the asset has occurred.

The estimated future net servicing revenue is affected by changes in the underlying assumptions, with the major assumption being prepayment speed. Accounting rules permit, under certain circumstances, the entity to use undiscounted cash flow when determining whether to write down PMSR.

If the estimated future net servicing revenues are greater than the carrying amount of the asset, then no impairment has occurred. However, adjustments are reflected as changes in the amount amortized in the future.

|Everyone Pays Now'

The ESFR asset is compared to the estimated future excess servicing fees discounted using the purchase date discount rate. If the carrying amount of the asset is greater than the present value of the estimated future excess servicing fees, a writedown of the asset occurs.

This accounting treatment allows the asset to earn in the future at the original estimated yield and does not beg the issue of "pay me now or pay me later": Everyone pays now.

Level of Disaggregation

Segments within a mortgage servicing portfolio prepay differently.

The driving force behind disaggregation is to diminish the use of unimpaired servicing assets to offset impaired assets.

The Securities and Exchange Commission does not consider aggregation to be in accordance with accounting rules, especially if the undiscounted method is used.

The underlying portfolio characteristics such as loan type (conventional, government, jumbo, nonconforming, etc.), interest rate structure (fixed, adjustable rate, GPM, etc.), coupon rates, and economic conditions -- both local and national -- affect prepayment speeds.

The most appropriate prepayment rates are the one that best reflect the portfolio being analyzed.

Most mortgage bankers have a sense of the prepayment speed of the overall portfolio. However, many do not track the prepayment speeds by significant segment. Without better information, most people default to the use of consensus prepayment rates published by the Wall Street investment houses. Convincing evidence is necessary to support rates other than consensus rates.

The |Buy Down'

In order to decrease the volatility in earnings experienced in recent years, many entities are choosing to sell the ESFRs at origination.

This process, referred to as a "buy down" of the rate by the issuing agency, shifts the risk of prepayment to the agency and provides the entity with a cash gain.

All excess servicing fees are then passed through to the issuing agency as payments are received from the borrower.

Entities are also considering prepayment insurance through various vehicles.

While many of these are new in form, the underlying issues remain the same: the shifting of prepayment or interest rate risk to another entity.

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