This reserve is also based upon a series of estimates such as the percentage of losses and the severity of the losses on the loans sold
Effective for fiscal years beginning after , companies adopted FASB Statement no. 156, Accounting for Servicing of Financial Assets, which amends Statement no. 140. Statement no. 156 changes the prescribed accounting for, and reporting of, the recognition and measurement of separately recognized servicing assets and liabilities. Upon Statement no. 156’s adoption, a company must first record servicing rights at fair value. Then it may choose to either subsequently measure its mortgage servicing rights at fair value and report changes in fair value in earnings, or amortize its mortgage servicing rights in proportion to and over the estimated net servicing income or loss and periodically assess the servicing rights for impairment or the need for an increased obligation.
In the event of impairment, an adjustment is recognized on the company’s income statement. Before Statement no. 156 was adopted, a company was required to hold mortgage servicing rights on its balance sheet at the lower of cost or ortize them in proportion to and over the estimated net servicing income or loss. When a transaction is structured as a securitization and accounted for as a financing, no mortgage servicing rights are recorded.
Unlike retained interests, mortgage servicing rights do have a secondary market. The problem is market prices are not always readily available and can be from service brokers, third-party market appraisers and market transactions a company has direct knowledge of. Therefore, these “market prices” are most commonly used to validate an internally generated valuation model.
Key assumptions that are used to value mortgage servicing rights include prepayment speeds and discount rates. Changes in fair value of the mortgage servicing rights consist of two primary components: (1) a reduction in fair value due to the realization of expected cash flows from the mortgage servicing rights and (2) a change in value resulting from changes in discount rates and prepayment speed assumptions, primarily due to changes in interest rates and other market factors (see Exhibit 1).
RECORDING PROFITS ON THE SALE OF POTENTIALLY BAD LOANS As noted above, in recording a gain on the sale of loans securitized and accounted for as a sale, two accounting estimates need to be made: (1) the value of the retained interest and, if applicable, (2) the value of the mortgage servicing rights. The fair value of each of these assets is based on a series of key assumptions that can significantly impact their fair value and are determined by management judgment. Similar to the valuation issues that have historically plagued hedge fund and private equity investments, any security that lacks a robust secondary market is complex and difficult to value and results can fall in a range of reasonably acceptable and justifiable values.
One typical valuation model for estimating the fair value of mortgage servicing rights is based upon the present value of estimated net future cash flows related to contractually specified services, which may also include the rights to prepayment penalties
In addition, when a company chooses payday loans in Dublin OH to sell its loans to a third party, typically it enters into agreements in which it will buy back the loans within six to 18 months. For example, an obligation to repurchase the loan can occur if (a) the loan is repaid prematurely, (b) an early payment default occurs or (c) the loan violates any other representation and warranty the company provided to the buyer. To account for this uncertainty, a company reserves a certain amount on its balance sheet, called a repurchase reserve, which it can draw upon to buy back the loan.
