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Accounting for advance reserves

The operational risks associated with advancing requires the mortgage servicer to have a robust reserving process. The reserve needs to account for instances of operational losses and losses related to credit exposure. In developing the reserve estimate, it is important to know the servicer’s actual loss history including claim shortfalls and advance write-offs. These losses should be back-tested to identify if they were noncompliant with the investor and agency guidelines, whether the advances should have been expensed upfront versus capitalized as an advance, whether losses are related to operational errors or whether the losses were credit related.

There are additional reserve considerations that exist for advances associated with active mortgage servicing rights (MSRs), advances obtained through a business combination and advances that are either recoverable (capitalized and not associated with an active MSR) or non-recoverable (expensed).

For advances tied to active MSRs, market participants address the potential loss associated with the related advances by accounting for it in the fair value of the MSR. The fair value model incorporates assumptions to capture the expected loss on advances and their overall impact on the fair value of MSRs. With the potential losses factored into the fair value, these advances typically wouldn’t require a separate reserve until there is no longer an active MSR.

In a business combination, the purchase accounting adjustments related to the fair value of the advances would factor into the required reserve calculation. When advances are acquired, the fair value mark typically represents the potential losses plus the time value of money component related to the fair value discount. Over time, careful assessment is needed to verify whether additional reserves are required for new subsequent advances or if the expected losses pertained to the acquired advances.