Next up in our mortgage servicing series is an article discussing applicable accounting guidance for mortgage servicers, lenders and originators. Our first article discussed ways to prepare your organization for the possibility of increased mortgage defaults and our second article discussed what happens in the servicing process when a loan becomes delinquent. Stay tuned for the fourth installment featuring auditing considerations related to the advance reserve.
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.
For conforming loans, servicers can claim allowable escrow and corporate advances, which are typically reasonable expenses as part of the primary claim, with supplemental claims for additional corporate advances and fees incurred. A robust process of correctly categorizing advances as recoverable or non-recoverable, as well as the timely and accurate submission of the claims, will result in a higher level of recoveries and appropriate capitalization or expense. The investor guidelines for government loans generally result in a lower amount of recoverable balances versus conforming loans. Moreover, for Veterans Affairs (“VA”) loans, in effect the primary claim for P&I is generally based on the appraised value of the property minus liquidation holding costs, while supplemental claims are paid based on a guarantee multiplier tied to veteran entitlement. This could result in additional advance losses or gains, based on this entitlement. Due to the operational risks and the composition of the servicing portfolio, it would be common to have a higher reserve rate for government loans. Market participants could have ineligible advances due to untimely submissions, un-claimable advances, additional advances that fell out of the claimed balance on recently modified loans, and advance balances on paid-in-full or transferred loans which could be challenging to recover – all leading to a larger reserve.
ASC 326, Financial Instruments – Credit losses
On June 16, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-13, Financial Instruments – Credit Losses (Topic 326) (CECL) (“ASC 326”). This standard was effective as of January 2022 for SEC Filers, excluding smaller reporting companies (“SRCs”). The guidance became effective for SRCs and all other filers in January 2023. Advances fall within the guidelines of ASC 326, which would dictate a reserve for credit losses on advance receivables; however, many market participants believe that the collection of advances is operational in nature and if the liquidation events and related claims are processed timely and completely, collection is likely to occur. Additional losses are normal operating losses associated with the business, or potentially due to operating errors. Such losses could be the result of claims not being processed correctly, advances not made in a timely manner, or advances made outside of agency, government or investor guidelines. As such, these losses are not related to credit, and shouldn’t be assessed under ASC 326. However, if it is determined that losses are related to credit, then the reserve should be assessed under ASC 326. Management should assess the materiality of credit-related losses and consult with their accountants and auditors when using it as a basis for the application of this standard.
CECL/credit risk for mortgage servicers
When a servicer determines that the credit risk contains more than a trivial amount of credit exposure, they should measure expected credit losses of financial assets on a collective (pool) basis when similar risk characteristics exist. Grouping of similar assets could include having similar asset types, the same counterparty, being in the same industry, similar vintages, and similar loss patterns, among other characteristics. When a servicer determines that a financial asset does not share risk characteristics with its other financial assets, the servicer should evaluate the financial assets for expected credit losses on an individual basis. It is important to note that the FASB did not define a bright-line for materiality when evaluating and assessing credit exposure. However, the FASB notes that an entity is not required to estimate an expected credit loss on a financial asset or group of financial assets when historical credit loss information adjusted for current conditions and reasonable and supportable forecasts, results in an expectation of zero credit losses.
In rolling out CECL, the FASB determined that an entity should have discretion in determining an approach that consistently and accurately reflects the credit risk of the assets being evaluated, but noted several acceptable common credit loss methods, including:
Loss given default and probability of default methods
Roll-rate methods
Loss-rate methods
Aging analysis such as AR aging subledgers
Discounted cash flow (DCF) methods
Subservicer advances - CECL considerations
Servicing advance receivables made by subservicers, also known as subservicer advances, are in scope of ASC 326. Advances made to related parties and entities under common control, such as advances made between consolidated entities, are scoped out of the guidance. When invoicing, many subservicers will net the servicing advance receivables against the servicing fees owed and net remit to the investor, effectively collecting on the advance immediately. However, many investors require that they receive the advances gross from the servicing fees owed from the subservicer. In such situations, ASC 326 may have a more prominent impact, as the uncollected gross advances may have a credit risk component. Subservicers should evaluate the amount of advances that are subject to this credit exposure.
In addition, most subservicers have commitments to make advances so long as they believe the advances will ultimately be recoverable from the individual obligor for missed payments, and to advance costs to protect and foreclose on the underlying property. These subservicers may have the unilateral right to cancel their contract with minimal notice, reducing their advance obligation. However, the right to cancel could differ on a contract-by-contract basis. As such, management should evaluate the credit risk related to their obligation to make future advances under ASC 326.
Advance reserves
When deriving a reserve for estimated operating losses, company specific loss history should be applied to the outstanding balance of the receivable. A full reserve should be applied to all known loss amounts which have yet to be charged off due to the timing and application of claims and any related claim proceeds. Following the assessment of these reserves, companies should consider implementing a coverage analysis to help support the appropriateness of its reserves or to investigate areas where there could be a process breakdown.
When measuring a reserve for credit losses, market participants should measure the credit losses on a collective (pool) basis when similar risk characteristics exist and on an individual basis when there are no similar characteristics. In deriving the measurement, market participants have flexibility to utilize a model that appropriately captures the credit risk on a consistent basis but can generally apply one of the models prescribed above. The basis for the measurement could start with historical losses, with expected losses forecasted across a scenario-based statistical analysis over a supportable forecast period. When performing an individual basis analysis, market participants could apply a collateral based practical expedient or an assumption based cash-flow analysis, which are subject to judgment.
It is crucial for mortgage servicers to navigate the complexities of identifying losses and establishing appropriate reserves. The implementation of CECL adds to the responsibilities of accounting teams, who must carefully analyze the sources of losses, whether they are operational or credit related.
This article is part of a series of mortgage servicing articles that Baker Tilly will be releasing in the coming months. Stay tuned for the next installment featuring auditing the advance reserve.
Baker Tilly’s Mortgage Center of Excellence offers assistance with servicing, regulatory compliance, quality control and risk management – all in one place. Our mortgage specialists can help servicers traverse the ever-changing mortgage landscape. Discuss the state of the industry with our team and how we can help you prepare for the future, today.
Co-author Matt Petrick, CPA is a senior finance and accounting executive specializing in the financial services industry, with a focus on mortgage and servicing entities. Matt has experience with REITs, financial institutions, business development companies and other funds. The discussions throughout the article should not be implied to represent the position, processes, or procedures of professional affiliations, current or former employers, or employer relationships.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought.
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