A better way to value mortgage assets.

In the old days, valuations of mortgage loans and mortgage servicing rights (MSRs) were often accepted, more or less, at face value. There was a presumption that the analysts knew what they were doing and were coming up with reasonable assessments of value. Those days are over.

Examiners and auditors bolstered by new Financial Accounting Standards Board (FASB) pronouncements, as well as the prospect of having valuation changes flow through the income statement, have increased the scrutiny of both the input and the output of valuation models. This has caused a good amount of angst in the valuation community. Technology can help relieve that angst.

There are tremendous uncertainties surrounding the valuation of mortgage-related assets. Analysts need to concern themselves with a wide variety of difficult-to-define (no less defend) borrower behaviors such as prepay propensities, as well as the probability and consequence of borrowers going into default. Additionally, they must confront the fickleness of the capital markets--those that might buy these assets.

Underlying all of these vagaries is the problem of discerning the appropriate discount rate/yield requirement to be used to calculate a net present value of the projected cash flows. All of these assumptions need to be well-documented and disclosed in financial statements.

FAS 159, combined with advances in information technology (IT), now provides an easier way to accomplish fair-market valuations. FAS 159 defines three different levels of valuation:

* Level 3 -- unobservable inputs (i.e., typical cash-flow models);

* Level 2 -- quoted prices for similar assets (e.g., backing into loan prices based on comparable securities prices); and

* Level 1 -- quoted prices, in active markets, for identical assets at the measurement date.

The lower levels (levels 2 and 3) are generally not allowed where level 1 pricing is available. While level 3 pricing has been the norm in this market, advances in information technology now allow for level 2 and even level 1 pricing of most of these loan and servicing assets. This not only increases the accuracy of these fair values, but also reduces dramatically modeling validation efforts and disclosure requirements. This is true for both mortgage loans and mortgage servicing rights.

Mortgage loans

Mortgage loans are originated and sold as either conforming or nonconforming product.

Conforming loans tend to have as their principal secondary market the securities markets. It is not too difficult to determine the price of a mortgage-backed security (MBS) into which particular loans could be pooled. Bloomberg and other technology tools allow for access to a central repository of such information. Analysts can then back into a loan price based on expected incremental transaction cost adjustments.

Nonconforming loans have as their principal market the major mortgage loan aggregators (Calabasas, California-based Countrywide Financial Corporation; O'Fallon, Missouri-based CitiMortgage Inc.; Littleton, Colorado-based Aurora Loan Services Inc., and others). These aggregators routinely buy loans at rate-sheet prices. Rate sheets are the primary source of price quotes for newly originated loans--a market of roughly 15 million loans per year. Additionally, these prices can be easily adjusted for most seasoned product by adjusting terms/roll dates with the passage of time.

Technology has facilitated the capture, digitizing and synthesis of the major loan aggregators' product descriptions, eligibility specifications (FICO[R] score/loan-to-value [LTV] grids, etc.) and daily rate sheets. Thus, loans need only be slotted against identical products contained in such a central repository and then priced against the respective aggregator's current rate sheets, including their price adjusters. There are essentially no transaction costs under such a system and, thus, no adjustment is required.

Mortgage servicing rights

Mortgage servicing rights are more problematic. While most rate sheets include adjustments for servicing-released premiums (SRPs), they need to be used cautiously. While aggregators' all-in pricing is by definition reasonable (because they will buy loans at those prices), there are cases where the split between the whole loan price and the SRP may not individually reflect market reality.

SRPs reflect non-capital-market issues such as servicing capacity (incremental cost of acquiring a loan depends on how many loans are being serviced, for example), expected prepayment patterns in an existing servicing portfolio, demographic preferences and cross-sale economics (which can be very important for large banks). Also, other financial considerations seem to occasionally bias the price split toward the SRP.

There is still, however, tremendous value in tracking these published SRPs by product type and geography over time. The resultant trends and indexes are very useful in benchmarking typical servicing cash-flow model (level 3) outputs.

Conclusion

The condition and objectives of everyone in the market--from consumers to originators to servicers, rating agencies and Wall Street--have a role in setting the price of loan assets. So all these factors should be considered in estimating value. The most objective way to determine this all-in value is to identify what the major aggregators are willing to pay for such an asset. These prices reflect all the pricing pressures and credit adjustments applied along the supply chain to the capital markets, and clearly represent the price offered by a willing buyer.

Using these central repositories of prices is more representative of fair value than the net present value of cash-flow projections, requires far fewer disclosures, and, with the improvements in information technology, is easy to access.

Tom Healy, CMB, is president of the Servicing Source, a division of the Sextant Group Inc. in Fort Lauderdale, Florida. The Servicing Source is a provider of independent and objective third-party valuations and valuation software to the mortgage lending and servicing industries. He can be reached at [e-mail].

By Tom Healy, CMB