6.5 Transfers of Servicing Rights

In 20X1, Entity D transfers mortgage loans on a “servicing-retained” basis (i.e., D retains the rights to service those mortgage loans). This transfer qualifies for sale accounting under ASC 860-10-40-5; therefore, D derecognizes the mortgage loans and recognizes an MSR asset as part of the proceeds of the transfer.

In 20X3, D is required to rerecognize the transferred mortgage loans. In accordance with ASC 860-20-25-10(b), D continues to recognize the MSR asset related to those rerecognized mortgage loans.

In 20X4, D enters into an agreement with a third party to transfer the mortgage loans on a “servicing-released” basis (i.e., D transfers the mortgage loans and the rights to service those mortgage loans to the third party).

Entity D is required to apply both ASC 860-10-40 and ASC 860-50-40 to the transfer that occurs in 20X4. ASC 860-10-40 applies to D’s accounting for the transfer of the mortgage loans, and ASC 860-50-40 applies to D’s accounting for the transfer of the MSR asset. Unlike Example 6-3, this example addresses a situation in which ASC 860-50-40 pertains to the transfer of the servicing rights because they were separately recognized as a servicing asset on the date of the transfer.

Entity E enters into the following transactions at the same time:

• A transfer of mortgage loans to the FNMA without transferring the servicing rights (i.e., servicing-retained).
• A transfer of the MSRs to X, a third-party FNMA-approved servicer.
• A subservicing contract with X under which E will service the transferred mortgage loans for a period of time in return for a fee that equals adequate compensation.

In this tri-party arrangement, the FNMA pays the purchase price for the mortgage loans and X pays E the purchase price for the acquisition of the servicing rights. Both payments equal fair value individually, and E is paid, in total, an aggregate amount equal to the fair value of the mortgage loans sold with servicing rights (i.e., on a servicing-released basis).

In this transaction, it would be acceptable for the transferor-seller (i.e., E) to apply either of the following views:

• View A — Apply only ASC 860-10-40-5 to the transfer of the mortgage loans (i.e., assume that the servicing was a component of the mortgage loans transferred).
• View B — Apply ASC 860-10-40-5 to the transfer of the mortgage loans (i.e., assume that the mortgage loans were sold with servicing retained) and apply ASC 860-50-40 to the transfer of the MSRs.

Our conclusion that these two views are acceptable is premised on the ambiguity in ASC 860-10 and ASC 860-50 with respect to how to account for such a transaction as well as on the assumption that the three parties had no prior relationships with respect to the mortgage loans transferred. An entity should elect one of the two views as an accounting policy and apply it consistently.

Entity F is a bank that services GNMA-eligible mortgage loans (“GNMA loans”) that are held in off-balance-sheet securitization entities. The GNMA loans were originated by F, and the transfers of such loans to the securitization entities qualified for sale accounting. Entity F has the option of purchasing delinquent GNMA loans owned by the securitization entities at par under an EBO with the GNMA. The delinquent GNMA loans that may be purchased under the EBO are loans that are in the early stages of foreclosure. Entity F purchases such delinquent GNMA loans because the interest income that accrues on these loans and is paid by another government entity, such as the Department of Housing, offsets some of the foreclosure costs that F incurs to service the loans. Although F services the GNMA loans held in the securitization entities, F did not initially recognize any MSR assets or liabilities because the benefits of servicing initially equaled adequate compensation. Although some GNMA loans have become delinquent, the delinquencies have not exceeded the estimated amounts initially expected; therefore, F has not recognized any servicing liability related to this servicing activity (i.e., overall, the benefits of servicing still equal or exceed adequate compensation).

The EBO is not accounted for as a derivative instrument (therefore, for simplicity, assume that F has not recognized any asset for the EBO). When the GNMA loans become delinquent (i.e., when they become eligible for repurchase), F has regained effective control over these loans and therefore records them on its balance sheet, with an offsetting obligation for the purchase price in accordance with ASC 860-20-25-10(a). When F purchases the GNMA loans in accordance with the EBO, it extinguishes the obligation and recognizes a loss. Over time, F has accumulated a $100 million portfolio of such GNMA loans, which are recognized as receivables on F’s balance sheet. Assume that, in all cases, F has exercised its EBO; therefore, all GNMA loans that were eligible to be purchased by F have been purchased. Entity F previously recognized the following journal entries for the EBO feature and related purchases of GNMA loans:

Entity F had EBOs triggered that allowed for the purchase of $100 million of GNMA loans. In accordance with ASC 860-20-30-3, F recognized at fair value the GNMA loans over which it regained effective control. The fair value equals 98 percent of the total $100 million purchase price. The 2 percent excess of the purchase price over fair value results entirely from the fact that a servicing obligation is embedded in these GNMA loans. The fair value of the GNMA loans is not affected by credit risk because the repayment of principal and interest on these loans is guaranteed by another government entity. It is assumed that the fair value of these GNMA loans has not been affected by changes in interest rates and that recognition of an allowance for credit losses is unnecessary.

Entity F pays par to purchase the GNMA loans under the EBO and therefore recognizes a loss on extinguishment of its obligation for the purchase price. Note that although ASC 860-20 prevents an entity from recognizing a loss when it initially recognizes financial assets upon regaining control, ASC 860-20-25-12 does not preclude the recognition of a loss when the purchase price is paid and the loans are repurchased.

After purchasing these GNMA loans, F enters into an agreement with Y, a third party, to assume the servicing obligation related to these GNMA loans. As of the date of this agreement, the carrying amount of the GNMA loans on F’s balance sheet has not changed. Because the costs of servicing these delinquent loans exceeds adequate compensation, F pays Y $2 million to assume this servicing obligation. Entity F retains the right to service the performing GNMA loans that remain in the securitization entities (i.e., only the MSRs related to the GNMA loans recognized on F’s balance sheet are assumed by Y). Note that the $2 million payment to Y does not represent a prepayment of all future servicing fees; rather, this payment is the amount Y demands to service these loans after taking into account the portion of the interest coupon on the loans that Y is entitled to in return for servicing them.

Assume that the transfer of the MSRs on these GNMA loans meets the conditions for sale accounting. Therefore, F is evaluating how to account for the $2 million payment made to Y to assume this servicing obligation. Entity F considers the following views regarding the recognition of the offsetting entry for the $2 million cash paid to Y:

• View A — Recognize as a prepaid servicing cost (i.e., an asset).
• View B — Recognize as an increase in the carrying amount of the GNMA loan receivables.
• View C — Recognize immediately as a loss.

On the basis of the facts, View B is appropriate. Application of this view is consistent with ASC 860-50-40-6. Note that when the servicing obligation is assumed, a gain or loss could arise if the amount paid differs from the adjustment to the carrying amount of the recognized GNMA loans that is made in accordance with ASC 860-50-40-6. However, there is no difference in this example. Rather, the removal of the inherent servicing obligation by using the allocation approach described in ASC 860-50-40-6, which increases the carrying amounts of the GNMA loans on F’s balance sheet, equals the amount paid to Y to assume the servicing obligation. Therefore, F recognizes the following entry:

After this entry is recognized, the carrying amount of the GNMA loans is $100 million, which equals the loans’ purchase price as well as their aggregate fair value (excluding servicing) when they were initially recognized. As discussed above, a gain or loss would have been recognized if the amount paid to Y to assume the servicing obligation had differed from the allocated carrying amount of the servicing obligation.

View A is not appropriate in this case because the offsetting entry should result in an adjustment to the carrying amount of the GNMA loans. View A and View B might not change total assets but would result in a different presentation on the balance sheet. In addition, the subsequent accounting may differ under View A because the amortization method applied to any prepaid asset may differ from the interest method under ASC 310-20.

View C is not appropriate because the economic loss resulting from the servicing obligation was recognized when the GNMA loans were repurchased and recognizing an additional loss on the transfer of the servicing obligation would result in counting the same loss twice.

Note that applying View B could result in a carrying amount of the GNMA loan receivables that exceeds the amounts for which the borrowers may prepay such loans without penalty. However, ASC 310-20-35-18(a) does not preclude recognition of this amount because it merely represents a premium paid on purchased loans.

Evaluation of Reimbursement Provisions as Protective Provisions

Entity G enters into a servicing rights purchase and sale agreement (the “agreement”) with a third party to sell G’s MSRs. The MSRs are related to loans originated and sold by G and servicing rights previously acquired from Z, a third party. In addition to standard eligibility representations and warranties, the agreement contains the following reimbursement provisions:

• Breach of loan origination and servicing representations — If the purchaser receives any request to repurchase a loan because of (1) a breach of an origination representation or warranty on any mortgage loan that was originated by G or (2) any breach of a servicing obligation by G before the date of the agreement, G is required to indemnify the purchaser for any losses, costs, or expenses related to this repurchase. (Note that this provision is only related to any breach associated with G’s actions upon origination of a mortgage loan or servicing of any mortgage loan. That is, this loss reimbursement is related only to G’s actions that were taken during the loan origination process or servicing process before the date of the agreement.)
• Breach of third-party origination representations — If the purchaser receives any request to repurchase a loan that was originated by Z because of a breach of an origination representation or warranty made by Z, as originator of the loan, G is required to indemnify the purchaser for any losses, costs, or expenses related to this repurchase in the event that the purchaser is unable to collect such amounts from Z within 60 days of the purchaser’s submission of a claim to Z. (Note that any payment by G under this provision does not relieve Z from its obligation to indemnify G. That is, G maintains the right to seek reimbursement from Z for any payment made to the purchaser.)
• Assessment of compensatory fees — G is responsible and liable for any fees or penalties imposed by the FHLMC and FNMA related to any mortgage loan foreclosures that exceed the required timelines of the FHLMC and FNMA. Entity G is responsible only for such fees that pertain to the period before the date of the agreement (i.e., fees that result from actions of G as servicer).

In view of the definition of protection provisions in ASC 860-50-40, provisions that must be evaluated under ASC 860-50-40-3(c) and 40-4 are those designed to (1) reflect a purchase price adjustment or (2) protect a purchaser against losses associated with the servicing rights acquired. That is, protective provisions are contract terms that are intended to adjust the sales price as a result of events that subsequently affect the purchaser’s acquired rights to service loans. Not all contingent payment provisions specified in a sale agreement represent protection provisions. An entity must use judgment to determine whether a reimbursement provision affects the risks and rewards of ownership of servicing rights.

Breach of Loan Origination and Servicing Representations

These contingent payments are related to G’s past actions. Such obligations would be retained by G regardless of whether G had sold the MSRs or acknowledged such a liability in the agreement. That is, the purchaser of MSRs may incur losses related to G’s past actions and these reimbursement provisions merely serve to acknowledge that any such losses are G’s responsibility. Therefore, these reimbursement provisions are not designed to provide any protection or adjustment related to the purchaser’s rights to service the mortgage loans (i.e., any such payments made by G under these provisions do not result in an adjustment to the sales price of the MSRs). The purchaser of the MSRs is merely acting as a collection agent for the owners of the underlying mortgage loans, and any payments made by G under these reimbursement provisions reflect amounts that ultimately are borne by the owners of the underlying mortgage loans. The obligation of G to make payments for these breaches either existed as of the date the mortgage loans were sold to third-party investors or result from actions of G as servicer (i.e., G’s obligation to make payments under these provisions did not arise from the agreement, and the fact that the purchaser of the MSRs is now servicing the loans does not change G’s obligations). Since this reimbursement provision is merely a mechanism to indemnify the new servicer for obligations that G had before the agreement, these payment provisions do not reflect protection provisions under ASC 860-50. Note that in reaching this conclusion, we determined that any indemnification of the purchaser of the MSRs for damages that result from G’s faulty servicing before the agreement does not protect the purchaser of the MSRs for risks of future changes in the fair value of the MSRs.

This payment provision requires G to retain a risk that is typically borne by a servicer of mortgage loans. Before the agreement, G was exposed to losses resulting from Z’s breach of origination representations to the extent that G was unable to collect amounts paid from Z. We would expect that, upon the sale of MSRs, this risk would be transferred to the purchaser as subsequent servicer. By agreeing to reimburse the purchaser for any losses incurred as a result of origination representations breached by Z that Z does not reimburse to the purchaser within 60 days, G is retaining a servicing risk associated with the MSRs. In other words, G is effectively becoming obligated for a risk for which only Z should be obligated. Therefore, this reimbursement provision represents a protective provision under ASC 860-50.

Assessment of Compensatory Fees

This payment provision does not represent a protective provision under ASC 860-50 for the same reasons described above for indemnifications that arise from G’s servicing of the mortgage loans before the date of the agreement.

Evaluation of Repurchase Provision as a Protective Provision

Entity H enters into an agreement to sell MSRs to Entity W. As part of the sale agreement, H has agreed that, for the next two years, it will not solicit a refinancing of any mortgage loan that is being serviced by W after the sale transaction. This nonsolicitation obligation only precludes H from soliciting refinancing transactions; H is permitted to refinance any mortgage loan that is being serviced by W as long as the borrower approaches H regarding the refinancing. Entity H cannot, however, solicit the refinancing unless its nonsolicitation obligation is explicitly waived by W.

The nonsolicitation obligation does not represent a protective provision. While this provision does reduce, to some extent, the prepayment risk to W, any payment arises from an action within the control of H. Furthermore, this provision is akin to a standard representation and warranty.