Rev Account Stud (2013) 18:859–867

DOI 10.1007/s11142-013-9242-y

Discussion of ‘‘The financial reporting of fair value

based on managerial inputs versus market inputs:
evidence from mortgage servicing rights’’

Bradley E. Hendricks • Catherine Shakespeare

Published online: 26 July 2013

 Springer Science+Business Media New York 2013

Abstract Contrary to the guidance provided by regulators and industry associa-

tions suggesting that mortgage servicing rights (MSRs) be recorded as Level 3
assets, Altamuro and Zhang identify that 25 % of banks classify them as Level 2
assets. This variation in the asset classification of a single asset type provides a
unique setting to examine the role of inputs in the fair value measurement process.
Altamuro and Zhang find that the fair value of MSRs based on managerial inputs
(Level 3) better reflects the economics of the underlying assets than the fair value of
MSRs based on market inputs (Level 2). This discussion examines the institutional
features of the MSR market, particularly the market concentration and the illiquidity
of the market, that are important when considering this result. The discussion also
raises a number of questions about the inputs used in the fair value process and calls
for further research on this topic.

Keywords Mortgage servicing rights
Fair value
Market inputs

Managerial inputs
FAS 157
ASC 820

JEL Classification G21
M41

1 Introduction

Standard setters, regulators, and academics each hold strong, sometimes divergent
beliefs about the use of fair value as a measurement attribute within financial
reporting. Ultimately, our understanding of this measurement attribute will only
progress with careful unbiased research designed to deepen our understanding of the

B. E. Hendricks
C. Shakespeare (&)

Stephen M. Ross School of Business, University of Michigan, 701 Tappan Street,
Ann Arbor, MI 48109, USA
e-mail: shakespe@umich.edu

123
860 B. E. Hendricks, C. Shakespeare

strengths and weaknesses of this measurement attribute. Altamuro and Zhang

(2013) provide such a study that examines whether fair value measurements using
Level 3 inputs better represent the underlying economics of the assets than do fair
value measurements using Level 2 inputs. While the prevailing belief is that the
market-based inputs used for Level 2 assets will result in a more relevant and
representationally faithful price than can be obtained from firm inputs subject to
manager manipulation (Level 3), this paper is successful in examining a situation
where the Level 2 inputs may be more suspect.
A key contribution of Altamuro and Zhang comes from their decision to examine
a specific asset recognized at fair value rather than a broad range of assets within an
entire level of the fair value hierarchy. By examining a specific asset type, the inputs
into the valuation model are largely held constant, providing a cleaner setting in
which to examine how the quality of the inputs used within a fair value model
impact both the asset’s valuation and the market’s perception of that valuation.
While the nature of these inputs is briefly touched upon by Altamuro and Zhang, we
believe that it is critical to understand the nature of the asset, the market for the
asset, and the key inputs that drive its valuation to understand this study’s results
and placement within the expanding fair value literature.
Section 2 provides an overview of the market for mortgage servicing rights
(MSRs). Section 3 examines the valuation of MSRs, including the significant inputs
that enter into its valuation in determining whether the asset is most representative
of a Level 2 or Level 3 asset. Section 4 highlights concerns with the research design
employed by Altamuro and Zhang, and Sect. 5 concludes.

2 Market for mortgage servicing rights

Mortgage servicing rights are intangible assets that arise from the originate-to-
distribute lending model. Under this model, lenders distribute the loans that they
originate via securitization, or they sell them into the secondary market in exchange
for new capital, which they can then use to make additional loans. This model
allows banks to limit the capital intensity associated with lending so long as they
can identify buyers for the loans that they originate. Historically, parties interested
in purchasing these loans have only been interested in receiving the contractual cash
flows associated with repayment but not in managing the relationship with the
borrowers.1 Therefore the originator must decide whether to retain the entire loan or
to bifurcate the loan into two separate assets; a passive asset (contractual right to the
principal and interest payments) and an active asset (servicing the loan in exchange
for a fee). Thus, while servicing is inherent in all loans, SFAS 140:61 notes that ‘‘it
becomes a distinct asset or liability only when contractually separated from the
underlying assets by sale or securitization of the assets with servicing retained or
separate purchase or assumption of the servicing.’’

1
For example, the largest purchasers of mortgages are the government-sponsored entities such as Fannie
Mae and Freddie Mac that have not historically shown an interest in servicing loans.

123
Evidence from mortgage servicing rights 861

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011

Bank1 Banks 2-5 Banks 6-10 Banks 11+

Fig. 1 Market concentration. Note Data was obtained from bank holding companies’ Y-9C quarterly
reports for the period first quarter of 2008 to fourth quarter of 2011. Fair value of mortgage servicing
rights is data item BHCK 6438 in the reports

The decision to retain an MSR involves consideration of the contracted fixed

compensation and the expected cost to service the loan. Typically, the servicer’s fee
consists of a right to retain a fixed portion of the basis points charged to the
borrower for interest on the unpaid principal balance of the loan. When estimating
the cost of servicing the loan, the servicer considers the costs associated with
responding to borrower inquiries, collecting and recording payments, making
payments to tax authorities and insurance companies, and remitting principal and
interest payments to the mortgage holder when applicable. However, these costs
differ across potential servicers according to their expertise in servicing (i.e.,
Cochran et al. 2004). As a result, the estimated net cash flows will differ among
servicers, giving rise to variation in the asset’s internal value. This variation is
further increased due to the value that a potential servicer places on the relationship
formed with the borrower by servicing the loan. For example, a bank with an
extensive product line may place a higher value on the relationship than a nonbank
servicer if the bank believes that it can use the relationship to cross-sell some of its
other products to the borrower. Thus the internal or intrinsic value that servicers
place on a MSR may exceed a third-party assessment of the asset’s discounted cash
flows.
Because the intrinsic value of MSRs is not uniform across servicers, servicers
with a competitive advantage (i.e., economies of scale) are willing to purchase
MSRs from other servicers that are not as efficient in loan servicing. While more
than 70 % of loans are originated by the ten largest lenders (FHFA 2011b), these
transactions further concentrate a market that is already heavily concentrated.
Figure 1 illustrates the heavy concentration of this market among bank holding
companies for the sample period of Altamuro and Zhang’s study.2 The
2
Data for Fig. 1 represents the fair value of MSRs obtained from bank holding companies’ Y-9C reports
(BHCK 6438). Admittedly, this does not capture the entire market for these rights as some MSRs are held

123
862 B. E. Hendricks, C. Shakespeare

concentration is striking: 80 % of the market is held by the five largest servicers.3

Not surprisingly, these providers are all large banks that can extract value from the
asset in excess of the net cash flows through forming relationships with borrowers.
The heavy concentration in servicers of MSRs makes this market unusual and any
attempts to generalize Altamuro and Zhang’s results to other markets should
consider the distinctive characteristics of the MSR market.

3 How to value a MSR: Level 2 or Level 3?

Mortgage servicing rights are initially recorded at fair value with subsequent
measurements at either amortized cost or fair value.4 To comply with this
accounting treatment, a servicer must estimate the asset’s fair value, which is
required to be ‘‘a market-based measurement, not an entity-specific measurement
(SFAS 157:29D).’’ This requires the servicer to record the asset’s fair value as an
exit price at the measurement date even if the servicer’s intention is to hold the asset
or liability to maturity. Thus the value of the MSR recognized by the servicer is not
its own intrinsic value but rather the market’s valuation of the asset.
The measurement hierarchy used to determine an asset’s fair value is intended to
increase the ‘‘consistency and comparability in fair value measurements… [by
giving] the highest priority to quoted prices (unadjusted) in active markets for
identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs
(Level 3) (SFAS 157:29).’’ Level 2 assets differ from Level 3 assets as they use
observable, rather than unobservable, inputs into a valuation model to determine the
fair value. Using this hierarchy to value MSRs is difficult because a liquid market
offering quoted prices does not exist. Thus the servicer is required to identify the
inputs that a third party market participant would use in its model. Specifically, the
servicer is tasked with including the market’s assessment of the asset’s credit risk,
prepayment risk, collateral, and product type (i.e., subprime vs. prime, ARM vs.
fixed, etc.) into its valuation model.
The incorporation of all of these factors to determine the fair value of the MSR is
a complex process since many of the inputs are not readily available for the
servicer’s specific loan portfolio. The Federal Housing Finance Association (FHFA)
acknowledges this point in its discussion paper on mortgage servicing, pointing out

Footnote 2 continued
by non-bank holding companies. However, the percentage of the MSR market held by these non-bank
holding companies during 2008–2011 (the sample period of Altamuro and Zhang 2013) is believed to be
\20 % of the total market.
3
The five servicers with the largest MSR assets recorded as of March 31, 2008, were (1) Wells Fargo &
Company, (2) JPMorgan Chase & Co., (3) Citigroup Inc., (4) Bank of America Corporation, and (5)
National City Corporation. As of Dec. 31, 2011, Ally Financial had become the fifth largest servicer, and
National City Corporation had been acquired by PNC Financial Services and was listed as the sixth
largest servicer.
4
As noted in Sect. 2 of Altamuro and Zhang, banks are permitted to make a onetime election to account
for MSRs at fair value rather than the lower of amortized cost or fair value. However, Table 1 of their
paper illustrates that a minority of banks had elected the fair value accounting treatment during their
sample period.

123
Evidence from mortgage servicing rights 863

that the difficulty in observing market-based inputs generally leads servicers to use a
Level 3 approach.5 Specifically, the FHFA states:
In estimating the fair value of MSRs, market participants generally use a Level
3 model-based fair value approach. Level 3 financial assets and liabilities
consist primarily of financial instruments for which there is limited market
activity and therefore little or no price transparency. As a result, the valuation
techniques used to estimate the fair value of Level 3 instruments involve
significant unobservable inputs, which generally are more subjective and
involve a high degree of management judgment and assumptions. The key
model assumptions used in valuing MSRs are typically interest rates,
prepayment speeds, and discount rates/Option Adjusted Spread (‘‘OAS’’)
levels. These assumptions are not entity specific assumptions but instead are
market-based consistent with the fair value notion. Market participants have a
broad range of views of these assumptions resulting in fair values that have a
wide range due to the lack of price transparency (FHFA 2011a).
The sentiment from the FHFA that these assets are most consistent with the Level
3 framework is also shared by other regulatory agencies and organizations,
including the Mortgage Bankers Association.6
Notwithstanding the regulatory conclusions regarding the accounting for these
assets, Altamuro and Zhang observe that nearly 25 % of the banks holding MSRs
record them as Level 2 assets, suggesting that they are using observable market-
based inputs to value the MSRs. In our opinion, this is a key finding of the paper that
should not be understated. Table 3 investigates the determinants of fair value level
classification by servicing banks, showing that both the characteristics of the loan
portfolio and of the bank itself impact the level at which MSRs are reported.
Specifically, Altamuro and Zhang find that those banks recording the MSRs as
Level 2 assets are relatively smaller, carry riskier loan portfolios, and are less likely
to use a big four auditor. These results are consistent with certain banks lacking the
technology to value these assets. This finding has broader implications for standard
setters as the ability of preparers to produce reliable fair value estimates is critical to
financial reporting.
Altamuro and Zhang devote much of their paper examining who classifies MSRs
as Level 2 versus Level 3. However, an important question that they do not
sufficiently address relates to the inputs being used in the valuation models.
Specifically, which inputs are used and are they of sufficient quality to reflect the
underlying characteristics associated with the bank’s MSR assets? For example, one
of the significant inputs into the valuation model for MSRs is the prepayment speed,
which estimates the rate at which a mortgage will be paid off ahead of its scheduled
contractual terms. This rate is important in considering the value for MSRs as the

5
Note that SFAS 157:22 requires that the level classification in its entirety is determined based on the
lowest level input that is significant to the fair value measurement. Thus, to obtain Level 2 status, a
servicer must be able to observe each of the significant inputs in the valuation model.
6
The MBA noted in its National Mortgage Servicing Conference & Expo in 2012 that MSRs do not have
a price discovery process associated with them and are thus most representative of Level 3 assets.

123
864 B. E. Hendricks, C. Shakespeare

100%

90%

80%

70%

60%

50%
Origination Refinance
40%

30%

20%

10%

0%
2008 2009 2010 2011

Fig. 2 Quarterly percentage of new loan originations compared to mortgage refinancing. Note Data was
obtained from the FHFA website at: www.fhfa.gov, accessed November 2012. The data is reported
quarterly and represents all new mortgage loans for the period 2008 through 2012

value of a MSR will be entirely impaired should the borrower elect to refinance the
underlying loan.
Figure 2 highlights the significance of considering prepayment in the MSR
valuation process by comparing the number of new mortgage originations to
refinanced mortgages during 2008–2011.7 The high number of refinanced mortgages
during the sample period of Altamuro and Zhang’s study suggests that significant
numbers of MSRs would have been written off and replaced with a new MSR but
not necessarily with the original servicer. While Fig. 2 details the significance of the
prepayment risk in valuing an MSR, it does not illustrate the difficulty associated
with determining that risk for the specific assets underlying a lender’s unique
servicing portfolio. Specifically, the prepayment risk varies for each type of asset
based on its unique characteristics such as product type (e.g., fixed vs. adjustable
rate), geographical location, the credit score of the borrower, and the vintage or age
of the loan. These are all considerations that must be made to value an MSR, and
servicers reporting these assets as Level 2 valuations purport to have obtained
observable inputs that would reflect these significant, but potentially unique,
portfolio characteristics.
To better understand the quality of observable inputs, such as the prepayment
speed, available to assist servicers with their valuation of MSRs for particular loan
types, we randomly chose one mortgage vintage from July 2009 and examined the
assumptions for a FNMA conventional 6 % mortgage loan on Bloomberg. We noted
that the prepayment assumptions provided by large banks ranged from 281 to 980
basis points, i.e., 2.81–9.8 % of the principal will be repaid early over a given time
horizon, typically 1 year. This range is not unusual based on other data sources we

7
Data for Fig. 2 was obtained from the FHFA website at: www.fhfa.gov.

123
Evidence from mortgage servicing rights 865

examined, including those provided by the Mortgage Bankers Association and the
Securities Market and Financial Markets Association. Given this range of
prepayment speeds, a servicer electing to use this input as an observable
prepayment assumption is then tasked with matching the specific characteristics
of its loan portfolio to that of the banks that list their prepayment assumptions on
Bloomberg or other data sources. However, these underlying characteristics of the
loan portfolios for the large banks providing these prepayment assumptions are not
observable to servicers attempting to value the MSR and the servicer’s portfolio is
unlikely to have similar characteristics to these large banks. Therefore it is not
entirely surprising that Altamuro and Zhang find that the Level 2 inputs do not
better represent the underlying economics of the specific loan portfolio than the
Level 3 inputs.

4 Research design

Altamuro and Zhang aim to examine whether the inputs to valuation for Level 3 fair
value better represent the economics underlying the servicer’s portfolio of loans
than those used for Level 2 valuations. To address this question, the research design
must control for differences in the level of risk in the underlying loan portfolios to
establish any causal inferences. The authors attempt to perform such an analysis in
Table 4 and find that the persistence of the servicing fees can be controlled for
across the two levels (column 4). Specifically, they proxy for the realized cash flows
associated with the asset with the servicing fees received and find that the difference
in the persistence of servicing fees is insignificant when the samples are matched on
size and changes in the housing price index for the bank’s state of incorporation and
when the MSRs are measured at the lower of cost or market. In other words, they
control for the differences in the realizations in cash flows, which then allows them
to examine the expected cash flows for this matched sample. However, it is difficult
to conclude whether the insignificance identified for the variable of interest in
column (4) stems from their matching on persistence alone or from the significant
drop in their sample size. Having established that the matching associated with
column 4 is the most appropriate, it is not clear why the authors continue to use the
matching algorithms specified in columns (1) to (3) for subsequent analyses. In our
opinion, column (4) should be the algorithm used for the subsequent analyses as it
reportedly controls for the underlying risk characteristics of the loan portfolios.
Altamuro and Zhang report that Table 5 represents the main results in their
paper. This table examines which fair value inputs for MSRs better reflect the
persistence of the underlying cash flow process. Surprisingly, an indicator variable
for Level 2 versus Level 3 never enters the regression. Instead, the research design
uses the variable Beta_Rank, defined as the quartile rank of the persistence of the
servicing fee estimated for each bank. As such, it is not clear how the authors
conclude that the difference in the association between the MSR asset and the
persistence is related to the choice of the bank’s selected fair value level.
As highlighted earlier, a significant component of any valuation model for MSRs
is estimating the prepayment risk for the underlying assets. Therefore an essential

123
866 B. E. Hendricks, C. Shakespeare

part to any research on the valuation of MSRs is to identify good proxies for the
prepayment risk specific to the servicer’s loan portfolio. However, the unobservable
nature of the characteristics underlying the bank’s specific loan portfolio makes this
a significant challenge for empirical researchers. Thus it may not be surprising that
REFI_RISK, the proxy for prepayment risk, is not statistically significant as a main
effect in regressions in Table 6. While Altamuro and Zhang attempt to identify
more refined proxies by using a weighted-average of the state-level refinancing rates
where the bank has operations, they do not report whether this refined measure is
significant as a main effect. However, they do disclose that their refined proxies are
very highly correlated with the original measure and the overall conclusions are
qualitatively similar. This highlights the continual challenge that empirical
researchers face to identify high quality proxies for the underlying constructs. We
recommend that future research into the fair value hierarchy, especially Level 3,
consider the importance of obtaining high quality proxies that match the specific
asset characteristics as inputs into the valuation models.

5 Conclusion

Overall, this paper contributes to our understanding of fair value measurement. We

believe that its key contribution is examining an individual asset class rather than a
broad range of asset classes within a particular level of the fair value hierarchy. This
provides an incremental understanding of which information may be taken from the
fair value measurement process. However, MSRs are actively managed assets that
trade in a concentrated industry and Altamuro and Zhang’s findings and conclusions
should be interpreted in this light. Any attempts to generalize their results must
consider how this market resembles and differs from the market for other asset
classes.
A key finding of the paper is that 25 % of banks classify the mortgage servicing
rights at Level 2 within the fair value hierarchy. This is extremely surprising as
industry guidance on how to value the asset from both regulators and industry
associations suggest that MSRs are most appropriately classified as Level 3 assets as
the key inputs to the valuation process are not observable. Given this, it is less
surprising that the Level 2 inputs are not more representative of the underlying
economics of the specific loan portfolio than the Level 3 inputs. While Altamuro
and Zhang investigate which types of banks are classifying the MSRs at Level 2,
they do not extend their analyses to consider how the inputs themselves vary or are
determined across the two levels.
Currently, accounting rules enforce a discrete 3 level hierarchy onto the
distribution of fair values for assets. In reality, these fair values exist on a continuum
with highly liquid assets at one end and unique one-off contracts at another. Future
research may examine how well this continuum maps into the hierarchy and
whether observing an input should be sufficient to include it in Level 2 irrespective
of the quality of the input. Further, Level 3 is required under SFAS 157 to be a
market-based measure even though it is unobservable. It is still an open question as
to how firms determine an unobservable market measure. Future research could

123
Evidence from mortgage servicing rights 867

examine whether Level 3 inputs are based on market measures or on entity-specific

measures, which would further deepen our understanding of the fair value
measurement attribute and fair value hierarchy.

Acknowledgments We would like to thank Jennifer Altamuro, Helen Zhang, James Scarborough, and
Matt Streadbeck for their assistance with the preparation of the discussion. In addition, we would like to
thank Patty Dechow (editor), Richard Sloan, and participants at the 2012 Review of Accounting
Conference.

References

Altamuro, J., & Zhang, H. (2013). The financial reporting of fair value based on managerial inputs
versus market inputs: Evidence from mortgage servicing rights. Review of Accounting Studies.
doi:10.1007/s11142-013-9234-y.
Cochran, R. J., Coffman, E. N., & Harless, D. W. (2004). Fair value capitalization of mortgage loan
servicing rights. Research in Accounting Regulation, 17, 153–165.
Federal Housing Finance Agency ‘‘FHFA’’. (2011a). Alternative mortgage servicing compensation
discussion paper. Retrieved from FHFA Website at: http://www.fhfa.gov/webfiles/22663/Servicing
CompDiscussionPaperFinal092711.pdf.
Federal Housing Finance Agency ‘‘FHFA’’. (2011b). Housing and Mortgage Markets 2010. Retrieved
from FHFA Website at: http://www.fhfa.gov/webfiles/21846/MMErevised81011.pdf.

123