10Transfers and Servicing and Variable Interest Entities – Audit and Accounting Guide Depository and Lending Institutions, 2nd Edition

Chapter 10
Transfers and Servicing and Variable Interest Entities

Introduction

10.01 This chapter discusses transfers of financial assets and servicing of financial assets (including mortgage banking) and variable interest entities (VIEs) which are often used to facilitate a transfer of financial assets. Common transfers of financial assets for financial institutions include whole loan sales, loan participations, asset securitizations, securities lending transactions, repurchase agreements, and banker’s acceptances. Such transfers may result in the seller having continuing involvement with the transferred financial assets, such as servicing rights, guarantees, retained interests in the assets, indemnity clauses, representations and warranties, or beneficial interests in securitized assets. Repurchase agreements are discussed in further detail in chapter 14, “Federal Funds and Repurchase Agreements," of this guide.

10.02 Financial institutions often have mortgage banking activities that consist primarily of the purchase or origination of mortgage loans for sale to secondary market investors and the subsequent servicing of those loans. Mortgage loans can be sold outright through whole loan sales or pooled and securitized. Access to the secondary mortgage market is an important source of liquidity for banks and savings institutions. Many institutions have deposit bases that are indexed to variable rates and, therefore, are particularly sensitive to interest-rate risk. Financial institutions with long term, fixed-rate assets funded with variable-rate deposit bases may incur losses in a rising interest-rate environment. Therefore, sales of mortgage loans and, in some cases, servicing rights and retained beneficial interests in the secondary market are an important source of funds to many institutions, supplemented by income streams from servicing and other fees. Access to the secondary market also provides opportunities to restructure existing long term portfolios.

10.03 Participants in the secondary market for residential financing include government-sponsored entities (GSEs) such as Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae); and federal agencies such as Government National Mortgage Association (Ginnie Mae) and the U.S. Department of Veterans' Affairs. These entities participate in the secondary market as issuers, investors, or guarantors of asset-backed securities (ABSs) such as mortgage-backed securities (MBSs), real estate mortgage investment conduits, and collateralized mortgage obligations. (Chapter 7, “Investments in Debt and Equity Securities,” of this guide describes ABS transactions and considerations for investors in ABSs.) Many entities are also active in the secondary market as issuers, investors, servicers, and financial guaranty companies.

10.04 When mortgage loans are originated for sale, the process includes not only finding an investor but also identifying loans that fit the investor's requirements, including underwriting criteria. Mortgage loans originated for sale normally must comply with specific standards governing documentation, appraisal, mortgage insurance, loan terms, and borrower qualifications. Investors typically review key loan terms and underlying documentation prior to completing their purchase. Individual loans that fail to meet the specified criteria are eliminated from the pool of loans eligible for sale. If exceptions cannot be corrected, the selling institution may have to either find alternative investors or retain the loans in its portfolio. In most cases, the originating institution continues to be subject to recourse by the investor for underwriting exceptions identified subsequent to the sale of the loans and any related defaults by borrowers. These obligations typically arise from the representations and warranties included in the pooling and servicing agreements.

10.05 The extent to which mortgage loans are originated for sale will differ for each institution. Factors such as liquidity, interest-rate exposure, asset/liability management policy, business plan, and capital considerations will influence an institution's mortgage banking activities. One institution may manage its interest-rate risk position by intentionally selling all fixed-rate mortgage loans it originates, whereas another institution may originate a variety of both fixed- and variable-rate loan products for sale in the secondary market.

Asset-Backed Securitizations

10.06 Securitization is often utilized by lending institutions to diversify funding sources. It involves the sale, generally to a trust, of a portfolio of loan receivables. Asset-backed certificates are then sold by the trust to investors through a private placement or public offering. Typically, the seller will retain the servicing rights for the loans sold to the trust and often retains a subordinated interest in the trust, which serves as a credit enhancement to the asset-backed certificates. Such structures provide companies the opportunity to obtain funding at competitive levels given the structural characteristics of securitization vehicles.

Loan Participations and Loan Syndications

10.07 In certain situations, a customer’s borrowing needs may exceed its bank’s legal lending limits or its self-imposed counterparty limits. To accommodate such a customer, the bank may share the credit risk with other banks through a loan participation. A loan participation, as defined in the FASB ASC glossary, is a transaction in which a single lender makes a large loan to a borrower and subsequently transfers undivided interests in the loan to groups of banks or other entities. Transfers by the originating lender may take the legal form of either assignments or participations. The transfers are usually on a nonrecourse basis, and the transferor (originating lender) continues to service the loan and is the lender of record. The transferee (participating entity) may or may not have the right to sell or transfer its participation during the term of the loan, depending on the terms of the participation agreement.1 A loan participation is in the scope of FASB ASC 860, Transfers and Servicing. In contrast, a loan syndication, as defined in the FASB ASC glossary, is a transaction in which several lenders share in lending to a single borrower. In a loan syndication, each lender loans a specific amount to the borrower and has the right to repayment from the borrower. A loan syndication is not a transfer of financial assets because each participant in a syndication is a lender of record, and therefore the transaction is not in the scope of FASB ASC 860. The “Glossary” section of the Federal Financial Institutions Examination Council’s Instructions for Preparation of Consolidated Reports of Condition and Income provides guidance that may assist in distinguishing between a loan participation and a loan syndication.

Loan Servicing

10.08 If mortgage or other loans are sold, the selling institution sometimes retains the right to service the loans for a servicing fee, normally expressed as a percentage of the unpaid principal balance of the loans that is collected over the life of the loans as payments are received. A typical servicing agreement requires the servicer to carry out the servicing function, including billing and collection of borrowers' payments; remittance of payments to the investor, insurers, and taxing authorities; loss mitigation activities; maintenance of custodial bank accounts; and related activities. The agreement also may involve significant risks being retained by the servicer arising from failure to abide by the terms of the servicing agreement. The servicer also may be required to advance funds to investors if there are shortfalls in the cash collected due to default by the underlying borrowers. These loans may have been originated by the servicer institution itself or by other financial institutions. When servicing mortgages for government entities (for example, Ginnie Mae) and GSEs (for example, Fannie Mae, Freddie Mac), institutions must meet certain minimum net-worth requirements and comply with the GSEs’ servicing standards. Inability to meet the requirements may result in termination of the servicing contracts.

Regulatory Matters

10.09 The Office of the Comptroller of the Currency (OCC), the FDIC, and the Board of Governors of the Federal Reserve System (Federal Reserve) (collectively, the federal banking agencies) limit the aggregate amount of servicing assets, which includes mortgage servicing assets, that may be included in regulatory capital.

10.10 On December 13, 1999, the federal banking agencies, including the Office of Thrift Supervision (OTS) (prior to its transfer of powers to the OCC, the FDIC, and the Federal Reserve),2 jointly issued the Interagency Guidelines on Asset Securitization that highlight the risks associated with asset securitization and emphasize the agencies’ concerns with certain retained interests generated from the securitization and sale of assets. The guidelines set forth the supervisory expectation that the value of retained interests in securitizations must be supported by objectively verifiable documentation of the assets’ fair-market value, utilizing reasonable, conservative valuation assumptions. Retained interests that do not meet such standards or that fail to meet the supervisory standards outlined in the guidance will be disallowed as assets of the bank for regulatory capital purposes. The guidance stresses the need for bank management to implement policies and procedures that include limits on the amount of retained interests that may be carried as a percentage of capital. Institutions that lack effective risk management programs or engage in practices deemed to present other safety and soundness concerns may be subject to more frequent supervisory review, limitations on retained interest holdings, more stringent capital requirements, or other supervisory response. On December 20, 2013, the Federal Reserve issued Risk Transfer Considerations When Assessing Capital Adequacy—Supplemental Guidance on Consolidated Supervision Framework for Large Financial Institutions, an advisory that provides guidance on how certain risk transfer transactions, such as securitizations, affect assessments of capital adequacy at large financial institutions. Readers are encouraged to view this guidance under the “Banking Information and Regulation—Supervision and Regulation Letters” page at www.federalreserve.gov.

10.11 On February 25, 2003, the federal banking agencies, including the OTS, issued the Interagency Advisory on Mortgage Banking. This guidance focuses on risks associated with valuation and modeling processes, hedging activities, management information systems, and internal audit processes in connection with mortgage banking activities.

10.12 On May 3, 2005, the federal banking agencies, including the OTS, and the National Credit Union Administration (NCUA) issued Interagency Advisory on Accounting and Reporting for Commitments to Originate and Sell Mortgage Loans. This advisory provides guidance related to the origination of mortgage loans that will be held for resale, and the sale of mortgage loans under mandatory delivery and best efforts contracts.

10.13 In September 2010, the FDIC approved a final rule to extend through December 31, 2010, the Safe Harbor Protection for Treatment by the FDIC as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection With a Securitization or Participation. Under this safe harbor, all securitizations or participations in process before the end of 2010 were permanently grandfathered under the existing terms of Title 12 U.S. Code of Federal Regulations (CFR) Part 360.6. The rule defines the conditions for safe harbor protection for securitizations and participations for which transfers of financial assets are made after September 30, 2010, and clarifies the application of the safe harbor to transactions that comply with the accounting standards (that is, FASB Statement Nos. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 [FASB ASU No. 2009-16, Transfers and Servicing (Topic 860): Accounting for Transfers of Financial Assets], and 167, Amendments to FASB Interpretation No. 46(R) [FASB ASU No. 2009-17, Consolidations (Topic 810): Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities]) for off-balance-sheet treatment as well as those that do not comply with those accounting standards. The conditions contained in the final rule will serve to protect the Deposit Insurance Fund and the FDIC’s interests as deposit insurer and receiver by aligning the conditions for the safe harbor with better and more sustainable securitization practices by insured depository institutions. For more information on this final ruling, readers are encouraged to visit the FDIC website at www.fdic.gov/news/news/press/2010/pr10216.html.

10.14 See chapter 9, “Credit Losses,” of this guide for regulatory matters related to loan and lease losses and nontraditional mortgage products and chapter 8, “Loans,” of this guide for regulatory matters related to commercial and residential mortgages.

10.15 The OCC’s Bank Accounting Advisory Series (BAAS) is updated periodically to express the Office of the Chief Accountant’s current views on accounting topics of interest to national banks and federal savings associations. See further discussion of the BAAS in paragraph 7.82 of this guide. Topic 9, “Income and Expense Recognition,” of the BAAS includes interpretations on accounting for transfers of financial assets and servicing. Readers are encouraged to view this publication under the “Publications—Bank Management” page at www.occ.gov.

Accounting and Financial Reporting3

Mortgage Loans and MBSs Held for Sale

10.16 FASB ASC 948, Financial Services—Mortgage Banking, includes accounting and reporting guidance applicable to mortgage banking entities and entities that engage in certain mortgage banking activities.

10.17 FASB ASC 948-310-35-1 states that mortgage loans held for sale (HFS) should be reported at the lower of cost or fair value, determined as of the balance sheet date. If a mortgage loan has been the hedged item in a fair value hedge (as addressed in FASB ASC 815, Derivatives and Hedging), the loan’s cost basis used in lower-of-cost-or-fair value accounting should reflect the effect of the adjustments of its carrying amount made pursuant to FASB ASC 815-25-35-1. After the securitization of a mortgage loan HFS that meets the conditions for a sale addressed in FASB ASC 860-10-40-5, FASB ASC 948-310-40-1 requires that any MBSs received by the transferor as proceeds should be classified in accordance with the provisions of FASB ASC 320, Investments—Debt and Equity Securities. However, FASB ASC 948-310-35-3A states that a mortgage banking entity should classify as trading any MBSs received as proceeds that it commits to sell before or during the securitization process. An entity is prohibited from reclassifying loans as investment securities unless the transfer of those loans meets the conditions for sale accounting addressed in FASB ASC 860-10-40-5.

10.18 FASB ASC 948-310-35-2 requires that the amount by which the cost exceeds fair value of mortgage loans HFS should be accounted for as a valuation allowance. Changes in the valuation allowance should be included in the determination of net income of the period in which the change occurs.

10.19 The valuation allowance addressed in paragraph 10.18 is not the same as the allowance for credit losses and thus the change should not be recognized in the provision for credit losses.

10.20 Many mortgage banking entities apply the fair value option to loans under FASB ASC 825, Financial Instruments. The “Fair Value Option” subsections of FASB ASC 825-10 address circumstances in which entities may choose, at specified election dates, to measure eligible items at fair value (the fair value option). FASB ASC 825-10-15 provides guidance on the scope of the “Fair Value Option” subsections. See chapter 20, “Fair Value,” of this guide for a summary of FASB ASC 825.

10.21 The fair value of mortgage loans and MBSs HFS should be measured by type of loan, as explained in FASB ASC 948-310-35-3. At a minimum, the fair value of residential (one- to four-family dwellings) and commercial mortgage loans should be measured separately. Either the aggregate or individual loan basis may be used in determining the lower of cost or fair value for each type of mortgage loan. Fair value for loans subject to investor purchase commitments (committed loans) and loans held on a speculative basis (uncommitted loans) should be measured separately as follows:

  1. a. Committed loans. Mortgage loans covered by investor commitments should be based on the fair values of the loans.
  2. b. Uncommitted loans. Fair value for uncommitted loans should be based on fair value in the principal market or, in the absence of a principal market, in the most advantageous market (see paragraphs 5–6C of FASB ASC 820-10-35). That determination relies on the principles in FASB ASC 820, Fair Value Measurement, and would include consideration of the following:

i.  Market prices and yields sought by market participants in the principal or most advantageous market.

ii.  Quoted Ginnie Mae security prices or other public market quotations for long-term mortgage loan rates.

iii.  Freddie Mac and Fannie Mae current delivery prices.

10.22 If a loan is held for resale, loan origination fees and the direct loan origination costs as specified in FASB ASC 310, Receivables, should be deferred until the related loan is sold as stated in FASB ASC 948-310-25-3. However, for loans subject to the fair value option as discussed in paragraph 10.20, such amounts are recognized in the income statement immediately.

10.23 Notwithstanding the characteristics discussed in FASB ASC 815-10-15-83, loan commitments that relate to the origination of mortgage loans that will be HFS, as discussed in FASB ASC 948-310-25-3, should be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender), as stated in FASB ASC 815-10-15-71. The fair value of loan commitments accounted for as derivative instruments should include the inherent value of servicing, in accordance with SEC Staff Accounting Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings” (codified in FASB ASC 815-10-S99-1).

10.24 FASB ASC 948-310-30-4 states that mortgage loans transferred from loans HFS to long-term-investment classification should be measured at the lower of cost or fair value on the date of transfer.

10.25 The carrying amount of mortgage loans to be sold to an affiliated entity (as defined in the FASB ASC glossary) should be adjusted to the lower of cost or fair value of the loans as of the date management decides that a sale to an affiliated entity will occur, as stated in paragraphs 1–2 of FASB ASC 948-310-30. If a particular class of mortgage loans or all loans are originated exclusively for an affiliated entity, the originator is acting as an agent of the affiliated entity, and the loan transfers should be accounted for at the originator's acquisition cost, as defined in the FASB ASC glossary.

Transfers and Servicing of Financial Assets

10.26 FASB ASC 860 establishes accounting and reporting standards for transfers and servicing of financial assets. FASB ASC 860-10-05-6 provides examples of the various types of transfers to which FASB ASC 860 applies, which include but are not limited to securitizations, factoring arrangements, transfers of receivables with recourse, securities lending transactions, repurchase agreements, loan participations, and banker’s acceptances.

10.27 FASB ASC 860 establishes accounting and reporting standards for transfers and servicing of financial assets, as well as establishes the accounting for transfers of servicing rights. Transfers of financial assets often occur in which the transferor has some continuing involvement either with the assets transferred or with the transferee. Transfers of financial assets with continuing involvement raise issues about the circumstances under which the transfers should be considered as sales of all or part of the assets or as secured borrowings and about how transferors and transferees should account for sales and secured borrowings. Continuing involvement is defined in FASB ASC 860-10-20 and includes, but is not limited to, servicing rights, guarantees, retained interests in the loans, or beneficial interests in securitized assets.

10.28 The objective of the derecognition guidance in FASB ASC 860-10-40 and related implementation guidance is to determine whether a transferor and its consolidated affiliates included in the financial statements being presented have surrendered control over transferred financial assets or third-party beneficial interests. This determination

  1. a. should first consider whether the transferee would be consolidated by the transferor (for implementation guidance, see FASB ASC 860-10-55-17D).
  2. b. should consider the transferor’s continuing involvement (as defined in the FASB ASC glossary) in the transferred financial assets.
  3. c. requires the use of judgment that should consider all arrangements or agreements made contemporaneously with, or in contemplation of, the transfer, even if they were not entered into at the time of the transfer.

With respect to item b, all continuing involvement by the transferor, its consolidated affiliates included in the financial statements being presented, or its agents should be considered continuing involvement by the transferor. In a transfer between two subsidiaries of a common parent, the transferor-subsidiary should not consider its parent’s involvements with the transferred financial assets in applying FASB ASC 860-10-40-5.

10.29 According to FASB ASC 860-10-40-4D, to be eligible for sale accounting, an entire financial asset cannot be divided into components before a transfer unless all of the components meet the definition of a participating interest. The legal form of the asset and what the asset conveys to its holders should be considered in determining what constitutes an entire financial asset (for implementation guidance, see FASB ASC 860-10-55-17E). An entity should not account for a transfer of an entire financial asset or a participating interest in an entire financial asset partially as a sale and partially as a secured borrowing.

10.30 FASB ASC 860-10-40-6A provides guidance on the characteristics of a participating interest. Critical for qualifying as a participating interest is that the transferee receives from the date of the transfer a proportionate (pro rata) ownership interest in an entire financial asset.

10.31 According to FASB ASC 860-10-40-4E, if a transfer of a portion of an entire financial asset meets the definition of a participating interest, the transferor should apply the guidance in FASB ASC 860-10-40-5 (see paragraph 10.32). If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transferor and transferee should account for the transfer as a secured borrowing with a pledge of collateral, in accordance with the guidance in FASB ASC 860-30-25-2. However, if the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, FASB ASC 860-10-40-5 (see paragraph 10.32) should be applied to the entire financial asset once all portions have been transferred.

10.32 FASB ASC 860-10-40-5 states that a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset in which the transferor surrenders control over those financial assets should be accounted for as a sale if and only if all of the following conditions are met:

  1. a. Isolation of transferred financial assets. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Transferred financial assets are isolated in bankruptcy or other receivership only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in the financial statements being presented. For multiple step transfers, a bankruptcy-remote entity (as defined in the FASB ASC glossary) is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable guidance on whether it should be consolidated (see paragraphs 7–14 of FASB ASC 860-10-40 and the guidance beginning in FASB ASC 860-10-55-18 [see discussion of paragraphs 18–18C of FASB ASC 860-10-55 in paragraphs 10.35–.38]). A set-off right (as defined in the FASB ASC glossary) is not an impediment to meeting the isolation condition.
  2. b. Transferee’s rights to pledge or exchange. This condition is met if both the following conditions are met:

i.  Each transferee (or, if the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities and that entity is constrained from pledging or exchanging the assets it receives, each third-party holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received.

ii.  No condition both constrains the transferee (or third-party holder of its beneficial interests) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (see paragraphs 15–21 of FASB ASC 860-10-40).

  1.   If the transferor, its consolidated affiliates included in the financial statements being presented, and its agents have no continuing involvement with the transferred financial assets, the condition under item (b) in FASB ASC 860-10-40-5 is met.
  2. c. Effective control. The transferor, its consolidated affiliates included in the financial statements being presented, or its agents do not maintain effective control over the transferred assets or third-party beneficial interests related to those transferred assets (see FASB ASC 860-10-40-22A). A transferor’s effective control over the transferred financial assets includes, but is not limited to, any of the following:

i.  An agreement that both entitles and obligates the transferor to repurchase or redeem the transferred financial assets before their maturity (see paragraphs 23–25 of FASB ASC 860-10-40).

ii.  An agreement, other than through a cleanup call (see paragraphs 28–39 of FASB ASC 860-10-40), that provides the transferor with both the unilateral ability to cause the holder to return specific financial assets and a more-than-trivial benefit attributable to that ability.

iii.  An agreement that permits the transferee to require the transferor to repurchase the transferred financial assets at a price that is so favorable to the transferee that it is probable that the transferee will require the transferor to repurchase them (see FASB ASC 860-10-55-42D).

10.33 For guidance on accounting for a transfer that satisfies the conditions in FASB ASC 860-10-40-5, see FASB ASC 860-20 (sales of financial assets), including derecognition guidance in FASB ASC 860-20-40 and guidance on recognition of any assets obtained and liabilities incurred in FASB ASC 860-20-25. For guidance on accounting for a transfer that does not satisfy the conditions of FASB ASC 860-10-40-5, see FASB ASC 860-30 (secured borrowings and collateral).

10.34 Paragraphs 16–18 of FASB ASC 860-10-05 provide background on securities lending transactions and paragraphs 19–21 of FASB ASC 860-10-05 provide background on repurchase agreements. Implementation guidance related to the application of FASB ASC 860 to repurchase agreements and securities lending transactions is discussed in paragraphs 51–56B of FASB ASC 860-10-55. Implementation guidance related to the application of FASB ASC 860 to wash sales is discussed in FASB ASC 860-10-55-57.

10.35 Isolation of transferred financial assets. Paragraphs 18–25A of FASB ASC 860-10-55 provide implementation guidance related to the isolation condition in item (a) in FASB ASC 860-10-40-5.

10.36 In the context of U.S. bankruptcy laws, a true sale opinion from an attorney is often required to support a conclusion that transferred financial assets are isolated from the transferor, any of its consolidated affiliates included in the financial statements being presented, and its creditors. In addition, a nonconsolidation opinion is often required if the transfer is to an affiliated entity. In the context of U.S. bankruptcy laws,

  1. a. a true sale opinion is an attorney’s conclusion that the transferred financial assets have been sold and are beyond the reach of the transferor’s creditors and that a court would conclude that the transferred financial assets would not be included in the transferor’s bankruptcy estate.
  2. b. a nonconsolidation opinion is an attorney’s conclusion that a court would recognize that an entity holding the transferred financial assets exists separately from the transferor. Additionally, a nonconsolidation opinion is an attorney’s conclusion that a court would not order the substantive consolidation of the assets and liabilities of the entity holding the transferred financial assets and the assets and liabilities of the transferor (and its consolidated affiliates included in the financial statements being presented) in the event of the transferor’s bankruptcy or receivership.

10.37 A legal opinion may not be required if a transferor has a reasonable basis to conclude that the appropriate legal opinion(s) would be given if requested. For example, the transferor might reach a conclusion without consulting an attorney if either of the following conditions exist:

  1. a. The transfer is a routine transfer of financial assets that does not result in any continuing involvement by the transferor.
  2. b. The transferor had experience with other transfers with similar facts and circumstances under the same applicable laws and regulations.

10.38 For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures (for example, banks subject to receivership by the FDIC in the United States or other jurisdictions), judgments about whether transferred financial assets have been isolated should be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions.

Sale of Financial Assets

10.39 Sale of a participating interest. Upon completion of a transfer of a participating interest that satisfies the conditions in FASB ASC 860-10-40-5 to be accounted for as a sale, FASB ASC 860-20-40-1A states that the transferor (seller) should

  1. a. allocate the previous carrying amount of the entire financial asset between both of the following on the basis of their relative fair values at the date of the transfer:

i.  The participating interest(s) sold

ii.  The participating interest that continues to be held by the transferor

  1. b. derecognize the participating interest(s) sold.
  2. c. apply the guidance in FASB ASC 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale.
  3. d. recognize in earnings any gain or loss on the sale.
  4. e. report any participating interest(s) that continue to be held by the transferor as the difference between the following amounts measured at the date of the transfer:

i.  The previous carrying amount of the entire financial asset

ii.  The amount derecognized

10.40 Sale of an entire financial asset or group of entire financial assets. Upon completion of a transfer of an entire financial asset or group of entire financial assets that satisfies the conditions in FASB ASC 860-10-40-5 to be accounted for as a sale, FASB ASC 860-20-40-1B states that the transferor (seller) should

  1. a. derecognize the transferred financial assets.
  2. b. apply the guidance in FASB ASC 860-20-25-1 and 860-20-30-1 on recognition and measurement of assets obtained and liabilities incurred in the sale.
  3. c. recognize in earnings any gain or loss on the sale.

If the transferred financial asset was accounted for under FASB ASC 320 as available for sale before the transfer, item a requires that the amount in other comprehensive income be recognized in earnings at the date of the transfer.

10.41 Transferor recognition and measurement of assets obtained and liabilities incurred in a sale of financial assets. Upon completion of a transfer of financial assets that satisfies the conditions to be accounted for as a sale in FASB ASC 860-10-50-5, FASB ASC 860-20-25-1 states the transferor (seller) should also recognize any assets obtained or liabilities incurred in the sale, including, but not limited to, any of the following:

  1. a. Cash
  2. b. Servicing assets
  3. c. Servicing liabilities
  4. d. In a sale of an entire financial asset or a group of entire financial assets, any of the following:

i.  The transferor’s beneficial interest in the transferred financial assets

ii.  Put or call options held or written (for example, guarantee or recourse obligations)

iii.  Forward commitments (for example, commitments to deliver additional receivables during the revolving periods of some securitizations)

iv.  Swaps (for example, provisions that convert interest rates from fixed to variable)

10.42 According to FASB ASC 860-20-30-1, the transferor should initially measure at fair value any asset obtained (or liability incurred) and recognized under FASB ASC 860-20-25-1.

10.43 Transferee recognition and measurement of assets obtained and liabilities incurred in a sale of financial assets. In accordance with FASB ASC 860-20-25-3 and FASB ASC 860-20-30-2, the transferee should recognize and initially measure all assets obtained (including any participating interest[s] obtained) and any liabilities incurred at fair value.

10.44 Financial assets subject to prepayment. FASB ASC 860-20-35-2 requires that financial assets, except for instruments that are within the scope of FASB ASC 815-10, that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment should be subsequently measured like investments in debt securities classified as available-for-sale or trading under FASB ASC 320. Examples of such financial assets include, but are not limited to, interest-only strips, other beneficial interests, loans, or other receivables.

Transfers of Loans With Recourse

10.45 Institutions may transfer loans with recourse. This may be accomplished to deliver loans into a particular investor's commitment program, to obtain a better price, or both. For example, a seller may be obligated to make full or partial payment to the purchaser if the debtor fails to pay when payment is due. Similarly, a seller may be obligated to make payments to the purchaser as the result of loan prepayments or because of adjustments resulting from defects (such as failure to perfect a security interest in collateral) of the transferred loans. In some cases (for example, student loans), underwriting exceptions identified subsequent to the transfer of loans may subject the seller to additional recourse risk if the borrower defaults on the loan. Because of the continuing risk of delinquency and foreclosure, the institution's management should carefully evaluate its potential contingent liabilities with respect to such loans.

10.46 FASB ASC 860 provides an overview of transfers of receivables with recourse. A transfer of receivables in their entireties with recourse should be accounted for as a sale, with the proceeds of the sale reduced by the fair value of the recourse obligation, if the conditions in FASB ASC 860-10-40-5 are met, as stated in item (a) in FASB ASC 860-10-55-46. Otherwise, a transfer of receivables with recourse should be accounted for as a secured borrowing. A transfer of a portion of a receivable with recourse, other than that permitted in item (c)(4) in FASB ASC 860-10-40-6A, does not meet the requirements of a participating interest and should be accounted for as a secured borrowing, as stated in item (b) in FASB ASC 860-10-55-46. The form and nature of recourse may have a bearing on legal isolation (see further discussion in paragraph 10.35).

Servicing Assets and Liabilities

10.47 According to FASB ASC 860-50-25-1, an entity should recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations:

  1. a. A servicer’s transfer of any of the following, if that transfer meets the requirements for sale accounting:

i.  An entire financial asset

ii.  A group of entire financial assets

iii.  A participating interest in an entire financial asset, in which circumstance the transferor should recognize a servicing asset or a servicing liability only related to the participating interest sold

  1. b. An acquisition or assumption of a servicing obligation that does not relate to financial assets of the servicer or its consolidated affiliates included in the financial statements being presented

10.48 Servicing rights are significant assets for some institutions. They have value in addition to the servicing fee to be received because of the servicer's ability to invest the "float" that results from payments that are received from borrowers but are not immediately passed on to the investors in the loans. Additionally, intrinsic value components of servicing rights may include ancillary income, such as late-payment charges and prepayment charges. Servicing rights can be purchased or sold either separately or as part of a loan. Loans sold along with the respective servicing rights are commonly referred to as servicing retained, whereas loans sold apart from the respective servicing rights are commonly referred to as serving released.

10.49 A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing with the underlying financial assets remaining on the transferor's balance sheet should not recognize a servicing asset or a servicing liability, as stated in FASB ASC 860-50-25-2.

10.50 FASB ASC 860-50-25-4 states that an entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held-to-maturity in accordance with FASB ASC 320 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced.

10.51 FASB ASC 860-50-30-1 states that an entity should initially measure at fair value, a servicing asset or servicing liability that qualifies for separate recognition regardless of whether explicit consideration was exchanged.

10.52 FASB ASC 860-50-35-1 states that an entity should subsequently measure each class of servicing assets and servicing liabilities using one of the following methods:

  1. a. Amortization method. Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues), and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date.
  2. b. Fair value measurement method. Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur.

10.53 FASB ASC 860-50-35-2 states that the election to subsequently measure servicing assets and servicing liabilities by using either the amortization method or the fair value measurement method should be made separately for each class of servicing assets and servicing liabilities.

10.54 Paragraphs 4–5 of FASB ASC 860-50-35 state that an entity should apply the same subsequent measurement method to each servicing asset and servicing liability in a class. Classes of servicing assets and servicing liabilities should be identified based on any of the following:

  1. a. The availability of market inputs used in determining the fair value of servicing assets or servicing liabilities.
  2. b. An entity's method for managing the risks of its servicing assets or servicing liabilities.

Once an entity elects the fair value measurement method for a class of servicing assets and servicing liabilities, that election should not be reversed, as stated in item (a) in FASB ASC 860-50-35-3. However, at the beginning of each year, for servicing assets and liabilities measured at amortized cost, an entity may make an irrevocable decision to subsequently measure a class of servicing assets or liabilities at fair value. If this election is made the cumulative effect adjustment should be recorded to retained earnings at the beginning of the year.

10.55 Transfers of servicing rights. The criteria in paragraphs 2–4 of FASB ASC 860-50-40 apply to transfers of servicing rights relating to loans previously sold and to transfers of servicing rights relating to loans that are retained by the transferor, as stated in FASB ASC 860-50-40-6.

10.56 More recently, there has been an increase in bulk transfers of servicing (such as sales of servicing rights from one servicer to another). That activity has been driven by several factors, including changes in bank regulatory capital requirements for mortgage servicing rights and changes in the tax treatment of certain servicing cash flows.

10.57 FASB ASC 860-50-40-2 states that the following criteria should be considered when evaluating whether a transfer of servicing rights qualifies as a sale:

  • Whether the transferor has received written approval from the investor if required.
  • Whether the transferee is a currently approved transferor/servicer and is not at risk of losing approved status.
  • If the transferor finances a portion of the sales price, whether an adequate nonrefundable down payment has been received (necessary to demonstrate the transferee's commitment to pay the remaining sales price) and whether the note receivable from the transferee provides full recourse to the transferee. Nonrecourse notes or notes with limited recourse (such as to the servicing) do not satisfy this criterion.
  • Temporary servicing performed by the transferor for a short period of time should be compensated in accordance with a subservicing contract that provides adequate compensation.

10.58 FASB ASC 860-50-40-3 states that the following criteria should also be considered when evaluating whether a transfer of servicing rights qualifies as a sale:

  1. a. Title has passed
  2. b. Substantially all risks and rewards of ownership have irrevocably passed to the buyer
  3. c. Any protection provisions retained by the seller are minor and can be reasonably estimated

10.59 Servicing rights may be purchased by brokers or investment bankers that intend to seek buyers for the rights. Although such purchases cannot be canceled, approval of the transfer of the rights is not requested by the seller until the broker enters into a transaction with the third-party purchaser. Thus, such transactions should generally be characterized as financing transactions and a sale has not occurred until an approval of transfer of rights has been requested, even though other contingencies are resolved.

10.60 FASB ASC 860-50-40-4 explains that if a sale is recognized and minor protection provisions exist, a liability should be accrued for the estimated obligation associated with those provisions. The seller retains only minor protection provisions if both of the following are met:

  1. a. The obligation associated with those provisions is estimated to be no more than 10 percent of the sales price.
  2. b. Risk of prepayment is retained for no longer than 120 days.

10.61 FASB ASC 860-50-40-5 states that a temporary subservicing contract in which the subservicing will be performed by the transferor for a short period of time would not necessarily preclude recognizing a sale at the closing date.

10.62 Paragraphs 7–9 of FASB ASC 860-50-40 provide additional guidance on sales of servicing rights with a subservicing contract.

10.63 Paragraphs 10–11 of FASB ASC 860-50-40 address a situation in which an entity sells the right to service mortgage loans that are owned by other parties. The related mortgage loans have been previously sold, with servicing retained, in a separate transaction. Because of the ability to invest the float that results from payments received from borrowers but not yet passed to the owners of the mortgages, the mortgage servicing rights can be sold for immediate cash or for a participation in the future interest stream of the loans. If a transfer of mortgage servicing rights qualifies as a sale under the criteria stated in FASB ASC 860-50-40-2 and the sale is for a participation in the future interest income stream, gain recognition is appropriate at the sale date. There are difficulties in measuring the amount of the gain if the sales price is based on a participation in future payments and there is no specified upper limit on the computed sales price. The transferor of mortgage servicing rights should consider all available information, including the amount of gain that would be recognized if the servicing rights were to be sold outright for a fixed cash price.

10.64 In general, three to six months elapse between entry into a contract to sell servicing rights and actual delivery of the loan portfolio to be serviced. These delays may result from the purchaser's inability to accept immediate delivery, the seller's inability to immediately transfer the servicing records and loan files, difficulties in obtaining necessary investor approval, requirements to give advance notification to mortgagors, or other planning considerations. Issues relating to the transfer of risks and rewards between buyers and sellers of servicing rights may be complex.

10.65 Paragraphs 1–2 of FASB ASC 860-50-45 state that an entity should report recognized servicing assets and servicing liabilities that are subsequently measured using the fair value measurement method in a manner that separates those carrying amounts on the face of the statement of financial position from the carrying amounts for separately recognized servicing assets and servicing liabilities that are subsequently measured using the amortization method. To accomplish that separate reporting, an entity may either (a) display separate line items for the amounts that are subsequently measured using the fair value measurement method and amounts that are subsequently measured using the amortization method or (b) present the aggregate of those amounts that are subsequently measured at fair value and those amounts that are subsequently measured using the amortization method (see paragraphs 9–11 of FASB ASC 860-50-35) and disclose parenthetically the amount that is subsequently measured at fair value that is included in the aggregate amount.

Secured Borrowings and Collateral

10.66 Paragraphs 2–3 of FASB ASC 860-30-05 state that a debtor (obligor) may grant a security interest in certain assets to a lender (the secured party) to serve as collateral for its obligation under a borrowing, with or without recourse to other assets of the obligor. An obligor under other kinds of current or potential obligations, for example, interest rate swaps, also may grant a security interest in certain assets to a secured party. If collateral is transferred to the secured party, the custodial arrangement is commonly referred to as a pledge. Secured parties sometimes are permitted to sell or repledge (or otherwise transfer) collateral held under a pledge. The same relationships occur, under different names, in transfers documented as sales that are accounted for as secured borrowings (see FASB ASC 860-30-25-2).

10.67 FASB ASC 860-30-25-2 requires that the transferor and transferee account for the transfer as a secured borrowing with pledge of collateral in either of the following circumstances:

  1. a. If a transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset does not meet the conditions for a sale in FASB ASC 860-10-40-5
  2. b. If a transfer of a portion of an entire financial asset does not meet the definition of a participating interest

The transferor should continue to report the transferred financial asset in its statement of financial position with no change in the asset’s measurement (that is, basis of accounting).

10.68 Cash Collateral. Paragraphs 3–4 of FASB ASC 860-30-25 state that all cash collateral should be recorded as an asset by the party receiving it (the secured party), together with a liability for the obligation to return it to the payer (obligor), whose asset is a receivable. Cash collateral used, for example, in securities lending transactions (see paragraphs 16–18 of FASB ASC 860-10-05) should be derecognized by the obligor and recognized by the secured party, not as collateral but rather as proceeds of either a sale or a borrowing.

10.69 Noncash Collateral. FASB ASC 860-30-25-5 states that the accounting for noncash collateral by the debtor (or obligor) and the secured party depends on whether the secured party has the right to sell or repledge the collateral and on whether the debtor has defaulted. Noncash collateral should be accounted for as follows:

  1. a. If the secured party (transferee) has the right by contract or custom to sell or repledge the collateral, then FASB ASC 860-30-45-1 requires that the obligor (transferor) should reclassify that asset and report that asset in its statement of financial position separately, (for example, as security pledged to creditors) from other assets not so encumbered.
  2. b. If the secured party (transferee) sells collateral pledged to it, it should recognize the proceeds from the sale and its obligation to return the collateral. The sale of the collateral is a transfer subject to the provisions of FASB ASC 860.
  3. c. If the obligor (transferor) defaults under the terms of the secured contract and is no longer entitled to redeem the pledged asset, it should derecognize the pledged asset as required by FASB ASC 860-30-40-1 and the secured party (transferee) should recognize the collateral as its asset initially measured at fair value (see FASB ASC 860-30-30-1) or, if it has already sold the collateral, derecognize its obligation to return the collateral (see FASB ASC 860-30-40-1).
  4. d. Except as provided in FASB ASC 860-30-40-1, the obligor (transferor) should continue to carry the collateral as its asset, and the secured party (transferee) should not recognize the pledged asset.

Loans Not Previously HFS

10.70 FASB ASC 310-10-35-49 states that once a decision has been made to sell loans not previously classified as HFS, such loans should be transferred into the HFS classification and carried at the lower of cost or fair value. At the time of the transfer into the HFS classification, any amount by which cost exceeds fair value should be accounted for as a valuation allowance. This guidance applies to both mortgage and nonmortgage loans.

10.71 The following paragraphs discuss whether the adjustments should be recorded by using an allowance method or as a direct write down, depending on the circumstances involved.

10.72 On March 26, 2001, the federal banking agencies, including the OTS and the NCUA issued Interagency Guidance on Certain Loans Held for Sale to provide instruction to institutions and examiners about the appropriate accounting and reporting treatment for certain loans that are sold directly from the loan portfolio or transferred to a HFS account. This guidance addresses transfers to the HFS account for loans within its scope and states that when a decision is made to sell a loan or portion thereof that was not originated or initially acquired with the intent to sell, the loan should be clearly identified and transferred to the HFS account.

10.73 Accordingly, for institutions subject to this guidance, once the decision has been made to sell loans not previously classified as HFS, such loans should be transferred into the HFS classification. For loans with declines in fair value that are attributable to credit quality, any reduction in the loan's value at the time of the transfer into the HFS classification should be reflected as a write-down of the recorded investment resulting in a new cost basis, with a corresponding reduction in the allowance for loan and lease losses. Thus, this guidance adds to the provisions of a requirement to write down the transferred loan and establish a new cost basis for institutions subject to this guidance.

10.74 In contrast, for loans with declines in fair value that are attributable to interest or foreign exchange rates and clearly are not attributable, in any respect, to credit or transfer risk, any amount by which the recorded investment exceeds fair value at the time of the transfer into the HFS classification should be accounted for as a valuation allowance.

Financial Statement Presentation

10.75 Loans or trade receivables may be presented on the balance sheet as aggregate amounts, as stated in FASB ASC 310-10-45-2. However, such receivables HFS should be a separate balance sheet category.

10.76 FASB ASC 310-10-50-3 states that if major categories of loans or trade receivables are not presented separately in the balance sheet (see FASB ASC 310-10-45-2), they should be disclosed in the notes to the financial statements. FASB ASC 860-20-50-5 states that the aggregate amount of gains or losses on sales of loans or trade receivables (including adjustments to record loans HFS at the lower of cost or fair value) should be presented separately in the financial statements or disclosed in the notes to the financial statements.

10.77 As explained in FASB ASC 230-10-45-21, cash receipts and cash payments resulting from acquisitions and sales of loans also should be classified as operating cash flows if those loans are acquired specifically for resale and are carried at fair value or at the lower of cost or fair value. For example, mortgage loans HFS are required to be reported at the lower of cost or fair value in accordance with FASB ASC 948. Receipts from collections or sales of loans made by the entity and of other entities' debt instruments (other than cash equivalents and certain debt instruments that are acquired specifically for resale as discussed in FASB ASC 230-10-45-21) that were purchased by the entity, are cash inflows from investing activities, according to item (a) in FASB ASC 230-10-45-12.

10.78 Many financial institutions currently present gains or losses on sales of loans or trade receivables separately on the face of the income statement. The financial statement disclosure requirements do not prohibit this industry practice.

10.79 FASB ASC 948-310-50-1 requires an entity to disclose the method used in determining the lower of cost or fair value of mortgage loans HFS (that is, aggregate or individual loan basis).

10.80 In addition, see chapter 18, “Derivative Instruments: Futures, Forwards, Options, Swaps, and Other Derivative Instruments,” of this guide for accounting and financial reporting of derivative instruments recognized in connection with mortgage banking activities.

10.81 FASB ASC 825-10-45 addresses financial statement presentation if the fair value option is elected for mortgage loans HFS.

Financial Statement Disclosure

10.82 FASB ASC 860 provides disclosure requirements for transfers and servicing of financial assets, including sales of financial assets, secured borrowings and collateral, and servicing assets and liabilities. Paragraphs 3–7 of FASB ASC 860-10-50 provide detailed guidance regarding the principal objectives of the disclosure requirements of FASB ASC 860 as well as consideration of disclosure aggregation. Those objectives are to provide financial statement users with an understanding of all of the following:

  1. a. A transferor’s continuing involvement, if any, with transferred financial assets
  2. b. The nature of any restrictions on assets reported by an entity in its statement of financial position that relate to a transferred financial asset, including the carrying amounts of those assets
  3. c. How servicing assets and servicing liabilities are reported under FASB ASC 860-50
  4. d. For both of the following, how the transfer of financial assets affects an entity’s financial position, financial performance, and cash flows:

i.  Transfers accounted for as sales, if a transferor has continuing involvement with the transferred financial asset

ii.  Transfers of financial assets accounted for as secured borrowing

The specific disclosures required by FASB ASC 860 are minimum requirements, and an entity may need to supplement the required disclosures depending on (a) the facts and circumstances of a transfer, (b) the nature of an entity’s continuing involvement with the transferred financial assets, or (c) the effect of an entity’s continuing involvement on the transferor’s financial position, financial performance, and cash flows.

10.83 Secured borrowing and collateral disclosure requirements. An entity should disclose all of the following for collateral, as stated in FASB ASC 860-30-50-1A:

  1. a. If the entity has entered into repurchase agreements or securities lending transactions, it should disclose its policy for requiring collateral or other security.
  2. b. As of the date of the latest statement of financial position presented, both of the following:

i.  The carrying amount and classification of any assets pledged as collateral that are not reclassified and separately reported in the statement of financial position in accordance with item (a) in FASB ASC 860-30-25-5 and associated liabilities.

ii.  Qualitative information about the relationship(s) between those assets and associated liabilities; for example, if assets are restricted solely to satisfy a specific obligation, a description of the nature of restrictions placed on those assets.

  1. c. If the entity has accepted collateral that it is permitted by contract or custom to sell or repledge, it should disclose all of the following:

i.  The fair value as of the date of each statement of financial position presented of that collateral.

ii.  The fair value as of the date of each statement of financial position presented of the portion of that collateral that it has sold or repledged.

iii.  Information about the sources and uses of that collateral.

10.84 To provide an understanding of the nature and risks of short-term collateralized financing obtained through repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions, that are accounted for as secured borrowings at the reporting date, FASB ASC 860-30-50-7 states that an entity should disclose the following information for each interim and annual period about the collateral pledged and the associated risks to which the transferor continues to be exposed after the transfer:

  1. a. A disaggregation of the gross obligation by the class of collateral pledged. An entity should determine the appropriate level of disaggregation and classes to be presented on the basis of the nature, characteristics, and risks of the collateral pledged. Total borrowings under those agreements should be reconciled to the amount of the gross liability for repurchase agreements and securities lending transactions disclosed in accordance with item (a) in FASB ASC 210-20-50-3 before any adjustments for offsetting. Any difference between the amount of the gross obligation disclosed under this paragraph and the amount disclosed in accordance with item (a) in FASB ASC 210-20-50-3 should be presented as reconciling item(s).
  2. b. The remaining contractual maturity of the repurchase agreements, securities lending transactions, and repurchase-to-maturity transactions. An entity should use judgment to determine an appropriate range of maturity intervals that would convey an understanding of the overall maturity profile of the entity’s financing agreements.
  3. c. A discussion of the potential risks associated with the agreements and related collateral pledged, including obligations arising from a decline in the fair value of the collateral pledged and how those risks are managed.

10.85 Servicing assets and servicing liabilities disclosure requirements. For all servicing assets and servicing liabilities, an entity should disclose all of the following, according to FASB ASC 860-50-50-2:

  1. a. Management's basis for determining its classes of servicing assets and servicing liabilities
  2. b. A description of the risks inherent in servicing assets and servicing liabilities and, if applicable, the instruments used to mitigate the income statement effect of changes in fair value of the servicing assets and servicing liabilities
  3. c. The amount of contractually specified servicing fees (which is defined in the FASB ASC glossary), late fees, and ancillary fees earned for each period for which results of operations are presented, including a description of where each amount is reported in the statement of income
  4. d. Quantitative and qualitative information about the assumptions used to estimate fair value (for example, discount rates, anticipated credit losses, and prepayment speeds)

Disclosure of quantitative information about the instruments used to manage the risks inherent in servicing assets and servicing liabilities, including the fair value of those instruments at the beginning and end of the period, is encouraged but not required. An entity that provides such quantitative information is also encouraged, but not required, to disclose quantitative and qualitative information about the assumptions to estimate the fair value of those instruments. FASB ASC 235-10-50 provides guidance on disclosures of accounting policies.

10.86 For servicing assets and servicing liabilities subsequently measured at fair value, FASB ASC 860-50-50-3 states that for each class of servicing assets and servicing liabilities, the activity in the balance of servicing assets and the activity in the balance of servicing liabilities (including a description of where changes in fair value are reported in the statement of income for each period for which results of operations are presented), including, but not limited to, the following:

  1. a. The beginning and ending balances
  2. b. Additions through purchases of servicing assets, assumptions of servicing obligations, and servicing obligations that result from transfers of financial assets
  3. c. Disposals
  4. d. Changes in fair value during the period resulting from either changes in valuation inputs or assumptions used in the valuation model or other changes in fair value and a description of those changes
  5. e. Other changes that affect the balance and a description of those changes

10.87 According to FASB ASC 860-50-50-4, all of the following should be disclosed for servicing assets and servicing liabilities measured subsequently under the amortization method in item (a) in FASB ASC 860-50-35-1:

  1. a. For each class of servicing assets and servicing liabilities, the activity in the balance of servicing assets and the activity in the balance of servicing liabilities (including a description of where changes in the carrying amount are reported in the statement of income for each period for which results of operations are presented), including, but not limited to, the following:

i.  The beginning and ending balances.

ii.  Additions through purchases of servicing assets, assumption of servicing obligations, and recognition of servicing obligations that result from transfers of financial assets.

iii.  Disposals.

iv.  Amortization.

v.  Application of valuation allowance to adjust carrying value of servicing assets.

vi.  Other-than-temporary impairments.

vii.  Other changes that affect the balance and a description of those changes.

  1. b. For each class of servicing assets and servicing liabilities, the fair value of recognized servicing assets and servicing liabilities at the beginning and end of the period.
  2. c. The risk characteristics of the underlying financial assets used to stratify recognized servicing assets for purposes of measuring impairment in accordance with FASB ASC 860-50-35-9. If the predominant risk characteristics and resulting stratums are changed, that fact and the reasons for those changes should be included in the disclosures about the risk characteristics of the underlying financial assets used to stratify the recognized servicing assets in accordance with this paragraph.
  3. d. For each period for which results of operations are presented, the activity by class in any valuation allowance for impairment of recognized servicing assets including all of the following:

i.  Beginning and ending balances.

ii.  Aggregate additions charged and recoveries credited to operations.

iii.  Aggregate write-downs charged against the allowance.

10.88 Sales of financial assets disclosure requirements. For securitizations, asset-backed financing arrangements, and similar transfers that are accounted for as sales when the transferor has continuing involvement with the transferred financial assets, the entity should disclose all of the following for each income statement presented, as stated in FASB ASC 860-20-50-3:

  1. a. The characteristics of the transfer including all of the following:

i.  A description of the transferor’s continuing involvement with the transferred financial assets.

ii.  The nature and initial fair value of both (a) the asset obtained as proceeds and (b) the liabilities incurred in the transfer.

iii.  The gain or loss from sale of transferred financial assets.

  1. b. For the initial fair value measurements in item a(ii), the level within the fair value hierarchy in FASB ASC 820 in which the fair value measurement fall, segregating fair value measurements using each of the following:

i.  Quoted prices in active markets for identical assets or liabilities (level 1).

ii.  Significant other observable inputs (level 2).

iii.  Significant unobservable inputs (level 3).

  1. c. For the initial fair value measurements in item a(ii), the key inputs and assumptions used in measuring the fair value of assets obtained and liabilities incurred as a result of the sale that relate to the transferor’s continuing involvement, including quantitative information about all of the following:

i.  Discount rates.

ii.  Expected prepayments including the expected weighted-average life of prepayable financial assets. The weighted-average life of prepayable assets in periods (for example, months or years) can be calculated by multiplying the principal collections expected in each future period by the number of periods until that future period, summing those products, and dividing the sum by the initial principal balance.

iii.  Anticipated credit losses, including expected static pool losses.

  1.   If an entity has aggregated transfers during a period in accordance with the guidance beginning in FASB ASC 860-10-50-5, it may disclose the range of assumptions.
  2. d. For the initial fair value measurements in item a(ii), the valuation technique(s) used to measure fair value.
  3. e. Cash flows between a transferor and transferee, including all of the following:

i.  Proceeds from new transfers.

ii.  Proceeds from collections reinvested in revolving-period transfers.

iii.  Purchases of previously transferred financial assets.

iv.  Servicing fees.

v.  Cash flows received from a transferor’s interests.

10.89 According to FASB ASC 860-20-50-4, for securitizations, asset-backed financing arrangements, and similar transfers accounted for as sales when the transferor has continuing involvement with the transferred financial assets, the entity should disclose all of the following for each statement of financial position presented:

  1. a. Qualitative and quantitative information about the transferor’s continuing involvement with transferred financial assets that provides financial statement users with sufficient information to assess the reasons for the continuing involvement and the risks related to the transferred financial assets to which the transferor continues to be exposed after the transfer and the extent that the transferor’s risk profile has changed as a result of the transfer (including, but not limited to, credit risk, interest rate risk, and other risks), including all of the following:

i.  The total principal amount outstanding

ii.  The amount that has been derecognized

iii.  The amount that continues to be recognized in the statement of financial position

iv.  Whether the transferor has provided financial or other support during the periods presented that it was not previously contractually required to provide to the transferee or its beneficial interest holders, including—when the transferor assisted the transferee or its beneficial interest holders in obtaining support—both (a) the type and amount of support and (b) the primary reasons for providing the support

  1.   An entity also is encouraged to disclose information about any liquidity arrangements, guarantees, or other commitments by third parties related to the transferred financial assets that may affect the fair value or risk of the related transferor’s interest.
  2. b. The entity’s accounting policies for subsequently measuring assets or liabilities that relate to the continuing involvement with the transferred financial assets.
  3. c. The key inputs and assumptions used in measuring the fair value of assets or liabilities that relate to the transferor’s continuing involvement including, at a minimum, but not limited to, quantitative information about all of the following:

i.  Discount rates.

ii.  Expected prepayments including the expected weighted-average life of prepayable financial assets (see item (c)(2) in FASB ASC 860-20-50-3).

iii.  Anticipated credit losses, including expected static pool losses, if applicable. Expected static pool losses can be calculated by summing the actual and projected future credit losses and dividing the sum by the original balance of the pool of assets.

  1.   If an entity has aggregated transfers during a period in accordance with the guidance beginning in FASB ASC 860-10-50-5, it may disclose the range of assumptions.
  2. d. For the transferor’s interest in the transferred financial assets, a sensitivity analysis or stress test showing the hypothetical effect on the fair value of those interests (including any servicing assets or servicing liabilities) of two or more unfavorable variations from the expected levels for each key assumption that is reported under item c independently from any change in another key assumption.
  3. e. A description of the objectives, methodology, and limitations of the sensitivity analysis or stress test.
  4. f. Information about the asset quality of transferred financial assets and any other financial assets that it manages together with them. This information should be separated between assets that have been derecognized and assets that continue to be recognized in the statement of financial position. This information is intended to provide financial statement users with an understanding of the risks inherent in the transferred financial assets as well as in other financial assets and liabilities that it manages together with transferred financial assets. For example, information for receivables should include, but is not limited to both of the following:

i.  Delinquencies at the end of the period.

ii.  Credit losses, net of recoveries, during the period.

10.90 To provide an understanding of the nature of the transactions, the transferor’s continuing exposure to the transferred financial assets, and the presentation of the components of the transaction in the financial statements, FASB ASC 860-20-50-4D states that an entity should disclose the following for outstanding transactions at the reporting date that meet the scope guidance in paragraphs 4A–4B of FASB ASC 860-20-50 by type of transaction (for example, repurchase agreement, securities lending transaction, and sale and total return swap) (except for those transactions that are excluded from the scope, as described in FASB ASC 860-20-50-4C):4

  1. a. The carrying amount of assets derecognized as of the date of derecognition:

i.  If the amounts that have been derecognized have changed significantly from the amounts that have been derecognized in prior periods or are not representative of the activity throughout the period, a discussion of the reasons for the change should be disclosed.

  1. b. The amount of gross cash proceeds received by the transferor for the assets derecognized as of the date of derecognition.
  2. c. Information about the transferor’s ongoing exposure to the economic return on the transferred financial assets:

i.  As of the reporting date, the fair value of assets derecognized by the transferor.

ii.  Amounts reported in the statement of financial position arising from the transaction (for example, the carrying value or fair value of forward repurchase agreements or swap contracts). To the extent that those amounts are captured in the derivative disclosures presented in accordance with FASB ASC 815-10-50-4B, an entity should provide a cross-reference to the appropriate line item in that disclosure.

iii.  A description of the arrangements that result in the transferor retaining substantially all of the exposure to the economic return on the transferred financial assets and the risks related to those arrangements.

10.91 In addition, see chapter 18 of this guide for disclosures required for derivative instruments recognized in connection with mortgage banking activities.

10.92 FASB ASC 820-10-50 and FASB ASC 825-10-50 provide additional guidance related to fair value disclosures.

VIEs5

10.93 Financial institutions use securitization vehicles to pool and repackage mortgage loans, credit card loans and other assets. They also use asset-backed commercial paper conduits and collateralized debt and loan obligation vehicles to issue equity and debt to investor. Other common investment vehicles used by financial institutions include partnerships for low income housing or historic rehabilitation. These vehicles should be evaluated to determine if they are VIEs. A reporting entity that holds a direct or indirect (explicit or implicit) variable interest in a legal entity must determine whether the guidance in the "Variable Interest Entities" subsections of FASB ASC 810-10 applies to that legal entity before considering other consolidation guidance. However, if a reporting entity does not have a direct or indirect (explicit or implicit) variable interest in a legal entity, then the reporting entity is not the primary beneficiary of that legal entity and is not required to provide disclosures for that legal entity under FASB ASC 810-10 "Variable Interest Entities" subsections.6

10.94 Per the FASB ASC glossary, a variable interest is defined as an investment or other interest that will absorb portions of a VIE’s expected losses or receive portions of the entity’s expected residual returns. Variable interests in a VIE are contractual, ownership, or other pecuniary interests in a VIE that change with changes in the fair value of the VIE’s net assets exclusive of variable interests. Equity interests with or without voting rights are considered variable interests if the legal entity is a VIE and to the extent that the investment is at risk as described in FASB ASC 810-10-15-14 (see paragraph 10.98). FASB ASC 810-10-25-55 explains how to determine whether a variable interest in specified assets of a legal entity is a variable interest in the entity. Paragraphs 16–41 of FASB ASC 810-10-55 describe various types of variable interests and explain in general how they may affect the determination of the primary beneficiary of a VIE.

10.95 "Pending Content" in paragraphs 37–38 of FASB ASC 810-10-55 provides detailed guidance in determining whether fees paid to a legal entity’s decision maker or service provider constitute a variable interest.

10.96 The VIE guidance in FASB ASC 810-10 explains how to identify a VIE and how to determine when a reporting entity includes the assets, liabilities, noncontrolling interests, and results of activities of a VIE in its consolidated financial statements. VIEs are often created for a single specified purpose, for example, to facilitate securitization, leasing, hedging, research and development, reinsurance, or other transactions or arrangements. The distinction between VIEs and other entities is based on the nature and amount of the equity investment and the rights and obligations of the equity investors.

10.97 FASB ASC 810-10-15-12 provides exceptions to consolidation that apply to both VIEs and voting interest entities, whereas "Pending Content" in FASB ASC 810-10-15-17 provides a listing of entities exempt from consolidation under VIE guidance but that may be subject to consolidation under other GAAP.

Considerations for Private Companies that Elect to use Standards as Issued by the Private Company Council

FASB ASU No. 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements (a consensus of the Private Company Council), permits a private company lessee (the reporting entity) to elect an alternative not to apply VIE guidance to a lessor entity if the following criteria are met:

  • The private company lessee and the lessor legal entity are under common control.
  • The private company lessee has a lease arrangement with the lessor legal entity.
  • Substantially all activities between the private company lessee and the lessor legal entity are related to leasing activities (including supporting leasing activities) between those two entities.
  • If the private company lessee explicitly guarantees or provides collateral for any obligation of the lessor legal entity related to the asset leased by the private company, then the principal amount of the obligation at inception of such guarantee or collateral arrangement does not exceed the value of the asset leased by the private company from the lessor legal entity.

In accordance with FASB ASC 810-10-15-17B, the accounting alternative is an accounting policy election that, when elected, should be applied by a private company lessee to all current and future lessor entities under common control that meet the criteria for applying this approach. If any of the criteria for applying the alternative cease to be met, a private company should apply the VIE guidance at the date of change on a prospective basis.

VIE Determination

10.98 According to "Pending Content" in FASB ASC 810-10-15-14, a legal entity should be subject to consolidation under the VIE guidance subsections of FASB ASC 810, Consolidation, if, by design, any of the following conditions exist:

  1. a. The total equity investment at risk is not sufficient to permit the legal entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. For this purpose, the total equity investment at risk has all of the following characteristics:

i.  Includes only equity investments in the legal entity that participate significantly in profits and losses even if those investments do not carry voting rights.

ii.  Does not include equity interests that the legal entity issued in exchange for subordinated interests in other VIEs.

iii.  Does not include amounts provided to the equity investor directly or indirectly by the legal entity or by other parties involved with the legal entity, unless the provider is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

iv.  Does not include amounts financed for the equity investor directly by the legal entity or by other parties involved with the legal entity, unless that party is a parent, subsidiary, or affiliate of the investor that is required to be included in the same set of consolidated financial statements as the investor.

Paragraphs 45–47 of FASB ASC 810-10-25 discuss the amount of the total equity investment at risk that is necessary to permit a legal entity to finance its activities without additional subordinated financial support.

  1. b. As a group the holders of the equity investment at risk lack any of the following three characteristics:

i.  The power through voting rights or similar rights to direct the activities of a legal entity that most significantly impact the entity’s economic performance. The investors do not have the power through voting rights or similar rights if no owners hold voting rights or similar rights (such as those of a common shareholder in a corporation or a general partner in a partnership). Legal entities that are not controlled by the holder of a majority voting interest because of noncontrolling shareholder veto rights, as discussed in paragraphs 2–14 of FASB ASC 810-10-25, are not VIEs if the shareholders as a group have the power to control the entity and the equity investment meets the other requirements of the “Variable Interest Entities” subsections. Kick-out rights or participating rights, as defined in the FASB ASC glossary, held by the holders of the equity investment at risk should not prevent interests other than the equity investment from having this characteristic unless a single equity holder (including its related parties and de facto agents) has the unilateral ability to exercise such rights. Alternatively, interests other than the equity investment at risk that provide the holders of those interests with kick-out rights or participating rights should not prevent the equity holders from having this characteristic unless a single reporting entity (including its related parties and de facto agents) has the unilateral ability to exercise those rights. A decision maker also should not prevent the equity holders from having this characteristic unless the fees paid to the decision maker represent a variable interest based on paragraphs 37–38 of FASB ASC 810-10-55.

ii.  The obligation to absorb the expected losses of the legal entity. The investor or investors do not have that obligation if they are directly or indirectly protected from the expected losses or are guaranteed a return by the legal entity itself or by other parties involved with the legal entity.

iii.  The right to receive the expected residual returns of the legal entity. The investors do not have the right if their return is capped by the legal entity’s governing documents or arrangements with other variable interest holders or the legal entity.

If interests other than the equity investment at risk provide the holders of that investment with the characteristics of a controlling financial interest or if interests other than the equity investment at risk prevent the equity holders from having the necessary characteristics, the entity is a VIE.

  1. c. The equity investors as a group also are considered to lack the characteristics in item b(i) if both of the following conditions are present:

i.  The voting rights of some investors are not proportional to their obligations to absorb the expected losses of the legal entity, their rights to receive the expected residual returns of the legal entity, or both.

ii.  Substantially all of the legal entity’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights. This provision is necessary to prevent a primary beneficiary from avoiding consolidation of a VIE by organizing the legal entity with nonsubstantive voting interests.

For purposes of applying this requirement, reporting entities should consider each party’s obligations to absorb expected losses and rights to receive expected residual returns related to all of that party’s interests in the legal entity and not only to its equity investment at risk.

Reconsideration of VIE Status

10.99 A legal entity that previously was not subject to the VIE guidance presented in FASB ASC 810-10 should not become subject to it simply because of losses in excess of its expected losses that reduce the equity investment, according to "Pending Content" in FASB ASC 810-10-35-4. The initial determination of whether a legal entity is a VIE should be reconsidered if any of the following occur:

  1. a. The legal entity’s governing documents or contractual arrangements are changed in a manner that changes the characteristics or adequacy of the legal entity’s equity investment at risk
  2. b. The equity investment or some part thereof is returned to the equity investors, and other interests become exposed to expected losses of the legal entity
  3. c. The legal entity undertakes additional activities or acquires additional assets, beyond those that were anticipated at the later of the inception of the entity or the latest reconsideration event, that increase the entity’s expected losses
  4. d. The legal entity receives an additional equity investment that is at risk, or the legal entity curtails or modifies its activities in a way that decreases its expected losses
  5. e. Changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance

Primary Beneficiary Evaluation

10.100 In accordance with "Pending Content" in paragraphs 38–38A of FASB ASC 810-10-25, a reporting entity should consolidate a VIE when the reporting entity has a variable interest (or combination of variable interests) that provides the reporting entity with a controlling financial interest on the basis of the provisions in paragraphs 38A–38G of FASB ASC 810-10-25. A reporting entity should be deemed to have a controlling financial interest in a VIE, and thus is the VIE’s primary beneficiary, if it has both of the following characteristics:

  1. a. The power to direct the activities of the VIE that most significantly impact the VIE’s economic performance
  2. b. The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE

Auditing10

Objectives

10.110 Audit objectives and procedures for loan origination and underwriting are discussed in chapter 8 of this guide. Audit objectives and procedures for securities, including MBSs, are addressed in chapter 7 of this guide. The primary audit objectives in this area are to obtain sufficient appropriate evidence that

  1. a. loans HFS exist and the institution has the right to them;
  2. b. loans HFS are carried at the lower of cost or fair value, or at fair value if that election has been made;
  3. c. loans HFS are properly classified, described, and disclosed in the financial statements;
  4. d. transfers of financial assets, including through repurchase agreements and securitizations, have been properly accounted for as sales or secured borrowings;
  5. e. gains and losses on the transfer of financial assets or servicing rights are properly measured, recorded, and disclosed;
  6. f. assets retained or obtained as a result of a transfer of a financial asset accounted for as a sale are properly recognized and measured initially and on an ongoing basis;
  7. g. representations and warranty liabilities, recourse obligations and other liabilities assumed as a result of a transfer of a financial asset accounted for as a sale are measured appropriately initially and on an ongoing basis;
  8. h. transfers of servicing rights have been properly accounted for as sales or secured borrowings;
  9. i. servicing rights are properly measured upon and subsequent to initial recognition, including key assumptions such as prepayment speeds, discount rates and market cost-to-service;
  10. j. derivatives are properly identified, valued, recorded and disclosed;
  11. k. the entity has complied with the disclosure objectives and requirements for transfers of financial assets in FASB ASC 860 for all transfers of financial assets and other applicable disclosures in other FASB ASC topics;
  12. l. the entity has identified a complete population of VIEs in which it has variable interests and arrived at the appropriate conclusion as to whether each should be consolidated; and
  13. m. the entity has complied with the disclosure objectives and requirements for VIEs in FASB ASC 810.

Planning

10.111 In accordance with AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AICPA, Professional Standards), the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement (as described in chapter 5, “Audit Considerations and Certain Financial Reporting Matters,” of this guide). The following procedures related to loan transfers and mortgage banking activities assist the auditor in obtaining the required understanding:

  1. a. Obtain an understanding of the entity’s transfer and servicing activities
  2. b. Inquire about the nature and frequency of transfers, the types of loans transferred, the extent of continuing involvement with the transferred assets, and the nature of obligations incurred
  3. c. Inquire about the processes, procedures, and controls employed by the entity at both the time of transfer and thereafter for recognition, measurement, and disclosures related to the transfer and servicing of assets

10.112 To obtain an understanding of mortgage banking activities in which the institution is engaged, the auditor may inquire about how the mortgage banking activities relate to management's objectives for managing interest-rate risk and enhancing liquidity. The auditor may also inquire about the reporting systems used by management to account for mortgage banking activities and may consider whether management has sufficient data to evaluate loan sale transactions, identify loans HFS, and track mortgage loan commitments and applications. Such information is usually needed to manage risks arising from mortgage banking activities.

10.113 Institutions acting as servicers of loans have a fiduciary responsibility to parties under the agreement. Failure to meet these responsibilities may result in contingent liabilities that could have a material effect on an institution's financial statements. Under contracts with third parties such as Ginnie Mae, Freddie Mac, Fannie Mae, and the U.S. Department of Housing and Urban Development (HUD), an institution must meet certain minimum net worth requirements. Failure to meet the requirements could result in termination of the servicing contract or the loss of a seller servicer number. In addition, the auditor should consider and evaluate the risk of material misstatement of the financial statements that could result from the entity’s mortgage banking activities including the institution's servicing systems controls over investor and escrow accounts (for example, for taxes and insurance or loan principal and interest) and the potential for contingent liabilities associated with noncompliance with investor-servicing requirements.

10.114 Contractual agreements with Ginnie Mae, Freddie Mac, Fannie Mae, HUD, or other investors may require engagements related to aspects of the contractual agreement or to the SEC Regulation AB or the Uniform Single Attestation Program for Mortgage Bankers. These agreements may require confirmation of the loans being serviced under specific contracts.

Internal Control Over Financial Reporting and Possible Tests of Controls

10.115 AU-C section 315 addresses the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through understanding the entity and its environment, including the entity’s internal control. Paragraphs .13–.14 of AU-C section 315 state that the auditor should obtain an understanding of internal control relevant to the audit (such as mortgage loans HFS, participations sold, and individually significant securitization transactions) and, in doing so, should evaluate the design of those controls and determine whether they have been implemented by performing procedures in addition to inquiry of the entity’s personnel. (See chapter 5 of this guide for further discussion of the components of internal control.) To provide a basis for designing and performing further audit procedures, paragraph .26 of AU-C section 315 states that the auditor should identify and assess the risks of material misstatement at the financial statement level and the relevant assertion level for classes of transactions, account balances, and disclosures.

10.116 The discussions of internal control activities in chapters 8–9 of this guide are also relevant to loan transfers and mortgage banking activities.

10.117 Policies and procedures. Examples of typical internal control activities relating to financial reporting of mortgage banking activities include, but are not limited to,

  • use of a quality control function to monitor underwriting and documentation practices;
  • executive management review of open and pending commitments to buy or sell and strategies to minimize exposure to changing interest rates;
  • loans transferred with continuing involvement are properly identified to determine whether sale or secured borrowing treatment is appropriate;
  • review of ongoing valuation of outstanding derivatives;
  • periodic reconciliation of cash receipts and payments applied to the servicing (custodial) system;
  • periodic reconciliations of custodial accounts (the level of account activity could determine the frequency of reconciliation);
  • periodic reconciliation of servicing fees received to servicing fee income recorded in the general ledger;
  • periodic evaluation of the recoverability of servicing rights and other capitalized costs;
  • procedures are established and reviewed for distinguishing loans HFS from those held for investment;
  • procedures and systems are established to ensure that reconsideration of VIEs takes place on an ongoing basis;
  • procedures to review investments and interests of the entity for VIE considerations;
  • procedures to review the assumptions used in the accounting for servicing rights, including review of data inputs for accuracy, review of reasonableness of assumptions by a qualified person and review of the models used to calculate estimates; and
  • review of recourse obligation and evaluation of potential liabilities.

10.118 Examples of typical internal control activities relating to financial reporting of loan transfers include, but are not limited to,

  • approval of sales by appropriate officers or committees;
  • periodic reconciliations of detailed trial balances to the general ledger balance of loans HFS;
  • procedures in place to engage counsel to provide a legal opinion when deemed necessary to support the assertion that transferred financial assets have been legally isolated from the transferor;
  • periodic review of the outstanding loans and locked-in borrower commitments for proper valuation;
  • procedures in place to ensure that derivative loan commitments, derivative sales contracts, and loans HFS are properly identified and valued;
  • procedures in place to ensure that interest and fee income and gains or losses on sales are properly recorded, and information required for GAAP disclosures is complete and accurate; and
  • procedures in place to ensure that assets obtained and liabilities incurred as a result of a transfer of a financial asset accounted for as a sale are properly accounted for initially and on an ongoing basis.

10.119 AU-C section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained (AICPA, Professional Standards), addresses the auditor’s responsibility to design and implement responses to the risks of material misstatement identified and assessed by the auditor in accordance with AU-C section 315 and to evaluate the audit evidence obtained in an audit of financial statements.

10.120 In accordance with paragraph .08 of AU-C section 330, the auditor should design and perform tests of controls to obtain sufficient appropriate audit evidence about the operating effectiveness of relevant controls if (a) the auditor’s assessment of risks of material misstatement at the relevant assertion level includes an expectation that the controls are operating effectively or (b) substantive procedures alone do not provide sufficient appropriate audit evidence at the relevant assertion level. Tests of controls that may be used to obtain evidence to support such an assessment include

  • selecting a sample of borrower remittances and testing reconciliation of payment amounts to income, principal, escrow, and service fee accounts;
  • testing custodial account reconciliations and supporting documentation to assess whether all activity is processed and cleared currently;
  • selecting a sample of delinquent loans serviced and considering whether collection and follow-up procedures are performed on a timely basis and are in accordance with investor requirements and management’s policies; and
  • examining controls over loan documentation. (See chapter 8 of this guide.)

10.121 The following are examples of tests of controls that may be used by the auditor to ensure that internal control over financial reporting of mortgage banking activities are operating effectively:

  • Review accounting policy manual updates and consultations.
  • Review of valuation of outstanding derivatives.
  • Examine applicable loan sale and servicing agreements for appropriate review and approval.
  • Determine that the appropriate personnel understand the accounting treatment for sales of loans and related financial reporting implications.
  • Examine accounting records to determine that verification procedures are effectively performed to ensure interest and fee income and gains or losses on sales of loans are properly recorded.
  • Examine reconciliations of cash receipts and payments to custodial accounts and servicing fees to the general ledger.
  • Examine and assess management’s valuation of servicing rights, including the controls over data inputs, review of assumptions and model utilized.
  • Test management’s process for identifying VIEs, evaluating whether VIEs should be consolidations and identifying reconsideration events for VIEs.
  • Examine and assess management’s impairment analysis for servicing rights, if applicable, including management’s stratification of the portfolio for the impairment analysis.
  • Examine evidence of management’s review of financial statements and footnotes to ensure that all required disclosures are included.
  • Review of recourse obligations and potential liabilities to be recognized.

Substantive Tests

10.122 Irrespective of the assessed risks of material misstatement, paragraph .18 of AU-C section 330 states that the auditor should design and perform substantive procedures for all relevant assertions related to each material class of transactions, account balance, and disclosure, which for a financial institution may include transfers of loans and mortgage banking activities. In accordance with paragraph .A45 of AU-C section 330, this requirement reflects the facts that (a) the auditor’s assessment of risk is judgmental and may not identify all risks of material misstatement and (b) inherent limitations to internal control exist, including management override.

10.123 Paragraph .06 of AU-C section 330 states that the auditor should design and perform further audit procedures whose nature, timing, and extent are based on, and responsive to, the assessed risks of material misstatement at the relevant assertion level. Examples of substantive tests that the auditor may perform include the following:

  • Selecting a sample of borrower remittances and testing allocation of payment amounts to income, principal, escrow, and service fee accounts.
  • Obtaining and testing the documentation supporting escrow and investor account reconciliations. (Custodial accounts may be off-balance-sheet accounts. Accordingly, the auditor may need to select custodial accounts from records independent of the general ledger. In this case, the auditor may need to perform separate tests of the completeness and accuracy of custodial records.)
  • Obtaining and testing supporting documentation for derivatives and related fair value determinations.
  • Evaluating the propriety of loan classifications to determine that all loans HFS within the loan portfolio are properly identified. (In evaluating whether loans are HFS or held for investment, the auditor should consider management policy and practices, for example, previous loan sale activity, types of loans sold, transactions subsequent to year-end, and pending contracts, and whether management has the ability and intent to hold the loans for the foreseeable future or until maturity.)
  • Assessing the documentation and recalculating the amounts supporting the measurement of lower of cost or fair value for loans HFS, or fair value should that election have been made.
  • Selecting a sample of financial asset transfers during the period and examining contracts to evaluate whether sale-versus-secured borrowing treatment and servicing assets and liabilities have been recognized properly. Interpretation No. 1, “The Use of Legal Interpretations As Audit Evidence to Support Management’s assertion That A Transfer of Financial Assets Has Met the Isolation Criterion in Paragraphs 7–14 of FASB ASC 860-10-40” (AICPA, Professional Standards, AU-C sec. 9620 par. .01–.21), of AU-C section 620, Using the Work of an Auditor’s Specialist, provides guidance to the auditor in obtaining sufficient appropriate audit evidence when an entity has derecognized financial assets in connection with a transfer to another entity.11
  • Recalculating a sample of financial asset sale transactions to test gains or losses by testing the valuation of assets retained and liabilities assumed and vouching payments received for those transactions.
  • Analytically projecting service fees for comparison to such expectations with service fee revenues reported in operating income for the period.
  • Analytically assessing gain on sale to the volume of loans sold and comparing this to auditor expectations.
  • Assessing the fair values of derivative loan commitments, derivative sales contracts, and loans HFS against the related notional amount and for directional consistency between the accounts.
  • Evaluating the adequacy of valuation allowances for servicing and escrow advances. (Some investors require that contractual interest and principal be remitted to them by the servicer regardless of mortgagor performance. Advances of such amounts are frequently made in anticipation of borrower performance and generally must be tracked on an individual basis to limit exposure to uncollectible advances.)
  • For servicing rights, assessing the assumptions used in the valuation process, considering their current reasonableness, and evaluating the effect of changes in assumptions on impairment or fair value measurement. Key assumptions include prepayment speeds, discount rates, cost-to-service and ancillary income.
  • Analyzing prepayment data used by management to calculate the fair value of servicing rights at sale date and the systems used to update prepayment data over time for actual prepayment experience, selecting a sample of loan pools sold in prior periods, and comparing the actual current loan balance with management estimates.
  • Evaluating the reasonableness of cost-to-service assumptions used to calculate the fair value of servicing rights, considering that a fair value should consider a market participant’s cost-to-service rather than the institution’s internal cost-to-service.
  • Analytically assessing the ancillary income assumptions used to calculate the fair value of servicing rights.
  • Analytically assessing the amount of initial servicing rights and ending servicing rights in relation to the related loan balances at those respective dates to auditor expectations.
  • Evaluating the method of amortizing servicing rights, if applicable, including key assumptions like the methodology for stratification of the portfolio for impairment purposes.
  • Evaluating the appropriateness of the liability for recourse obligations. Loan sale or servicing agreements generally address recourse provisions and should be reviewed for all substantial investors to ensure that portfolios sold with recourse are included in recourse liability considerations.
  • Confirming selected loan balances serviced for others and related information directly with the borrower, investor, or trustee.
  • Reviewing legal documents (such as bylaws and servicing agreements) for securitization trusts and other VIEs to determine that consolidation or nonconsolidation is appropriate.
  • Obtaining legal opinions for securitizations derecognized from the balance sheet.
  • Reviewing financial statements and footnotes to determine that all required disclosures have been made.

Notes

  1. a. Transfers of financial assets with an agreement to repurchase the transferred financial asset (or a substantially-the-same financial asset) before maturity at a fixed or determinable price that will be settled in a form other than the return of the transferred financial asset (for example, the transaction is cash-settled).
  2. b. Transfers of financial assets with an agreement that requires that the transferor retain substantially all of the exposure to the economic return on the transferred financial asset (for example, a sale with a total return swap).
  1. a. Transfers of financial assets with an agreement to purchase another financial asset that is not substantially the same as the initial transferred financial asset in accordance with item (a) in FASB ASC 860-10-40-24, for example, a dollar roll transaction accounted for as a sale because the financial asset to be purchased is not substantially the same as the initially transferred financial assets in accordance with item (a) in FASB ASC 860-10-40-24.
  2. b. Securitizations, asset-backed financing arrangements, and similar transfers, in which both the transfer is accounted for as a sale and the transferor has continuing involvement with the transferred financial assets, that are subject to the disclosures in paragraphs 3–4 of FASB ASC 860-20-50.

__________________________