6.2 Servicing overview

Servicing is inherent in all financial assets. Servicing rights are most often associated with assets such as mortgage loans, credit card receivables, automobile loans, and trade receivables. The contractual right to service financial assets that are held by a third party can be developed or acquired through a variety of means, including explicitly through a contract or implicitly through the origination of a financial asset.

Many activities fall under the umbrella of servicing, including:

Collecting principal, interest, and escrow payments from borrowers
Paying taxes and insurance from escrowed funds
Monitoring delinquencies
Completing workouts/restructurings
Executing foreclosures
Remitting fees to guarantors, trustees, and others providing services
Accounting for and remitting principal and interest payments to the holders of beneficial interests or participating interests in the financial assets

The benefits of servicing contracts are typically made up of several components, including contractually specified servicing fees and the right to collect other ancillary sources of income, such as float and late charges. In some cases (e.g., mortgage servicing contracts), the contractually specified servicing fees are set at a level above what is necessary to generate enough cash flow to maintain profitable servicing operations. The incremental future cash flows are intended to align the interests of the servicer with that of the mortgage-backed security (MBS) holders and borrowers. If a servicer is entitled to cash flows in excess of an amount that would adequately compensate the servicer for performing the required servicing duties, it should recognize a servicing asset provided the requirements of ASC 860 have been met. See TS 6.3.1 for information on when a servicing right should be separately recognized.

Servicing rights come with related risks. The fair value of a servicing right is subject to interest rate and prepayment risks. Prepayments are driven (in part) by a consumer’s sensitivity to changing interest rates, which are difficult to predict. Additionally, servicers of mortgage loans and other asset-backed securities may be subject to specific servicing standards. As a result, they may also face operational, regulatory, and reputational risks.

Companies often manage or protect against the financial risks of servicing (the unexpected change in fair value) associated with early prepayment by using derivative financial instruments and investment securities. Typical risk management products include interest rate floors, caps, swaps and swaptions, agency MBS, forward contracts, Treasury and Eurodollar futures contracts, and options on futures contracts.

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