Many owners of mortgage servicing rights are exposing themselves to undue mark-to-market volatility through the short-sighted definition of risk/impairment tranches.

Owners of mortgage servicing rights, using the amortization accounting method, are required under ASC860 to:

• Stratify the assets by risk tranche; and
• Recognize impairment through a valuation of each tranche.  

Stratifying the assets by risk tranche is not a trivial decision.

Stratification requires a management decision defining tranches “based on one or more of the predominant risk characteristics of the underlying assets.  These characteristics may include financial type, size, interest rate, date of origination, term, and geographic location.”  Many of our clients have selected interest rate as the predominant risk characteristic.  This is pretty much a guarantee that there will be an impairment at some point in the future.

As can be seen in the provided chart, this client defined risk tranches by coupon range.  As might be expected, 95% of their portfolio has coupons under 5.5%.  Additionally, the total market value exceeds their remaining basis by $257,628.  Yet, they still have an impairment of $11,122!

The problem is that ASC860 goes on to say that “the amount of impairment recognized separately shall be the amount by which the carrying amount of servicing assets exceeds their fair value. … Fair value in excess of the carrying amount of servicing assets for that stratum, however, shall not be recognized.”  By defining risk tranches by coupon ranges, impairments are inevitable over an interest rate cycle.

Yet there are other defensible tranche definitions.  Other clients use:

• product type (e.g. government, conventional insured, uninsured, etc.)
• investor (e.g. FHLB, GNMA, FNMA, Private, etc.)
• originator (retail versus purchased)
• among many others.  

Any of these alternative tranche definitions would have resulted in no impairment in the example given above.

Defining impairment tranches requires a good deal of thought.  Once decided upon, it can be very difficult to change (but not impossible). The overall goal should be to:

• Define “risk” as anything but interest rate volatility.  Interest rate volatility is a certainty (not a risk) in our industry, and should be incorporated into the initial basis.
• Minimize the number of risk tranches depending on the size of the servicing portfolio.  The fewer the number of tranches, the lower the probability of an eventual impairment.

While the probability of impairments cannot be eliminated, it can certainly be minimized.

In a constantly shifting interest rate environment, minimizing MSR impairment risk requires more than just compliance—it demands strategic insight. The way you define risk tranches can significantly affect your exposure to volatility and unnecessary write-downs. Your institution’s best bet is to work with a partner that not only understands the nuances of ASC860, but also brings deep, data-driven expertise to guide smarter tranche definitions and valuation decisions. At Level1Analytics, we help institutions navigate complex servicing challenges with clarity and confidence—so you can stay ahead, no matter how the market moves.

 ¹ASC860