This final installment in our mortgage servicing series is an article discussing the audit guidance relevant to advance reserves. Our first article discussed ways to prepare your organization for the possibility of increased mortgage defaults, and our second article discussed what happens in the servicing process when a loan becomes delinquent. Article three included applicable accounting guidance for mortgage servicers. For more information on the subject, visit the Mortgage Center of Excellence.
When testing the advance reserve, it is common practice for engagement teams, both external audit and internal audit, to test management’s reserve model as opposed to performing an independent assessment or subsequent activity analysis. It can be difficult or inefficient to independently determine an appropriate reserve given the multiple data points and inputs needed for the advance reserve. Further, given the filing requirements for SEC issuers, performing a subsequent activity analysis generally does not allow for enough time to determine if the advance reserve was adequate. Outlined below are common steps involved in auditing the advance reserve.
When evaluating a company’s methodology for reserving for advances, engagement teams should first consider if the methods used to develop the advance reserve estimate are in conformity with generally accepted accounting principles (GAAP) and appropriate given the engagement team’s understanding of the company and its operating environment. For the advance reserve, auditors should determine if the reserve conforms with the accounting codification that is appropriate based on whether the losses are tied to credit or operating losses (see article three). The determination of the accounting guidance is concurrent with understanding the entity.
Many servicers believe that losses on advances relate to the precision of processing claims, along with the precision of loss mitigation procedures. As such, losses related to credit risk are trivial, and generally fall outside of an Accounting Standards Codification 326 (ASC 326) reserve evaluation. The auditor should confirm the client’s position through their understanding of the entity by reviewing the types of losses experienced, and how these losses align with investor and agency guidelines. If the auditor cannot confirm that losses are related to non-precise or untimely claim operations, or if the auditor discovers contradictory evidence such as losses related to credit exposure, then the auditor should evaluate if the company’s method was appropriate or if further assessment is required.
While all of the steps in testing the advance reserve are important, the procedures performed on “testing the data utilized” – including the completeness and accuracy of the information included in the reserve – is the step that is most often scrutinized. There are several pieces of information that go into an advance reserve:
The servicer advance detail (subledger) houses the information that will drive the reserve and includes data such as advance balance, type of advance (P&I, T&I and foreclosure related) bifurcated between agency and non-agency buckets, delinquency status, foreclosure status, and whether it is recoverable or non-recoverable. Engagement teams should test the completeness and accuracy of the advance detail.
As it relates to the completeness of the advance detail, a reconciliation of the detail to the servicing system is a common completeness test. However, in practice, due to system limitations or the significant volume of transactions, it could be challenging to maintain a precise advance subledger. Given this, engagement teams should also consider performing additional completeness procedures such as the following:
The completeness of the subledger is important from a reporting standpoint, but also from a valuation perspective, as an understatement of the detail could lead to an understatement of the reserve (i.e., less advances to reserve for).
For the accuracy of the advance detail, the engagement team should determine what detail is ultimately driving the advance loss reserve and subject them to substantive testing. The advance balance is an obvious driver of the reserve and engagement teams should perform procedures over the existence and accuracy of the balance. Engagement teams should also look at agency type, as each agency has different guidelines for recoverability. The Government National Mortgage Association or GNMA (Ginnie Mae) guidelines generally result in smaller recoverable balances, and as such, a GNMA advance reserve could reflect a larger amount of non-recoverable advances whereas a Federal National Mortgage Association or “FNMA” and Federal Home Loan Mortgage Corporation or FHLMC reserve may reflect larger recoveries.
Also, engagement teams should test the type of advance (P&I, T&I, foreclosure/other) as certain advances are typically non-recoverable or have limits on what is recoverable and therefore, such advances would have a larger amount of reserve or would be directly expensed. For agency type, advance type, or other pertinent fields that drive the advance reserve, engagement teams should leverage their existence and accuracy procedures performed over the advance balance. Alternatively, teams can perform a test of details, commonly known as an attribute test, to ensure accuracy. The engagement team should also test controls around how advances and related vendor expenses are coded in the servicing system and the controls around the accuracy of vendor remittances and investor reporting.
The general ledger (GL) typically is a separate system or record for the advance balance. Therefore, the completeness of the advance GL balances is supported through a reconciliation to the advance subledger. If there are discrepancies between the GL and the advance detail, engagement teams should understand the reconciling items and its potential impact on the advance reserve. Through routine audit procedures such as GL completeness, journal entry testing and various other account reconciliations, engagement teams are able to gain comfort over the completeness and accuracy of the general ledger. However, it is important to note that the GL itself (or reconciliation of the subledger to the GL), is not always a sufficient audit procedure to ensure the completeness of the servicer advance detail, as there could be a “garbage in, garbage out” argument if the GL is being populated from faulty information.
Historical claim losses by type are often a key input to the reserve. Engagement teams should perform completeness and accuracy procedures over the claim losses.
When leveraging subservicers, the engagement team should assess the relevant Statement on Standards for Attestation Engagements “SSAE” 18 System and Organizational Controls “SOC” 1 reports to verify that the controls highlighted above are in place and operating effectively.
The assumptions that most often drive the advance reserve, relate to recoverability verse non-recoverability, historical losses, agency type, and status.
The recoverability of advances is often dictated by the agency. Engagement teams must evaluate the criteria used to properly classify or segment advances and determine recoverability. Advances may be 100% recoverable, or there may be a percentage that is not recoverable. The team should challenge management’s assumption on recoverability by examining past performance via servicer data.
The utilization of historical losses to predict losses that currently exist in the advance portfolio is a common input utilized in advance reserve models. Additionally, management typically has an associated lookback period for the losses and may place more weight on losses in current periods as they may be more indicative of the current state, in terms of recoverability guidelines, servicing operations, and borrower performance. Audit teams should examine the lookback period for any potential bias and consider if the data was included or excluded and whether that would change the reserve significantly. For instance, if the period utilized for historical losses is from a period with minimal losses, but the upcoming period is expected to yield higher losses, the auditor should challenge whether the lookback period is appropriate. In addition, a lookback test provides additional support to identify if losses recognized were recoverable or non-recoverable under investor and agency guidelines or whether it is related to operational errors. This lookback test can provide further evidence that management has historically reserved for and bucketed their advances appropriately.
The type of advance and its corresponding recovery rate can vary. Principal is often considered largely recoverable whereas interest is generally not fully recoverable at the current note rate. Also, each agency dictates which advances are recoverable, such as their guidelines for various corporate advances, and as such, agency type can play an important role in the reserve estimate. Accordingly, it is not uncommon for losses on GNMA advances to be higher than losses on other agencies due to the nature and volume of the advance transactions. According to the Congressional Budget Office (CBO), “Ginnie Mae would be exposed to the risk of large losses in a period of severe economic stress that included high default rates on mortgages.” Due to the nature of the GNMA program, GNMA loans are typically on houses with lower valuations to a broader range of homeowners with qualifying credit criteria; therefore, liquidation costs could be higher related to property preservation.
One additional nuance to advance type, relates to whether advances were recognized through the normal course of business or acquired through a business combination. In a business combination, the purchase accounting adjustments related to the fair value of the advances would factor into the required reserve calculation. When advances are acquired, the fair value mark typically represents the expected losses plus the time value of money component related to the fair value discount. As such, segmentation by agency type and the recoverability of advances by type, are important assumptions that engagement teams should subject to their testing procedures.
Status of an advance can relate to whether there is an active MSR, if the loan is paid in full or if the servicing was sold or transferred. The active versus inactive status of an MSR drives a few considerations. If active, the chance of recovering the advance will be higher as the company being audited is still servicing the loan; however, if the company does not have an active MSR, it becomes increasingly more difficult to collect advances since the company’s servicing department is no longer in charge of collection or is actively working the customer. This is also likely the case for loans that have been paid in full. Accordingly, there may be assumptions related to collectability based on the active or inactive status of an MSR and whether the loan has been paid in full.
Another consideration for active MSRs is when a Company elects to fair value their MSRs, where they often build in an advance loss/recoverability rate in the valuation. As such, when reviewing the advance reserve, it is important to test that advances associated with MSRs carried at fair value are not grossing up the advance reserve estimate.
Auditing the advance reserve estimate for mortgage companies involves evaluating methods, testing the completeness and accuracy of data, and assessing key assumptions. By challenging management's assumptions, reviewing historical performance, and considering industry guidelines, auditors can provide valuable assurance on the adequacy of the advance reserve estimate.
This article aims to help you better understand servicing advances from an audit perspective. Companies and interested parties should monitor developments in servicing advances and contact their accountants, consultants and industry specialists prior to taking instruction from this article. Baker Tilly professionals are available to discuss your questions and individual needs through our Mortgage Center of Excellence.
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Co-author Matt Petrick, CPA is a senior finance and accounting executive specializing in the financial services industry, with a focus on mortgage and servicing entities. Matt has experience with REITs, financial institutions, business development companies and other funds. The discussions throughout the article should not be implied to represent the position, processes, or procedures of professional affiliations, current or former employers, or employer relationships.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought.
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