The financial reporting of fair value based on managerial inputs versus market inputs: evidence from mortgage servicing rights

Abstract

This research examines whether the fair value of mortgage servicing rights (MSRs) based on managerial inputs (Level 3) better reflects the cash flow and risk characteristics of the underlying assets than the fair value of MSRs based on market inputs (Level 2). Using mortgage servicing fees as a proxy for the underlying cash flows, we find that the valuation multiples for MSRs based on Level 3 inputs are more positively associated with the persistence of future servicing fees compared with the fair value of MSRs based on Level 2 inputs. We also document that only the valuation multiples based on Level 3 fair values are negatively associated with proxies for risk factors. Our results suggest that, although unobservable inputs are subject to managerial discretions, managers can generate higher quality fair value estimates than market inputs due to their information advantage, especially when the market for the underlying asset is inactive. ABSTRACTThis research studies one specific financial instrument -Mortgage Servicing Rights (MSRs) and examines whether the fair value of MSRs based on managerial inputs (Level 3) has financial reporting characteristics that differ from the fair value of MSRs based on market inputs (Level 2). Since fair value represents discounted future cash flows, we use future mortgage servicing fees as a proxy for future cash flows and measure whether the fair value of MSRs reflects the persistence of future servicing fees. We find that the fair value of MSRs based on managerial inputs (Level 3) better reflects the persistence of future servicing fees compared with the fair value of MSRs based on market inputs (Level 2). We also document that Level 3 fair values have a stronger association with proxies for default risk and prepayment risk. Consistent with conjectures made by Ryan (2008) and Laux and Leuz (2009), our results suggest that, although unobservable inputs are subject to managerial discretions, managers have the potential to generate higher quality fair value estimates than market inputs due to their information advantage, especially when the market for the underlying asset is inactive.

Private Equity Valuation Before and After ASC 820

“…On the other hand,Lawrence et al (2016) find that, in a sample of closed-end funds, Level 3 fair values are of similar value relevance to Level 1 and Level 2 fair values. In a mortgage servicing setting,Altamuro and Zhang (2013) find that valuations based on Level 3 inputs are more positively related to the persistence of future cash flows than are valuations based on Level 2 inputs.…”

“…Several studies explore differences across underlying asset types (Levels 1, 2, and 3) in value relevance (Song, Thomas, and Yi 2010;Lawrence, Siriviriyakul, and Sloan 2016), information risk (Riedl and Serafeim 2011), and representational faithfulness (Altamuro and Zhang 2013).…”

Fair Value Measurement in Financial Reporting

“…In contrast to these studies, Altamuro and Zhang [2013] propose that, compared to mortgage servicing rights (MSRs) estimated using Level 2 inputs, MSRs estimated using Level 3 inputs will have lower levels of information risk and better estimation quality. Their prediction is based on the fact that the fair value of MSRs is calculated as the sum of the discounted expected future cash flows for pools of loans associated with the MSRs, and that, as compared to adjustment of generally available pricing indices (i.e., Level 2 inputs), managers possess superior information about loan prepayments and other factors that affect the cash flows from loans.…”

“…As noted by Hendricks and Shakespeare [2013], the MSR setting used by Altamuro and Zhang [2013] is a source of research-design strength because it focuses on a single financial instrument. The setting also includes features that impede drawing clear conclusions about the relative reliability of Level 2 versus Level 3 fair value measurements.…”

Fool's gold or value for money? The link between abnormal audit fees, audit firm type, fair‐value disclosures, and market valuation

“…Altamuro and Zhang () used the example of mortgage servicing rights to document a situation in which the Level 3 inputs are preferable to the Level 2 inputs. However, because their findings are based on a small market with very special characteristics, the influence of that particular asset class on the aggregated fair‐value assets per level should be small (Hendricks & Shakespeare, ).…”