NOTE 5 - MORTGAGE BANKING

In its mortgage banking business, the Company sells residential mortgages to GSEs and other parties, who may issue securities backed by pools of such loans. The Company retains no beneficial interests in these sales, but may retain the servicing rights for the loans sold. The Company is obligated to subsequently repurchase a loan if the purchaser discovers a representation or warranty violation such as noncompliance with eligibility or servicing requirements, or customer fraud that should have been identified in a loan file review.

The Company recognizes the right to service residential mortgage loans for others, or MSRs, as separate assets, which are presented in other assets on the Consolidated Balance Sheets, when purchased, or when servicing is contractually separated from the underlying mortgage loans by sale with servicing rights retained. The following table summarizes activity related to residential mortgage loans sold with servicing rights retained for the three months ended March 31, 2019 and 2018.



	Three Months Ended March 31,
(in millions)	2019		2018
Residential mortgage loans sold with servicing retained		$2,919		$655
Gain on sales ⁽¹⁾	37		13
Contractually specified servicing, late and other ancillary fees⁽¹⁾	48		15

⁽¹⁾ Reported in mortgage banking fees on the Consolidated Statements of Operations.

As of August 1, 2018, the Company maintains two separate classes of MSRs which at the time of initial capitalization, are differentiated by how the risk associated with valuation changes of the MSRs is managed. The acquired FAMC portfolio is accounted for under the fair value method while the Company’s MSR portfolio held before the FAMC acquisition is accounted for under the amortization method. Beginning January 1, 2019, all of the Company’s newly originated MSRs are accounted for under the fair value method. The Company implemented an active hedging strategy to manage the risk associated with changes in the value of the MSR portfolio accounted for under the fair value method, which includes the purchase of freestanding derivatives. Any change in fair value during the period for MSRs carried under the fair value method, as well as amortization and impairment of MSRs under the amortization method, is recorded in mortgage banking fees in the Consolidated Statements of Operations.

The following table summarizes changes in MSRs recorded using the amortization method for the three months ended March 31, 2019 and 2018.



	As of and for the Three Months Ended March 31,
(in millions)	2019			2018
Mortgage servicing rights:
Balance as of beginning of period		$221			$201
Amount capitalized	—			8
Amortization	(9		)	(8		)
Carrying amount before valuation allowance	212			201
Valuation allowance for servicing assets:
Balance as of beginning of period	—			3
Valuation recoveries	—			(3		)
Balance at end of period	—			—
Net carrying value of MSRs		$212			$201

The following table summarizes changes in MSRs recorded using the fair value method for the three months ended March 31, 2019. There were no MSRs recorded using the fair value method for the three months ended March 31, 2018.



	Three Months Ended March 31, 2019
(in millions)	Three Months Ended March 31, 2019
Fair value as of beginning of the period		$600
Amounts capitalized	35
Changes in unpaid principal balance during the period ⁽¹⁾	(26		)
Changes in fair value during the period ⁽²⁾	(46		)
Fair value at end of the period		$563

⁽¹⁾ Represents changes in value due to i) passage of time including the impact from both regularly scheduled loan principal payments and partial paydowns, and ii)

loans that paid off during the period.

⁽²⁾ Represents changes in value primarily due to market driven changes in interest rates and prepayment speeds.

The fair value of MSRs is estimated by using the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, contractual servicing fee income, servicing costs, default rates, ancillary income, and other economic factors, which are determined based on current market interest rates. The valuation does not attempt to forecast or predict the future direction of interest rates.

The sensitivity analysis below presents the impact to current fair value of an immediate 50 basis point and 100 basis point adverse change in the key economic assumptions and presents the decline in fair value that would occur if the adverse change were realized. These sensitivities are hypothetical, with the effect of a variation in a particular assumption on the fair value of the mortgage servicing rights calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (e.g., changes in interest rates, which drive changes in prepayment rates, could result in changes in the discount rates), which may amplify or counteract the sensitivities. The primary risk inherent in the Company’s MSRs is an increase in prepayments of the underlying mortgage loans serviced, which is dependent upon movements in market interest rates.

For MSRs under the amortization method, the key economic assumptions used to estimate the fair value are presented below:



	March 31, 2019			December 31, 2018
	Actual	Decline in fair value due to		Actual	Decline in fair value due to
(dollars in millions)	Actual	Decline in fair value due to		Actual	Decline in fair value due to
Fair value	$224	50 bps adverse change	100 bps adverse change	$243	50 bps adverse change	100 bps adverse change
Weighted average life (in years)	6.1	50 bps adverse change	100 bps adverse change	6.5	50 bps adverse change	100 bps adverse change
Weighted average constant prepayment rate	9.6%	$27	$58	8.5%	$24	$56
Weighted average discount rate	9.3%	4	8	9.3%	5	9

For MSRs under the fair value method, the key economic assumptions used to estimate the fair value are presented below:



	March 31, 2019			December 31, 2018
	Actual	Decline in fair value due to		Actual	Decline in fair value due to
(dollars in millions)	Actual	Decline in fair value due to		Actual	Decline in fair value due to
Fair value	$563	50 bps adverse change	100 bps adverse change	$600	50 bps adverse change	100 bps adverse change
Weighted average life (in years)	6.7	50 bps adverse change	100 bps adverse change	8.0	50 bps adverse change	100 bps adverse change
Weighted average constant prepayment rate	10.7%	$81	$177	8.2%	$68	$148
Weighted average option adjusted spread	568 bps	11	22	609 bps	13	26

Citizens accounts for derivatives in its mortgage banking operations at fair value on the balance sheet as derivative assets or derivative liabilities, depending on whether the derivative had a positive (asset) or negative (liability) fair value as of the balance sheet date. The Company’s mortgage banking derivatives include commitments to originate mortgages held for sale, certain loan sale agreements, and other financial instruments that meet the definition of a derivative. Refer to Note 9 "Derivatives" for additional information.