MORTGAGE BANKING

12 Months Ended

Dec. 31, 2019

NOTE 7 - MORTGAGE BANKING

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.

Mortgage loans held for sale are accounted for at fair value on an individual loan basis. Changes in the fair value, and realized gains and losses on the sales of mortgage loans, are reported in mortgage banking income.

The following table summarizes activity related to the Company’s residential mortgage loan sales and the Company's mortgage banking activity:



	Year Ended December 31,
(in millions)	2019		2018		2017
Residential mortgage loan sold with servicing retained		$20,430		$8,149		$3,161
Gain on sales⁽¹⁾	251		89		35
Contractually specified servicing, late and other ancillary fees⁽¹⁾	208		118		53

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

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. MSRs are initially recorded at fair value. Subsequent to the initial recognition, MSRs are measured using either the fair value method or the amortization method. MSRs accounted for under the amortization method are subsequently accounted for at lower of cost or fair value, net of accumulated amortization, which is recorded in proportion to, and over the period of, net servicing income. The unpaid principal balance of the related residential mortgage loans was $77.5 billion and $69.6 billion as of December 31, 2019 and 2018, respectively.

In connection with the August 1, 2018 acquisition of FAMC, the Company began maintaining two separate classes of MSRs which, at the time of initial capitalization, were differentiated by how the risk associated with valuation changes of the MSRs was being 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. Depending on the interest rate environment, economic hedges may be used to protect the market value of MSRs accounted for under the amortization method. Any changes 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, are recorded in mortgage banking fees in the Consolidated Statements of Operations.

The following table summarizes changes in MSRs recorded using the amortization method:



	As of and for the Year Ended December 31,
(in millions)	2019			2018
Mortgage servicing rights:
Balance as of beginning of period		$221			$201
Amount capitalized	—			36
Purchases	—			16
Amortization	(38		)	(32		)
Carrying amount before valuation allowance	183			221
Valuation allowance for servicing assets:
Balance as of beginning of period	—			3
Valuation charge-offs (recoveries)	1			(3		)
Balance at end of period	1			—
Net carrying value of MSRs		$182			$221

The following table summarizes changes in MSRs recorded using the fair value method:



	As of and for the Year Ended December 31,
(in millions)	2019			2018
Fair value as of beginning of the period		$600			$—
Acquired MSRs	—			590
Amounts capitalized	270			73
Changes in unpaid principal balance during the period ⁽¹⁾	(119		)	(32		)
Changes in fair value during the period ⁽²⁾	(109		)	(31		)
Fair value at end of the period		$642			$600

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

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 analyses below present the impact to current fair value of an immediate 50 basis point and 100 basis point adverse change in key economic assumptions and the decline in fair value if the respective adverse change was realized. These sensitivities are hypothetical, with the effect of a variation in a particular assumption on the fair value of the MSRs 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:



	December 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	$193	50 bps adverse change	100 bps adverse change	$243	50 bps adverse change	100 bps adverse change
Weighted average life (in years)	6.4	50 bps adverse change	100 bps adverse change	6.5	50 bps adverse change	100 bps adverse change
Weighted average constant prepayment rate	8.9%	$28	$53	8.5%	$24	$56
Weighted average discount rate	9.4%	4	7	9.3%	5	9

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



	December 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	$642	50 bps adverse change	100 bps adverse change	$600	50 bps adverse change	100 bps adverse change
Weighted average life (in years)	5.5	50 bps adverse change	100 bps adverse change	8.0	50 bps adverse change	100 bps adverse change
Weighted average constant prepayment rate	13.9%	$116	$222	8.2%	$68	$148
Weighted average option adjusted spread	440 bps	12	25	609 bps	13	26

Citizens accounts for derivatives in its mortgage banking operations at fair value on the Consolidated Balance Sheets 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 13 for additional information.