MORTGAGE BANKING

9 Months Ended

Sep. 30, 2020

NOTE 5 - MORTGAGE BANKING AND OTHER

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:



	Three Months Ended September 30,				Nine Months Ended September 30,
(in millions)	2020		2019		2020		2019
Cash proceeds from residential mortgage loans sold with servicing retained		$9,504		$6,117		$23,668		$13,265
Gain on sales ⁽¹⁾	273		88		699		180
Contractually specified servicing, late and other ancillary fees⁽¹⁾	56		53		169		152

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

Effective January 1, 2020, the Company elected to account for all MSRs previously accounted for under the amortization method under the fair value method. Under the fair value method, MSRs are recorded at fair value at each reporting date with any changes in fair value during the period recorded in mortgage banking fees in the Consolidated Statements of Operations. The unpaid principal balance of the related residential mortgage loans was $80.7 billion and $77.5 billion as of September 30, 2020 and December 31, 2019, respectively. The Company manages an active hedging strategy to manage the risk associated with changes in the value of the MSR portfolio, which includes the purchase of freestanding derivatives.

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



	As of and for the Three Months Ended September 30,						As of and for the Nine Months Ended September 30,
(in millions)	2020			2019			2020			2019
Fair value as of beginning of the period		$568			$531			$642			$600
Transfers upon election of fair value method	—			—			190			—
Fair value as of beginning of the period, adjusted	568			531			832			600
Amounts capitalized	85			78			238			170
Changes in unpaid principal balance during the period ⁽¹⁾	(55		)	(31		)	(141		)	(88		)
Changes in fair value during the period ⁽²⁾	8			(68		)	(323		)	(172		)
Fair value at end of the period		$606			$510			$606			$510

⁽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 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 largely dependent upon movements in market interest rates.



	September 30, 2020			December 31, 2019
	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	$606	50 bps adverse change	100 bps adverse change	$642	50 bps adverse change	100 bps adverse change
Weighted average life (in years)	3.8	50 bps adverse change	100 bps adverse change	5.5	50 bps adverse change	100 bps adverse change
Weighted average constant prepayment rate	19.4%	$116	$169	13.9%	$116	$222
Weighted average option adjusted spread	608 bps	10	21	440 bps	12	25

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 9 for additional information.

Other Serviced Loans

From time to time, Citizens engages in other servicing relationships. The following table presents the unpaid principal balance of other serviced loans:



(in millions)	September 30, 2020		December 31, 2019
Education⁽¹⁾		$866		$—
Commercial⁽²⁾	44		33

⁽¹⁾Represents the servicing associated with education loans sold. See Note 7 for further information.

⁽²⁾Represents the government guaranteed portion of SBA loans sold to outside investors.