Financial Reporting of Fair Value Based on Model Inputs versus Market Inputs: Evidence from Mortgage Servicing Rights

Abstract

This 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.