Residential Mortgage Servicing Rights (MSRs) Market Update
A decline in refinancing volumes, spurred by a sudden rise in long-term interest rates between May and July led to lower mortgage banking income for numerous firms across the sector but opposed to focusing on the negative, let us focus on all of the positives.
1) Credit qualities are potentially the best that they have ever been which will result in fewer losses and loss reserves for many.
2) The shift from a strong refinance market into to a strong new purchase market should help to offset some of the impact of lower refinance revenue.
3) Either by force or voluntarily, the state of the US housing market over the last 5 years caused many to exit the industry thereby reducing the potential number of competitors.
At 4.47%, the published Freddie Mac 30 Year Primary rate is off its recent high of 4.58% set on August 22nd, but substantially higher than the all time low of 3.31% on November 21, 2012.
MIAC’s Monthly GSA Survey
The below chart displays results that were derived from MIAC’s hypothetical auction process, which analyzes a select group of Generic Servicing Assets that collectively simulate the agency market cohorts as a whole. Participating firms, which mainly represent large to middle tier servicers, submit Mortgage Servicing Rights values to MIAC for each cohort, which reflects what they would pay for a similar asset if offered in the marketplace today. As a participating member, firms receive beneficial market feedback that includes high, low, and median values and how other member firms compare to each of these benchmarks.
Seasoned Conventional 30-year cohorts with a weighted average note rate of 4.87%, an average age of 36 months, and a delinquency percentage of 4.42%, generally ranged in the mid 3 to low 4 multiple range and collectively, average results by product were as follows:
The Fed has been buying $85 billion-a-month in bonds to keep long-term interest rates low and encourage borrowing and spending. A major factor for the Federal Reserve in determining when to reduce and ultimately eliminate its economic stimulus was job growth as evidenced by the Feds recent tapering announcement within weeks of the unemployment rate dropping to 7.0 percent which is at its lowest point since November 2008 when unemployment rates were at 6.8%. Put into perspective, from 1948 to present, the United States unemployment rate averaged 5.82%. Despite being worse than historical average, as the graph illustrates, percentages are steadily improving and have declined by 0.9 percent since January of this year. Current statistics have the number of unemployed at 10.9 million.
The delinquency rate for mortgage loans on one-to-four-unit residential properties has been steadily improving and according to the MBA, now sits at a seasonally adjusted rate of 6.41%. By historical standards, the percentage of loans that are 30, 60, or 90 days delinquent is still slightly elevated, but it does represent a 36% improvement over the high mark of 10.06% set in March 2010. The delinquency rate includes loans that are 30 or more days past due, but does not incorporate loans in foreclosure.
As you can see from the chart below, foreclosures as a percentage of total loans outstanding continue to improve. They are now at their lowest point since September 2008 when the percentage of loans in foreclosure was at 2.97%. This has resulted in steady improvement in portfolio performance and improved economics.
Mortgage Prepayment Speeds
Anyone that owns or services mortgage loans has likely experienced a significant decline in recognized prepay speeds over the last several quarters. While variances among Dealer Prepayment Forecasts are showing some tightening, as illustrated below, projected speeds can vary widely between firms. Only a true understanding of your institution’s underlying assets will produce the most reliable results.
Illustrated in the chart below, at roughly 83 basis points, the end-of-month primary/secondary (30-Year Freddie Mac Fixed Rate / Freddie Mac 30-Year Gold Coupon) spread is well below the peaks obtained in 2012. Despite regression to the “new” mean, it’s noteworthy to show how the mean has been affected by this lengthy period of abnormally high Primary/Secondary spreads. The current 5-year mean is 82 basis points, however, as the second chart depicts, 5 years ago, the same 5-year mean was roughly 50 basis points.
In assessing a Mortgage Servicing Rights value, it is critical that one incorporates the true refinance rate as opposed to a secondary rate plus a constant spread; otherwise, there is a risk of not fully capturing the constantly evolving spreads, thereby over or under estimating prepay speeds.
Mortgage Market Volatility
The 2-Year through the 5-Year Swap rate is an often used benchmark for earnings projections on float. Significantly lower historical swap rates lead to lower float income and thus lower MSR values. As rates rise, firms need to think about the impact that higher rates will have when determining the best execution spread between a scheduled/scheduled where P&I and Prepay float is a possibility and actual/actual remittance structure. Float income can create a valuation spread between the various remittance types but lower float revenue coupled with sometimes higher cost of funds on advances can even the playing field. In extreme cases where the cost of funds exceeds the earnings potential, MSR’s with an actual/actual remittance type can result in a higher MSR value than a scheduled/scheduled remittance structure. The reason is that the derived float income may not be enough to offset the negative impact due to higher cost of advances. Under the normal case, as short term earnings rates rise, so too will the valuation difference between the various remittance structures. As of December 16th, 5-Year rates have bounced well off of their lows and at 1.62% are currently below their 6 month high of 2.00% set on September 5th but well above their 6 month low of .95% set on May 16th.
MIAC Modeling Corner
The decision of whether or not to sell Mortgage Servicing Rights can be complex. The choice to sell may be strategic in nature, or more need based for earnings or capital reduction. Either way, there are Pros and Cons to both decisions.
Before making the decision to sell, it is important to understand how the decision may affect both long and short term earnings. For starters, it is paramount to have a firm understanding of the degree of convexity given current positioning on the “S Curve”. For instance, the lower the note rate relative to current market, changes in market value may become de minimus. Alternatively put, MSR values can hit what may be referred to as a “Glass Ceiling”. Once a portfolio of MSR’s note rate is already below current market rates, the incentive to refinance is relatively unchanged between, for instance, 100 basis points below current market and 200 basis points below current market. At that point on the curve, significant upside to MSR value may be attributed to changes in economic earnings rates and even that may be minimized depending on the remittance structure. Given the rapid ascent in market rates, your firms upside may be nearing the point at which additional upside gain in MSR value is limited. For those looking to sell at or near market high’s, whether strategic or need based, they may choose to take advantage of their current position by selling a portion of all of their MSR holdings.
Also on the list of considerations is accounting treatment. GAAP requires all MSR’s to be initially booked at Fair Market Value (“FMV”). However, they can choose to maintain FMV on the asset or use Lower of Cost or Market (“LOCOM”) in subsequent reporting periods. The majority of mortgage firms over the last several years chose to maintain their MSR’s on a LOCOM basis. While LOCOM has numerous benefits to those looking to minimize the impact of volatility, one obvious downside is the inability to write the MSR asset value above its existing amortized book basis. A rapid ascent in MSR values left many firms with the inability to take short term advantage of being able to recognize the upside in value. The quickest and easiest way to recognize the spread between current LOCOM book basis and Fair Market Value is to sell the existing MSR’s. As a reminder, firms cannot toggle back and forth between LOCOM and Fair Value accounting treatment so if there is any adversity toward migration to Fair Value Accounting Treatment, selling all or a portion of a firms existing MSR portfolio may be the preferred route.
Anyone retaining MSR’s today may be subject to changes in the regulatory environment including but not limited to Basel III, Qualified Mortgage, and Qualified Residential Mortgage. While regulation is often born for the right reasons, the inevitable side affect is almost always increased servicing costs. The already thin margins makes potential increases to servicing expense difficult to handle for everyone except those with the most preferential economies of scale. Strategic transactions designed to limit ones exposure to the increased regulatory cost may serve to minimize a firm’s exposure.
When taking into consideration the required accounting treatment, the potential need for impairment testing, amortization, and possible risk volatility mitigation, managing the MSR asset can be complex even for those with sufficient resources. While delegating those responsibilities to MIAC is a valid option, others not wanting to manage the complexity of this asset may decide that a sell strategy is in their best interest now that markets have returned in force.
Selling MSR’s today may jeopardize future earnings particularly if rates continue to rise. As rates rise, the expected life of the MSR asset increases which can provide a natural hedge during times of decreased originations. Firms may hold the asset to pay off or maturity, or as-is oftentimes the case, firms may treat their MSR portfolio as a “Piggy Bank” and only sell on an as-needed basis to accomplish quarterly earnings. Either way, selling MSR’s today may mean forgoing potential future revenue streams.
Servicing MSR’s can be complex and expensive and may represent significant opportunity cost. Even so, firms may choose a long term retention strategy solely because they don’t want to pass their customer’s to competing firms who may leverage the seller’s client base for cross-sell opportunities. For those lacking in products, infrastructure, or the resources to cross-sell, selling may be a wise decision. For others, retaining potentially low margin MSR’s may be the best long term decision considering prospective opportunities afforded by a retention strategy.
Not long ago, buyers eagerly paid 5 and higher multiples for product. For those contemplating the purchase of servicing, keep in mind that although Mortgage Servicing Rights values remain low relative to historical peaks. Most agree that stricter regulation is and will continue to result in higher servicing expenses. Nevertheless, few would disagree about the pristine nature of most product being originated today. Depending on the type of collateral being transacted, some buyers are showing a willingness to lower their margins for the right to own servicing that they perceive as carrying very little risk relative to product originated just six years prior. This holds true across all sectors, including, but not limited to, agency production.
By: Michael Carnes, SVP, Capital Markets Group
MIAC Perspectives – Winter 2014
Q4 2013 – Mortgage Servicing Rights Market Update