Mortgage Rates since September have been relatively stable and range bound leading to Mortgage Servicing Rights (MSR) valuations that have also stayed in a fairly tight range of +/- 10 basis points over the past quarter. Most of our clients with lower coupon product have stayed within a +/- 5 basis point range. The 30-Year Fixed Rate Mortgage averaged 4.11% in September as per the Freddie Mac Primary Mortgage Rate (NMCMFUS), whereas it has averaged 3.99% in the latest November period.
Prepayments in general have inched higher, with faster prepayments in general reducing MSR values slightly. Cusp coupon product with clean collateral attributes such as the 2009-2011 Agency cohorts are seeing more prepayment volatility than both the seasoned and the more credit impaired cohorts. The limited overall market breadth and strict underwriting standards remain, which is muting prepayments for the more credit impaired product.
Home prices remain fairly weak as stated in the latest Case Shiller reports that had the US Home Price Index down 3.90% year-over-year. On the other hand, the latest readings on Consumer Confidence were strong albeit the seasonal holiday period. The Conference Board Index on Consumer Confidence registered its highest monthly gain since 2003. This gauge was in addition to the higher confidence readings of the University of Michigan index of consumer sentiment.
Figure 1 displays results that were derived though MIAC® 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 member firms’ values compare to each of these benchmarks.
As the chart above depicts, from August to November, GSA portfolio values are down by approximately one quarter of a multiple or on average 6 to 9 basis points. MSR transactions have been concentrated in some large Agency and Non-Agency purchases. Some smaller MSR transactions have been in the market with most transactions occurring on low seasoned product. We continue to see a wider bid/ask spread on market executions than historical past. Continued discussions on funding costs tied to servicing advances, prepayment performance versus model derived prepayment projections, Basel III, and balance sheet issues are being factored into the MSR markets and have lead to market execution pricing in general being lower than cash flow based values.
Mark-to-Market Loan-to-Values continue to be a good indication of portfolio performance. Delinquent loans continue to drive values lower due to the increased costs to service associated with these loans, and the respective funding of the delinquent advances.
Lastly, the increased cost to refinance a loan, and the increased regulatory and compliance hurdles will continue to be monitored for its impact to the Mortgage Servicing Rights Asset.
The major drivers and commentary regarding mortgage delinquencies, prepayment projections, and earnings rates are listed below. Additionally we discuss some of the mortgage news concerning HARP and the proposals on Mortgage Service Fees in the MSR Modeling Corner.
The delinquency rate for mortgage loans on one-to-four-unit residential properties dropped to a seasonally adjusted rate of 7.99% as of the end of the third quarter of 2011 according to the MBA. This represents a 5% improvement over the second quarter of 2011 level of 8.44%. The delinquency rate includes loans that are 30 or more days past due, but does not incorporate loans in foreclosure.
The percentage of loans in foreclosure at the end of the third quarter was 4.43 percent and stable with the previous second quarter results. While this number has labored and is not showing nearly the improvement that delinquencies are showing, for now, foreclosure percentages are at least displaying some stability at current levels according to the latest MBA survey results.
Mortgage Prepayment Speeds
For the last 5 years, primary/secondary spreads averaged approximately 63 basis points with spreads at times reaching as high as 144 basis points. At a current spread of 90 basis points, the primary/secondary spread has widened significantly from the 5-year median of 64 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, one runs the risk of over inflating pre-pay speeds.
Prepayments remain a credit driven event, as tight underwriting standards and lack of refinance ability remain driving factors for the majority of borrowers outside of the top tier borrowers. Continued weak housing and high unemployment continue to play a hand in muting prepayments for the majority of mortgage products.
Policy risk may impact the future outlook for prepayments. A continued push by Washington for lower mortgage rates, adjusted guidelines making access to refinancing slightly less stringent (HARP) and a continued trend for mortgage rates staying near or through historical mortgage rate lows are just a few examples that may impact prepayments.
Further performance variances among servicers based on their collateral attributes and internal policies provide additional volatility in terms of forecasting prepayments, so servicer specific prepayment risk is becoming more relevant.
Escrow Earnings Rates
Escrow earnings rates have been range bound in the past few months and saw significant reduction in rates from the Second Quarter Period. Quarter- over- Quarter Escrow rates based on the Three Year and Five Year Swap Rates have in general been flat on the Five Year Swap. September Month-End Swap Rates were 74 basis points and 126 basis points respectively on the Three and Five Year Swap Rate. November Swap Rates were 89 basis points and 134 basis points.
The slight back-up in escrow earning rates resulted in a slight uptick in the Float income streams on MSR values.
MIAC Modeling Corner
HARP Loans and the FHFA Proposed Fee Structure
Discussions concerning the new HARP structure have been discussed at length. Outlined below are some of the major modeling points and their impact on MSR values for HARP eligible loans.
In general, we isolate base on the eligibility requirements on HARP as follows;
1) The mortgage must be owned or guaranteed by Freddie Mac or Fannie Mae.
2) The mortgage must have been sold to Fannie Mae or Freddie Mac on or before May 31, 2009.
3) The mortgage cannot have been refinanced under HARP previously, unless it is a Fannie Mae loan that was refinanced under HARP from March-May, 2009.
4) The current loan-to-value (LTV) ratio must be greater than 80%.
5) The borrower must be current on the mortgage at the time of the refinance, with no late payment in the past six months and no more than one late payment in the past 12 months
Some of the key points include the following:
1) Rep and Warranty relief
2) Verbal verification of employment and source of income
3) Reduction/Elimination of Loan Level Pricing Adjusters (LLPA’s)
MIAC’s® WinOAS™ MSR valuation model can isolate HARP eligible loans based on the specific HARP criteria. Portfolio performance and overall collateral and borrower characteristics are adjusted to take into consideration HARP, namely faster baseline speeds over non HARP eligible product of similar collateral attributes.
Servicing Compensation Proposals
Lastly, we provide highlights on the proposals on the revised servicer compensation structure. MIAC® would like to offer observations on the impact of a change to the servicing fee structure. The current servicing compensation options have room for improvement when it comes to delinquent mortgage servicing rights. Changing the servicing fee from its current form may have implications in terms of asset values, modeling risk, prepayment performance, hedging strategies, and capital and risk structures to name a few. We discussed many of the pros and cons of the various options in a white paper released in April of this year, and will now focus our attention on the major proposals that have been making rounds in the industry. Please see our previously released white paper on this subject at: www.miacanalytics.com/aboutmiacnews/AlternativeServicingFeeProposal
1) Existing Service Fee Structure: Leaving the current servicing fee (SFee) structure as is. Generic Minimum Service Fee (SFee) rate of 25 basis points;
2) Lowering to a Minimum Service Fee: This would still be a part of the balance sheet asset, but kept at a minimum of say 20.0 basis points and creating a reserve account to handle future delinquencies and losses;
3) Creating a Fee for Service structure, where the servicer is paid a set amount for servicing performing loans and a set amount for servicing delinquent loans.
Proposal One: Keep the Service Fee Structure as is with no changes
In considering the existing service fee structure, there has been debate over whether the current service fee levels are too high in comparison to the services delivered. One argument is that due to ‘economies’ of scale, the servicers are generating too much service fee income premiums given the administrative work to service loans.
Another argument is that incentives are not properly aligned and should be redesigned to reflect the reduced cost on current loans and the increased cost on delinquent loans. However, in discussions with many servicers, servicing costs have increased as the financial landscape over the past few years has continued to evolve.
Increased regulatory compliance costs, delinquency advance costs, repurchase risk exposure, system modifications and increased time spent servicing the portfolio have all resulted in stress on the profit margins of many servicers. This point is outlined in more detail below.
Historically, Servicing Fee revenue steams steadily increased as average loan balances on newly originated loans were on the rise. The additional revenue helped to offset increasing costs, but as loan balances began to decline, so did the profit margins.
Many servicers’ business models were built on automated, turnkey processes to create economies of scale. However, once servicing portfolio performance started to deteriorate, associated expenses increased, while the income side of the cash flow servicing rights equation stayed constant or even lessened.
In cases where delinquencies increased, servicing advances ballooned to advance the principal and interest on the delinquent loans. Performing Loan Servicing Fee Revenue decreased as more loans became highly delinquent. In general, on GSE loans, less late fee income was generated on the severely delinquent loans, float income decreased as market rates declined, and servicing income, which represents approximately 70% to 85% of the revenue side of the cash flow, was reduced. Service fee revenue in general declines over time while expenses increase. Increasing delinquencies and lower quality credit product caused by better quality product leaving the portfolio are some of the reasons for this occurrence.
In terms of the GSE servicer, many of the cash flow revenues have diminishing returns, meaning higher initial cash flows (revenues) with low initial costs (expenses) in the beginning life of the mortgage servicing rights portfolio. As the portfolio ages and delinquencies increase, the servicer collects less service fee revenue while his cost structure (expenses) increases to handle delinquent loans. Often, the servicing fee revenue streams in addition to the revenue from late fee income, escrow float earnings and cross selling opportunities that added additional ancillary income may not be enough to offset the expenses at a certain delinquency threshold.
Proposal Two: Lower the Service Fee and Create a Reserve Account for future delinquencies and Losses
Another proposal is to take the 25 basis point servicing fee strip and distribute it into two components. There would be a 20 Basis point strip and the remaining 5 Basis Points would be placed in a Cash Reserve Account to handle future delinquencies and losses. In this proposal, the 5 Basis points are anticipated to cover the compensation for delinquent loans. The servicer will have a few options: they could service these delinquent loans in-house, preferably in a separate loss mitigation division, or have them subserviced at a specialty servicing shop. Additionally, any unused reserve would be released to the owner of the servicing rights. In concept, the approach has merit. The difficulty is ascertaining the proper coverage so that a servicer is not putting too much aside in reserves nor not putting aside enough in reserves to cover delinquency costs.
The accumulated risk based reserves will aid the investor, classified as the GSE’s or the Private Label Originator, as they will accumulate more credit reserves to offset future collateral delinquencies or losses. First line losses should be covered by this increased insurance fund reserve. This reserve (insurance) fund will benefit from the originator having more skin in the game, thereby reducing investor losses. As borrower credit profiles decline, increased reserves may be set aside to allow for the increased projected losses.
Proposal Three: Fee for Service
In the fee for service proposal, the guarantor would have a set dollar fee to service a loan for both performing and non performing loans. Because performing loans in general have a low cost structure, the amount set aside may be small such as $10.00 per month. The performing servicing fees would be reassessed to account for changes in the servicing requirements.
Nonperforming loans would receive a separate compensation and most likely would be incentive and performance based.
Servicer Impacts from Proposal Two & Three
Smaller servicers that did not have performance issues, namely delinquency and advance issues, will have a significant reduction in revenue income derived from the reduced service fee. Given their higher servicing cost structure, higher market yield requirements, and higher capital costs, the smaller servicer may find that reduced MSRs no longer cover the risk in owning mortgage servicing rights. Prepayment volatility will still be a factor, albeit it will have a smaller impact to overall values given the reduced service fee.
In Figure 2, MIAC® demonstrates the impact to the servicer with various cost structures, default projections, and prepayment scenarios. In our servicing cost example, refer to the $100 marginal cost projection for a small servicer.
Additionally, the smaller servicer often does not service the loan internally on their own servicing platform and may use a sub-servicer. This frequently results in revenue streams exclusive of service fee income (namely, late fee, ancillary income, and float income) being partially or fully passed through to the subservicer. Higher expenses (servicing costs, funding costs) with less revenue offset (late fee, float, and ancillary income) may result in fewer lenders being able to continue holding MSRs. The smaller servicer may hold a smaller portion of MSRs and/or may sell the MSRs servicing released (AOT).
The end result is likely to be fewer servicers. The risk is that all servicing is eventually congregated with a few, large investors that have robust enough cross selling operations that make servicing for reduced revenue possible to stay in the servicing business. A business line that has for years been driven by economies of scale will be become even more so. Additionally, most lenders consider the home mortgage a central part of the customer relationship from which many other mutually profitable relationships are formed (e.g., checking, savings, money market, credit card accounts, etc.) Most lenders agree that not managing the mortgage servicing relationship frequently results in losing the customer altogether to larger servicing institutions over time. Small originators will have diminished customer relationships. Additionally, servicing congregated at only a handful of servicers puts taxpayers at further risk of investors becoming “Too Big to Fail”. Whether the eight-hundred pound gorilla investor is public or private, their value and risk to the overall economy will be increased and undeniable.
Large servicers should experience more positives than negatives. On the assumption that large servicers (namely banks) have cheap access to capital, lower servicing costs due to economies of scale, and in general lower yield requirements, these large servicers should still be able to make a profit on the performing MSRs, (albeit at a reduced service fee revenue projection). However, late fee income, float income, and ancillary income resulting in fewer cross selling opportunities will again, disadvantage the smaller servicer.
In addition, the large servicers tend to have hedging programs in place to manage the interest rate prepayment exposure and earnings volatility. By having a smaller service fee and hence MSR financial exposure, the large servicer may not require as active a hedging strategy and profile, thereby resulting in decreased hedging costs and overall expenses. Some of the reduction in revenue from the reduced servicing fee may be offset by these lower expenses (hedging costs).
Additionally, with a lower value assigned to the MSRs, the mortgage servicer’s balance sheet related to MSRs would be reduced, a positive for Tier1 regulatory capital requirements under Basel III. In our servicing cost example, refer to Figure 2 under the $50 marginal cost projection.
Overall impact to the servicing market of a reduced service fee and the use of a risk-based tiered reserve may promote higher quality originations. Higher risk collateral that would already incorporate higher mortgage market rates would incur a higher reserve structure resulting in higher note rates (premium coupon) product. From a servicing standpoint, this high premium coupon product would have lower servicing values for at market and below market rate mortgage servicing rights.
Modeling the correct reserve to correspond to the delinquency and credit loss projection will become very important so as not to overcharge or undercharge the borrower for the perceived risk exposure to delinquencies and losses. MSR values will be attributed to the projected performance and collateral attributes of the servicing asset.
We discussed the overall market and the drivers that we will continue to monitor in 2012. Prepayment Volatility may continue to be a factor as the market gathers new evidence of the regulatory landscape coming out of Washington and its impact on markets. Continued debate on housing, delinquency performance and proactive measures to clean up the housing overstock will continue for some time. We see this as continued headwinds that may make 2012 quite similar to the performance that we have seen throughout 2011. The service fee compensation proposals have some positive aspects. At the same time, no one method in and of itself provides a key for making the current servicing method obsolete.
Based on the recent vintage outperformance and strong collateral attributes, at times it seems the industry is recommending changes that still warrant further inspection. Some of these changes will result in a significant changing of the mortgage landscape in its current form. We remain optimistic that models and modeling tools along with hard fought experience in these financial markets will continue to create possibilities and opportunity. We look forward to continued service in working with you.
Michael Carnes, Senior Vice President, Capital Markets Group
MIAC Perspectives – Spring/Summer 2013
Q2 2013 – Mortgage Servicing Rights Market Update