Mark W. writes, “Patrick Henry exclaimed, ‘Give me liberty or give me death.’ Are you going to the beach this weekend?” American Airlines announced that face masks will be required beginning May 11. Drinking isn’t restricted, and anyone can have some “furlough merlot,” wine consumed in an attempt to relieve the frustration of not working or long workdays at home. (Also known as “bored-eaux”.) My cat Myrtle seems entirely unfazed by the tumult in the servicing business. But it is a hot topic, especially since the value of servicing directly flows through to rates sheets just as much as mortgage-backed security prices do. More on that below.
In the lending world, loads of volume continue, but how much filters down to the bottom line in terms of margin remains to be seen. And on “the back side,” what are warehouse lenders seeing? Jerry Davis, Managing Director/Mgr. Warehouse Lending at Legacy Texas Bank, observed, “My clientele has done an amazing job of changing up their execution. Clients have quickly moved away from selling to the aggregators, with their long turn times and volatile servicing values, and shifted sales to Agency execution. Although we are seeing great funding volumes, the amount of time loans are staying ‘on the line’ has dropped dramatically. We are prepared for lenders needing additional lines, but they haven’t been needed due to this shift in execution.” Thank you, Jerry.
Forbes tells us that 3 million borrowers could be more than 90 days behind on payments (90 days is what they define as ‘seriously delinquent’, but could also include people in a forbearance program) if unemployment hovers around the 10% mark for at least the next year. Which brings up the issue: what is the downside expense risk to any company servicing loans versus the upside benefit? Delinquencies and foreclosures can cost tens of thousands of dollars per loan.
Keefe, Bruyette & Woods issued some research on Mr. Cooper Thursday. “COOP significantly expanded servicing advance facilities post quarter-end. The company added $650m to its GSE facility and another $200m to its PLS facility. Management noted they are confident in having capacity to handle forbearance take-up rising to nearly 19% from 5.6% currently. The company guided to both Servicing and Xome segments at breakeven in 2Q because of interest rate pressure on custodial deposits (from prepayments), staffing up in anticipation of higher modification volumes, fee waivers to support customers, and the foreclosure moratorium. Very profitable mortgage originations should help offset that earnings pressure. While April volumes moderated a bit, the margin bounced back to January/February levels at above 1.5% in terms of pretax margin. The March margin was depressed at 0.3%, which we believe was likely caused by hedging losses driven by volatility in the MBS/TBA markets.”
Home loan servicing background
MSR (Mortgage Servicing Rights) valuation can seem very complex and somewhat esoteric, but it does wholly impact borrower pricing, and thus we care. An MSR is the contractual obligation to service designated pools of mortgages. This right is frequently sold for a fee that reflects the underlying value to the owner. Basic mortgage servicing right typically involves a servicing fee, providing the obligation to “service” a pool of mortgages by receiving and processing mortgage loan payments while also handling additional financial requirements such as negotiating loan modifications, supervising foreclosures and calculating periodic payment adjustments.
As aggregators have backed away from paying much of anything for servicing rights, lenders have shifted gears to being interested in servicing their own loans. Or having a subservicer do it for them. After all, aren’t the rights to collect the borrower’s monthly payment for months and years into the future worth more than zero? The compensation is netted out of the interest every month. The owner owns a financial asset as well as a performance contract. The servicer must send the money on to the investor, keeping a slice for themselves. STRATMOR’s Seth Sprague reminds us that, “The servicer only is paid its service fee when the borrower makes their mortgage payment.”
Who can own an MSR? Are they freely tradeable? Private label (loans not guaranteed by the government, or backed by Freddie & Fannie) or Agency products are serviced by licensed, agency-approved servicers, or a Ginnie Mae issuer. The ability to transfer the servicing certainly exists for the owner, as well as the ability to monetize the value. The economic value is the right to receive the monthly payment: compensation for performing the job (to pay the staff) and there’s the excess servicing spread (portion of the monthly income over and above the cost).
So who are the big Ginnie servicing buyers? Seth relayed that in 2019 they were recognizable names: Lakeview, Mr. Cooper, PennyMac, M&T, Freedom Mortgage, Rushmore, Fifth Third, Ocwen, Roundpoint, TMS, NewRez, and Chase lead the pack.
Banks still own the majority of mortgage servicing rights, though with these financial institutions increasingly having to deal with challenges such as regulatory changes and the need to improve capital reserves, banks are at times more inclined to sell the MSR assets that don’t represent an appropriate return for the capital required. For an investment asset as complex as excess mortgage servicing rights, it is vital to have an in-depth understanding of both benefits and limitations. Seth observes that servicing is currently held by about 60% at banks and 40% at nonbanks; 90% of MSRs were at banks in the 2008.
There are several benefits of investing in mortgage servicing rights. MSRs represent a significant investment opportunity with the ability to “scale up” to larger transactions, as banks have sold MSRs worth trillions of dollars over the last decade. The asset produces predictable and steady cash flow without increasing financial liabilities, and can act as a hedge as fixed-rate debt instruments typically decrease in value as interest rates increase. MSRs are based on well-defined obligations that are tied to a pool of existing mortgage loans. While they can be readily bought and sold, creating “new” MSRs requires new loan pools and more mortgages. This creates a solid foundation for the asset’s value. Until recently there was an active market of MSRs in 2019 and into 2020.
March saw a big, volatile rally in MBS prices, and rates fell. Pipelines appreciated, and lenders hedging their locks “sold forward” their expected closing percentage. Those forward sales were subjected to margin calls due to the rally. (Securities sold at 98 were later worth 105, and broker-dealers wanted a piece of that seven point swing as the mark-to-market hit lenders) But the MSRs also lose value in a rally (when bond & MBS prices increase) due to refinancing increasing and loans in a servicing portfolio paying off early. That said, lenders who have a servicing portfolio can cover part of the exposure to bond market moves. And can help offset the margin call exposure. When managing both it can help limit risk and helps to lower the amount of negative convexity.
But currently there are very few servicing transfers being made. There isn’t much being bought or sold, since the market has so many uncertainties. Ginnie MSRs have been hit hard. Last year a handful of institutions were buyers of Ginnie servicing, and they’ve “gone back in their shells.” Servicing deals, which in recent years ranged from 3×1 to 5×1 multiples, might be at a one multiple now, which implies a 30 percent yield. So buyers have begun sniffing around. MSR values will probably lag the overall market since lenders are holding on to them and retain the MSRs. If the supply outweighs the demand, it will hurt the market. Value is different than the price. Investors in servicing are asking, “What is fair value, where forbearance has been mandated? And what is the difference in value between new and older servicing?”
However there are some limitations. As a key source of potential MSR value is derived from pricing discrepancies due to forced institutional sales and misunderstanding of asset values, realizing this benefit of MSRs requires active portfolio management and expert knowledge of how MSRs should be valued, and substantial capital resources to execute purchases with a quick turnaround, an in an industry predicated on strong relationships.
What impacts the value of the MSRs? It changes every day, but let’s say over 7% of borrowers are in forbearance, could easily head toward 8%. Roughly 10% of Ginnie (primarily FHA & VA loans) loans are in forbearance. What modeling assumptions are being used by investors? Future unemployment? Delinquencies, foreclosures, borrower behavior? Some are hoping that the cure rates when we come out of this will be high. Voluntary and involuntary prepayment behavior will be impacted.
Now the economy (and with it, homeowners who owe money) is reeling. Investors in the MBS assets (usually not the servicer) want their monthly payments, and for a good chunk of the outstanding balances are contractually guaranteed receiving it. And thus talk has focused on advances where servicers are required to advance monies in some types to the bond holders. Someone has to provide liquidity for that missed payment. And servicer must cover the costs like taxes and insurance, pursue remedies, and foreclosure costs.
Some companies finance the acquisition of servicing, just like their clients are financing the acquisition of a home. There are some creative ways to finance the two pieces of servicing (the usual monthly income and any excess servicing income). Some banks offer MSR financing for servicing, where banks loan money against MSRs. But banks can loan money against the cash flow. Some servicers will split off the excess servicing spread and earn money for a REIT. (Different cash flows can even be re-combined if you want to be creative.) And servicing advances can be pledged for financing. Pledging the MSR, or pledge excess spread, requires Freddie and Fannie’s approval via a form of acknowledgment. The purchaser of the spread must agree that their interest is subordinate to the Agencies. And buyer has to agree to assume the seller’s responsibilities, and possible liabilities.
What about hedging servicing? Most agree that the best hedge is to be in the origination business: a “global hedge.” When rates fall, it pushes MSR values down due to loans paying off early, but origination increases through a lender’s retail, consumer direct channel, or correspondent channel. Lower rates lead to higher prepayments, but with an expected increase in refinancing activity with a 2-3-month lag. Ideally, the risk in a pipeline of locked loans matches the risk in the MSR portfolio.
Ginnie Mae has added “Ginnie Mae Begins Publishing PTAP/C19 Data“.
Mortgage Quality Management Research has released commentary on some poignant compliance hot topics recently. Those included specific CFPB requirements regarding the content included in notices of servicing transfers of the Real Estate Settlement Procedures Act (Regulation X), IT security controls organizations should consider implementing in conjunction with remote work procedures to protect data and clients’/customers’ information, and states temporary changes to their loan originator licensing requirements in the wake of COVID-19.
Where do things go from here?
When Freddie and Fannie set the limit of P&I advances at four months it helped MSR values slightly. (By the way, F&F require 25 basis points for servicing.) A few buyers were rumored to have crept back in, since it helps owners better project their cash flows.
Over at Ginnie Mae, the PTAP facility was created as a “last resort” to supply advances. It has all kinds of constraints, including executive compensation limits that aren’t clear. The PTAP hasn’t really helped too much, with rumors of less than five issuers taking advantage of it, although it is expected to grow in popularity over time. Smaller servicers will probably have a hard time finding financing for their advances, although servicers know that early pay offs can offset advances.
(By the way, Ginnie does not require an acknowledgment agreement for transfers, but may put one in place. There are other aspects that are very detailed and should be reviewed by an attorney. Private label deals are different. There may be investor consent required. They may be less risky in terms of losing the asset, but less able to transfer the asset.)
There is an expectation that financing advances will only go higher since delinquencies and foreclosures are expected to increase. Certainly, forbearances have increased, as noted above. The advances are relatively safe, but the question of “when” the servicer will receive any money to help cover the costs is a huge consideration. The timing of reimbursements is up in the air. Does the servicer have other assets that can be used as collateral? Fannie has an acknowledgment agreement addressing advance reimbursements. Ginnie views advances differently, and (basically) viewed them as part of the servicing rights. If the servicing is transferred, say to a buyer, the new party has the right to the reimbursement. To its credit Ginnie has been very focused on helping its servicers find financing. On the Private Label side of things, servicing advances are common, and often expressly permit the servicer to sell and to pledge advances to secure the financing.
When do we go back to normal? Any conjecture is based on the virus since the health of the population is paramount. (Insert political discussion of your choice here.) Certain things must happen regarding the pandemic, but most believe that a return to normal economic conditions is more than a year out. Support for housing must continue/expand. Don’t forget that services have six months of borrowers being in forbearance for those that accept it. And most believe that borrowers will probably extend. Credit problems can easily mount. And problems with loans in any servicing portfolio create bandwidth issue with existing servicers. With the trillions of dollars of servicing outstanding, originators should at least keep an eye on news & changes.
I hope the weather is good today for my trip to ‘’Puerto Backyarda’’. I’m getting tired of ‘’Los Livingroom’’.
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