Despite falling primary rates, MSR values remain reasonably strong as realized prepayments continue to be slower than industry expectations, primarily as a consequence of high LTVs in the wake of the housing downturn. About 28% of U.S. homeowners now owe more on their properties than their properties are worth, according to Zillow. This is an increase from this time last year, when an estimated 22% of homeowners were underwater. Both Zillow and FHFA’s purchase-only index tracked home prices down by 3% in the first quarter, while some economists are predicting 6% to 8% depreciation for the remainder of the year. On the slightly more optimistic side, there is growing consensus that housing will find a floor in 2012, but only time will tell.

Figure 2 tracks aggregate MIAC® Conventional Agency 30-year Generic Servicing Assets (GSA™) from August 2010 to June 2011. As can be seen, the aggregate rose in value by almost three-quarters of a multiple from August 2010 to June 2011. In aggregate, the cohorts, with a weighted average note rate of 5.60%, an average age of 32 months and a delinquency percentage of 5.25%, generally ranged in the high 3 to low 4 multiple range during the most recent month compiled (June, 2011).

MIAC’s GSAs index homogenous MSR assets. Currently we track roughly 300 of these Reference Benchmarks, based on current MBS issuance. GSAs are defined to be consistent with the generic MBS for which dealers provide prepayment forecasts to the Bond Market Association’s (SIFMA) dealer consensus prepayment forecast survey. MIAC prices them by surveying a broad representation of the MSR market. Participants submit prices for each cohort that reflect what they would pay for a similar asset if offered in the marketplace today.  Of course, GSA’s are calibrated against any actual MSR transactions as they occur as well.

The Department of Labor’s latest report, for July, indicates the number of unemployed persons declined slightly to 13.9 million, leaving the unemployment rate at the 9.1 percent (Figure 3). Employment in most private-sector industries remains fairly stable while government jobs continue to trend down.

The delinquency rate for mortgage loans on one-to-four-unit residential properties rose slightly, to a seasonally adjusted rate of 8.32% as of the end of the first quarter of 2011, according to the MBA. However, this is a 17% improvement over the first quarter of 2010, when mortgage delinquencies peaked at 10.06%. The delinquency rate includes loans that are 30 or more days past due but does not incorporate loans in foreclosure. Rates for various mortgage subsectors and the overall foreclosure rate are shown in Figure 4 for Q1 2011 and Q4 2010.

The percentage of loans in foreclosure at the end of the first quarter was 4.52 percent, off the peak of 4.64% at year end 2010.  This measure had ranged between 1% and 1.5% over the ten-year period before 2008, when it rose sharply to plateau at current levels in 2010.

One thing rising rates has not encouraged is conformity in prepay speeds among market participants. This is exemplified by the Dealer Prepayment Forecasts provided to Bloomberg - and which are the basis for the market median widely used in pricing and analysis. The variation between dealer’s models continues to be wide, as shown for the spot date August 9, 2011 in Figure 5. The wide range in projections around the median underscores the fact that a thorough, granular understanding of the underlying asset is required to produce reliable MSR values.

Earning rates, as proxied by the 5-year swap rate tracked in Figure 7, were near 12-month highs early this year, but the relief afforded servicers was relatively short lived. As can be seen in the figure, it pierced the 12-month low set last November in the wake of recent turbulence following the US debt downgrade and renewed Eurozone concerns.

MIAC Modeling Corner         

Mortgage repurchase put-backs have accelerated sharply with rising delinquency rates, forcing the mortgage industry to consider whether loan loss reserves - and the methodology they use to estimate those reserves - are adequate. How should the impact of rep and warrant put-back requests be reflected on MSR valuations?

Indeed, there exists some confusion about what the impact of a put-back should be on MSR values. Most firms elect to establish a rep and warrant put-back risk reserve account, to which such costs as administrative fees associated with challenging the put-back claim can be assigned. It is also key to avoid double counting by assigning the same costs to both the credit loss reserve and the MSR reserve, or by including fees, and credit losses that are already captured in the MSR model.

In general, the markdown to MSR values as a result of put-back activity would be a fraction of the loss netted to a loss reserve. Higher marginal costs of reviewing and contesting put-backs by investors may raise the projected servicing costs, reducing MSR values by a few basis points, while credit losses can be a significant fraction of a point or more. Whether projecting credit losses or charges to MSR reserves, each servicer’s situation needs careful, customized consideration. This is true regardless of whether a firm employs a market value or intrinsic-based approach to MSR valuation. Losses will vary dramatically from firm to firm. Small servicers could go for years without experiencing a single put-back while mega-servicers are experiencing mounting expenses from both credit losses and efforts to fight repurchase demands. Regardless of size, a servicer’s loss experience will be strongly affect by high concentrations in states with the sharpest housing contractions, such as Florida, Arizona, Nevada and California.

In response to the specific risk raised by rep and warrant put-backs, MIAC has introduced tools in its WinOAS™ valuation model to separately estimate both the credit losses and the administrative costs incurred.

For those contemplating buying servicing, consider that MSR values remain at historically low levels, creating one of the best buyer’s markets in history. Prices for servicing have dropped to very attractive yields relative to the risk profile of the asset class. Economic values (forecasted cash flows) of MSRs are intrinsically more attractive than current market values due to supply/demand dynamics and an overly risk-sensitive market. This holds true across all sectors, including Agency and pockets within the higher touch sector such as Non-Agency and certain Ginnie Mae collateral pools.