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Mike Carnes , VP
Capital Markets Group
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Residential Market Update
Wednesday, July 07th, 2010.
The back and forth nature of the news driving today’s market can be confusing to say the least. Because of the multitude of mixed messages, some have even begun to describe market conditions as being “Bipolar”. To help put recent market challenges into perspective, we must focus on the fundamental drivers of value. In this case: delinquencies, prepay speeds, and market volatility.
Delinquencies
According to the Mortgage Bankers Association (MBA), delinquency rates hit an all time record, surpassing the 10% level in the first quarter of 2010. The seasonally adjusted rate is an increase of 6.2% over the previous quarter and 10.3% ahead of one year ago. Virtually all product types endured an increase in delinquencies over a 12-month span and prime mortgages, which make up 68% of the market, posted the largest increase with serious delinquencies up by a whopping 16%. However, the same MBA report showed the non-seasonally adjusted delinquency rate declined by 11.3% from the previous quarter. Is the drop simply capturing the normal decline, or is it reflecting a broader indicator of sustained market improvement?
Delinquencies in servicing portfolios of different firms can vary drastically depending on 1) loan type 2) degree of participation in various loan modification programs and 3) foreclosure moratoriums. Longer foreclosure timelines impact the timing of losses and therefore negatively impact loss severity due to higher interest advances and other carrying costs such as maintenance fees, property taxes, etc. The longer timelines are largely dependent upon servicer capacity as well as a firm’s ability to adapt to government guidelines such as HAMP.
While loan modifications can artificially lead to higher cure rates and lower near term defaults, re-default rates will vary drastically depending on the type and term of the modification. Principal and Interest recapitalization modifications impact the timing of losses, but will have no impact on the loss amount should the borrower re-default – not to mention that re-default rates under this approach can be higher than with other methods. On the opposite end of the spectrum, principal forgiveness will cause losses to come sooner, but the lower CLTV should result in lower defaults as well as reduce the need for future principal write-down.
The combined effect on re-default rates and the impact on cash flows can be complex, but one thing appears certain: borrowers are more likely to re-default when their monthly payments aren’t reduced enough in modifications to make staying in a home affordable. With roughly one-forth of homeowners owing more on their home than their home is worth, the type of modification will be key in reducing future loss severity. Additionally, studies show that early intervention produces better results. Borrowers current on their payments now but at high risk of default are much less likely to re-default than borrowers who received modifications after missing one or more payments.
As more foreclosures are worked through the system, as more modifications are completed and as cleaner, newer vintage product starts to make up a larger percentage of a firm’s portfolio, it will eventually have a positive impact on a portfolio’s overall performance matrices. Until then, the market needs to have a good handle on how to address the increased risk exposure.
Despite the fact that foreclosure inventory rates are up by over 20% year-over-year, Mortgage Servicing Rights coupled with the current rate environment are showing tremendous resiliency in light of adverse conditions. The below graph displays the historical results of MIAC’s hypothetical auction process of a select group of Generic Servicing Assets in which numerous firms participate.
Prepayment Speeds
Now, let’s shift our focus to prepayment speeds. During this period of ongoing volatility, prepayment expectations show a wide variance from firm to firm and can produce a serious whipsaw effect on values without hands-on servicer intervention. The Bloomberg caption below shows how speeds can vary widely between firms.
Furthermore, recent declines in secondary rates are being partially offset by a widening of the primary/secondary spreads. As illustrated in the table below, primary base mortgage rates are approximately 75 basis points higher than secondary current coupon mortgage rates. This compares to a historical average of approximately 50 basis points. In assessing an MSR 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.
Market Volatility
Shifting our focus from prepay speeds, weak market sentiment being fueled by market volatility and continued high unemployment is not very encouraging. High unemployment remains one of the biggest risks to sustained economic recovery. Until unemployment claims begin to show noticeable improvement, earning rates will likely remain fairly range bound. Many clients rely on longer-dated escrow earnings rates in the two-through-five year swap sector and as the below chart suggests, recent recovery attempts quickly turned negative again.
Conclusion:
Regardless of how conservatively or aggressively your firm chooses to value its MSRs, it’s highly recommended that you know your data and ultimately what assumption matrices must be assigned to produce reliable MSR values. It is entirely possible that your values are either under or over valued and only a thorough understanding of your portfolio’s collateral attributes coupled with today’s market conditions will suffice in the determination of MSR worth.
Unfortunately, a firm may try to support a particular value by saying the Option Adjusted Spread (OAS) is rich to static, or there are no available benchmark trades occurring, or my cost to service is lower then the rest of the industry. At times, all of these arguments may have merit, but be cautious of the fact that trade activity is quietly heating up, thereby providing a much needed market benchmark. On the flip side, some companies tend to overestimate their risk exposure, thereby causing the firm to book at a level far below a fair market price. Neither approach is recommended, and both require careful oversight in order to avoid false values.
Questions to ask yourself and the rest of your management team in managing your portfolio include the following:
How does your firm’s strategy for handling the increased risk exposure compare to your competitors’?
Do you have the MSR modeling capabilities to estimate risk?
How are you incorporating revised loan to values into your valuation process?
Are you incorporating other performance matrices like vintage year, FICO, and geographic distribution into your default projections?
How are you using the collateral attributes to value the MSRs?
Is specialized subservicing a viable alternative to your current servicing approach?
For those of you contemplating the purchase of servicing, consider the following. In spite of recent resiliency, MSR values remain at historically low levels, which creates one of the best buyer’s markets in history. From MIAC’s perspective, we believe prices for servicing have dropped to very attractive yields relative to the risk profile of the asset class. We believe the economics (forecasted cash flows) of MSRs are intrinsically worth more 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.
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