For several years now the mortgage industry has grappled with a series of internal and systemic shocks that have created temporary disruptions and inefficiencies in the origination, financing and sale of loans. And the future is no more certain: business volumes are expected to begin exhibiting year-over-year declines while regulatory uncertainty continues at a peak. At the top of the list of regulatory developments still forthcoming are final definitions of Qualified Residential Mortgage (QRM) and Qualified Mortgage (QM) under Dodd-Frank (respectively, under Risk Retention and Ability to Repay rules), alternative servicing compensation, Basel III risk-based capital requirements, the government's role in housing finance and the fate of the GSEs. These events have had - and will continue to have - far reaching effects on available capital and liquidity for mortgages and servicing rights, perceptions of counter-party risk, and the dynamics of mortgage securitization.
Throughout this period of upheaval and changing market dynamics, MIAC® has honed its role as industry leader in secondary risk management, assisting lenders in the implementation of best practices and the selection of optimal execution and risk management strategies given the lender's stage of business development. Many of these practices and strategies have been discussed in past MIAC® Perspectives, including making the transition from best-efforts to mandatory execution, evaluating best execution and re-best execution, measuring the option of direct delivery to the GSEs agencies, determining best execution of servicing-released versus-retained, and properly integrating MSR price and price sensitivity into the risk measurement process.
In particular, given the ongoing state of market flux, a reiteration of best-practices is warranted. Also we return to several themes from past MIAC Perspectives:
1) Establish and maintain maximum Execution Flexibility in the secondary market.
2) Run best-execution and re-best-execution analysis daily for every investor option for each loan.
3) Establish and maintain a methodology for valuing MSR in both pipeline and portfolio.
Execution Flexibility
As they evolve and expand their business options, mortgage companies make common transitions: from Broker to Banker; Best Efforts to Mandatory; Servicing Released to Servicing Retained; Originating for Sale to Originating for Portfolio. However, from MIAC®’s best practices perspective, a comprehensive risk management strategy dictates that at every stage of development, mortgage companies should avoid “all or nothing” propositions in their secondary market execution. Typically, profits are maximized by actively comparing available execution opportunities and engaging in multiple execution paths simultaneously. Unfortunately, some firms have legacy issues with one or more investors, and are limited on either a temporary or permanent basis from reaching the highest level of execution flexibility. However, whatever its execution options are, a firm should be prepared to alter its secondary market execution for some loans during certain periods. By adhering to a robust best-execution discipline, a firm can leverage all of the execution options available.
Secondary Market Execution Spreads and Price Volatility
Several key execution, or pricing “spreads” are dynamic, and firms should monitor these spreads continuously in order to optimize secondary marketing results:
- Best-Efforts vs. Mandatory;
The spread between Best-Efforts and Mandatory pricing is an important benchmark for those firms that have transitioned to mandatory execution, and it provides a gauge of the risk-reward for doing so. For a variety of reasons, this spread is in nearly continuous flux on an intra-investor, inter-investor, and inter-originator basis, so the only meaningful representation of this dynamic is on a daily, loan-level basis. Over the past several years, this spread has been very attractive for firms that can effectively measure and manage their fallout and market value risk.
The market SRP (Servicing Released Premium) that aggregators will pay also has great volatility. While SRPs are generally correlated to market interest rates, our daily surveillance of investor pricing and MSR values indicates that SRPs are more volatile than the value of the underlying servicing rights. We conclude from this that market SRPs are driven by factors separate from the cash-flow value of the MSR. For secondary market participants who are flexible enough to execute a “hybrid” strategy, this dynamic creates opportunities to retain servicing when the MSR is undervalued, and release servicing when it is overvalued.
The execution delta between Agency Cash Window and MBS is often overlooked. Fannie Mae and Freddie Mac have been driven by regulatory fiat into “buy-sell” mode. This means that Cash execution is directly derived from pricing in the MBS market. However, as we have seen with aggregator investor pricing, Agency Cash execution does not move in lock-step with the MBS market, and has its own hot-spots and cold-spots relative to MBS. As a result, secondary market participants who are executing on an agency-direct basis would benefit from a daily loan-level best execution analysis between these two execution styles.
To sum up, due to the historically high level of uncertainty regarding the future structure of the industry, MIAC®’s perspective is that there has never been a greater need for secondary market participants to develop and maintain relationships with as wide an array of investors as possible. The growing number of REITs, as well as regional and local banks and credit unions should all be considered, especially for the origination and sale of Jumbo, and short duration ARMs, Hybrid-ARMs, and other “portfolio” loans (e.g. Non-QRM/QM) in their deposit footprint.
Best Execution Analysis
MIAC®’s perspective is that best execution analysis should be done a) at the loan level, b) at least once each day, c) must include all applicable investor price adjustments, d) must consider all possible investor delivery options, and e) should be re-done at each interest rate shock level (re-best execution analysis). To maximize flexibility and competition in the secondary market, that means (for conventional loans) modeling and analyzing the execution for:
1) All available servicing released “Aggregator” executions;
2) Servicing released options for both Fannie Mae and Freddie Mac;
3) Servicing retained options for both Fannie Mae and Freddie Mac ;
4) Agency cash window execution vs. MBS/PC execution ;
5) The best execution assuming interest rates change;
The more complex the pricing structure, the more opportunities there are for aggregators to arbitrage the risks, so all of these potential adjustments must be measured daily in order to optimize the execution. Also, only a granular and robust best execution analysis that includes a defendable MSR valuation will be able to effectively isolate the opportunity to retain servicing
Along with secondary market price discovery, best-execution analysis feeds the sensitivity analysis that should be the cornerstone of a firm’s pipeline hedging activity. In essence, the best execution provides the baseline for the interest shock analysis, because it drives the calculation of price sensitivity that the hedge is meant to offset.
Once a complete measurement of all of the pipeline risks has been accomplished, management and hedging of those risks can begin. Professional, modern day hedging is a dynamic activity that accounts for changes in value correlated to changes in interest rates. The goal is to strike the correct balance between the sensitivity of the assets (loans and servicing rights) and the sensitivity of the liabilities (hedge vehicle) in order to preserve the net profitability of the position across a range of potential rate shocks.
MSR Retention and Valuation
As noted above, actual SRPs often do not reflect the intrinsic value of the underlying MSR to the originator nor the fair market value of the MSR. This dynamic creates an outstanding opportunity for originators of MSR to retain MSR when the fundamental economic value of the asset is greater than the released market price.
However, the opportunity for retaining servicing is not uniform across the spectrum of originations. In order to effectively execute a hybrid strategy, a daily comparison (at the loan-level) of the actual SRP with the economic value of the MSR is an absolute necessity to 1) ascertain the true execution spread between Servicing Released and Servicing Retained executions, 2) arrive at a correct and defendable economic decision regarding servicing disposition, and 3) produce a defendable fair value for the new MSR asset.
Also, there may be a limit to how much servicing a firm can retain, due to cash, capital, and IRR requirements. Nonetheless, we at MIAC® advise all firms to be as opportunistic as possible and allow the economics of the execution to drive the execution decision at the loan level.
Economic Value vs. Fair Market Value vs. SRP
At the time that a loan is delivered to a servicing retained execution, the firm must assign “fair market value” to the servicing. This is the present value of the future cash flows which will be carried on the balance sheet as the MSR asset for the associated loan. The value is usually expressed in basis points, but may be referenced by the “multiple”. Referencing the value as a multiple is useful for comparing the value of loans or portfolios with different characteristics. The multiple is simply derived by dividing the value in basis points by the annual servicing fee. For example a Fannie Mae 30-YR FRM portfolio valued at 85bps, and with 25bp annual servicing fee, would have multiple equal to 3.4 (85/25). A Ginnie Mae 30-YR FRM portfolio valued at 85 bps, and with a 44 bps annual servicing fee, would have a multiple equal to 1.932.
Determining fair value is a challenge, since MSR’s are illiquid, thinly traded assets. To address this, MIAC® has developed the most robust methods available for MSR price discovery and measuring fair market value.
The fair market value approach is dependent on two things: 1) the model itself and 2) the assumptions (inputs to the model) that drive the valuation (output from the model). Many variables are factored into the valuation of an MSR portfolio, among them: market (or client-based) expectations of voluntary and involuntary prepayments, cost of servicing, remittance cycle, interest on escrows and remittances, delinquency and advance obligations, and time to foreclosure.
MIAC® is the industry leading firm in valuing MSRs and dedicates considerable resources and business process controls to the development of realistic market assumptions for all the variables impacting the valuation of MSR’s. Our GSA (“Generic Servicing Asset”) service employs a monthly survey of a broad universe of servicers in the industry using reference bench marks consistent with current MBS production. The results of the survey provide a market-based consensus on the variables and assumptions that impact the value of the MSR, which can then be used to calibrate valuations for individual firms. The GSA provides MIAC® with the closest thing the mortgage industry has to market-based price discovery for MSR, and enables MIAC® to assist firms with valuing and managing the MSR asset through its entire life cycle.
An alternative to using market-based assumptions is to use assumptions that reflect the “economic value” of the MSR asset. This set of assumptions is specific to the client. For a retained-vs.-released decision, the appropriate comparison is to the value of the servicing measured using a client’s own cost and capital structure with particular adjustments for the historical portfolio prepayment experience, as well as other assumptions that may differ from market-based assumptions, including cost-to-service, discount rate, ancillary income, and escrow earnings rate. These are the assumptions that are most likely to be realized when the originator retains the MSRs.
FAS 156 requires that the MSR be originally booked at fair market value, but thereafter the holder of the MSR has the option to elect to maintain the asset as fair market value or amortized cost basis. The MSR must be re-valued periodically, and any decline in value is taken as a reduction in earnings as well as a reduction in the asset, and thus a reduction in tangible net worth. Given the potential earnings volatility, clients need to evaluate whether they should hedge their MSR earnings risk.
Successfully capturing economic opportunity presented by retaining servicing entails a multi-step process.
The major components are:
- Developing appropriate and defendable servicing valuation assumptions;
- Employing and defendable valuation methodology for valuing the pipeline MSR and portfolio MSR;
- Integrating MSR Valuation with best-execution, pipeline risk and hedging analytics, and development of street pricing;
- Closely monitoring the performance of the MSR portfolio, including a periodic valuation of the MSR portfolio;
- Creating a feedback loop between the portfolio MSR valuation and pipeline MSR valuation to “true-up” the value experience with the value assumptions;
Developing a disciplined methodology for valuing MSR in the pipeline and the portfolio is critical to executing the servicing-retained strategy. MIAC®’s perspective on MSR continues to be that it represents a long-term investment opportunity that should be carefully considered from many angles:
- MSR is not a liquid asset, and we advise against any approach to retaining servicing that relies on trading gains to achieve target returns;
- Origination, ownership and management of MSR represents a major shift in the business plan for firms that have structured their operations around servicing-released execution;
- The retention of MSR has significant implications for the firm’s balance sheet, earnings, cash-flow, and operations, and may impact investor and financing relationships;
Conclusion
We titled this piece “The Dynamic and The Static” because we recognize that, through the turmoil and changes of recent years, there are some things that have not changed. For the fourth quarter 2008 MIAC® Perspectives, we outlined a discipline for approaching the secondary market. With few exceptions, those who adopted that prescription over the following years were able to capitalize on some great opportunities arising in the market. Executing that same discipline going forward will be even more critical. It should come as no surprise that the conclusions and recommendations we made in MIAC® Perspectives in September 2008 are confirmed and reiterated:
- The general pyramid structure of the secondary market in its current (and historic) form will continue for at least two to three more year
- Many mortgage bankers would benefit from a “portable pipeline” strategy through use of mandatory executions with multiple investors;
- Those who can get agency approval for direct sales should do so to avoid aggregator credit-overlays and expand their execution options;
- Disciplined valuation of the MSR in the pipeline and robust retained/released analytics will enable mortgage companies to manage their full range of execution options.
MIAC® delivers a full spectrum of secondary market risk management solutions that provide the tightest possible integration of the following components:
- Periodic MSR valuation for reporting/ accounting;
- Dynamic pull-through modeling;
- Daily loan-level best execution analytics;
- Daily valuation of the MSR in the pipeline;
- Daily retained vs. released analytics;
- Daily execution-specific position sensitivity analytics;
- Periodic MSR sensitivity analysis for balance sheet risk management;
- Professional secondary market and MSR risk management expertise and advisory services.
Douglas Mayers
Senior Vice President, Client Solutions Group