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Perception of increased prepayments and expectations on defaults has increased in the MSR market. Although the newer 2009 and 2010 Agency Collateral has some of the best product attributes to date, risk aversion for buying MSR’s continues. Investors are now requiring higher rates of return as market transactions have become more infrequent and at times distressed. Cost to service numbers are on the rise due to increasing defaults and the realization that these costs must be accounted for.
According to MBA’s delinquency statistics, serious delinquencies increased by over 50% between the fourth quarter of 2008 and the fourth quarter of 2009. Thirty-day and sixty-day delinquencies have stabilized and have even shown some improvement. We believe it is very important to incorporate delinquency projections that reflect the delinquency performance trends arising since late 2007. We also believe MSR values frequently are being priced without reflecting the performance projections resulting from the market shutdown. Liquidity concerns and the deteriorating delinquency performance occurring across the credit spectrum create added risks that must be correctly priced.
During this time of increased volatility, prepayment expectations show a wide variance from firm to firm and can produce a serious whipsaw effect on values without intervention and a true understanding of actual prepayment behavior. The Bloomberg caption on the right shows how speeds can vary widely between firms.
Recent Headlines
Last month, Fannie Mae and Freddie Mac said they would escalate the buyout of approximately $200 billion in seriously delinquent home loans. While all GSE prepayments will increase for at market and premium coupon stacks, 2005 to 2007 vintage product will produce the majority of the buyouts. Fannie Mae prepayments will probably spike over a 3- to 4-month period on 120 plus day delinquencies that are bought out over a period of a few months. Freddie Mac will have bought out all 120 plus day delinquencies leading to prepayments in excess of 80% CPR by the March report.
Even after the initial push, GSE buyouts should continue in earnest as long as the GSE’s can fund the buyouts through their debt at a lower cost then the loan coupon rate. This differential will be the Carry Spread Cost Savings to the GSE’s.
Although borrower behavior is unaffected by the GSE announcement, accelerated buyouts result in faster reported MBS prepayments because MBS prepayments include voluntary and involuntary prepayments. Like most market participants, MIAC uses reported MBS prepayments as part of the mix for calibrating prospective voluntary and involuntary borrower behavior to reflect a market consensus behavior. In addition to historical reported MBS prepayments, MIAC utilizes implied voluntary prepayments from MIAC’s GSA pricing, historical roll transition matrices, Wall Street dealer forecasts, Bloomberg Medians forecasts, and other MBS prepayment forecasts to a MSR market consensus calibration. In addition, MIAC utilizes a tiered default projection by modifying the probability that delinquent loans have a greater propensity of reaching 120 days past due. Currently we estimate that more than 80 percent of 90-day delinquent loans will roll into 120’s leading to buyouts. Taking the percent of 120 plus day delinquencies and adding it to the SMM (Single Month Mortality) can give some estimates of the projected cumulative voluntary/involuntary prepayment. Clearly servicers will benefit from no longer having to advance principal and interest post buyout.
Market Pulse
While there continues to be pockets of opportunity for niche players, and some firms are taking full advantage of the buyers market, there is a general lack of liquidity in the bulk MSR market for most servicing asset classes. We have seen some activity in the Non Agency MSR sector. The limited transaction activity of the past few years is varied but this is largely attributable to the following:
1) Many of the large servicers have been on the sidelines making MSR absorption more difficult. According to the latest statistics from National Mortgage News, the top five servicers comprise a market share of approximately 67%, and the top 10 servicers encompass approximately 75%. Who of the remaining servicers can reasonably absorb substantial volume without stressing their existing servicing platforms or balance sheets? To highlight the vast size disparity between the top 25 servicers, an aquisition of $10 billion in UPB (what was once considered an attractive deal size by top servicers), would represent a 35% increase in portfolio size to the 25th largest servicer in the nation.
Middle tier servicers, mostly banks, have left the market mostly due to their capital constraints but also because of the volatility of the MSR asset relative to their ability to apply effective risk management strategies to mitigate that risk. Small servicers have not shown the financial strength to purchase multiple bulk portfolios over an extended period of time, especially with the lack of warehouse lending available and Fannie Mae’s new capital requirements which have drained excess cash.
On a positive note, there are several new entrants into the MSR market, mostly from the high touch servicing sector. The market is hopeful that they will provide some level of sustained demand that will help stabilize and eventually increase MSR values.
2) There is continued lack of demand for portfolios under $10 Billion for several reasons.
>Large servicers have no need to purchase blocks of seasoned servicing when they are originating $10-20 Billion a month of very clean, low note rate servicing under much tighter underwriting standards then seasoned product.
>Counter party risk has come to the forefront of the decision process on any large MSR acquisition due to the increase in Fannie Mae’s and Freddie Mac’s put-back activities. This dynamic will continue to shape the MSR market environment for the foreseeable future.
>Headline Risk – Despite being in the midst of one of the best buyer markets in history, many MSR buyers remain fearful of making “The Big Decision”. One bad decision can leave a lasting effect and few buyers are willing to put their jobs on the line, no matter how attractive a deal may seem.
Conclusion:
Why buy servicing? From MIAC’s perspective, we believe the prices for Agency servicing have dropped to very attractive s relative to the risk profile of the asset class. We also 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. For high touch servicing operations with strong advance funding capabilities, the higher touch MSRs, like Non Agency and certain Ginnie Mae collateral pools, may represent very attractive yields relative to other Agency classes.
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