Monday, August 16th, 2009.

     Among the changes that the mortgage industry has experienced over the past year, perhaps the most fundamental and profound for mortgage lending firms is a shift in the opportunity for retaining servicing. Most banks and credit unions that originate mortgages prefer a servicing retained (“SRT”) secondary market execution.  But for the past 15 years or more, the dominant secondary market execution for independent mortgage bankers (“IMB”) has been servicing released (“SRL”).

      Until the mid-1990’s, it was fairly common for mortgage lending firms to have direct agency relationships, and retain servicing on MBS or cash-window sales on a significant portion of their production. The growth of correspondent lending, and the advent of the mega-servicers produced a tax-advantaged servicing-released premium (“SRP”) that made it significantly non-economic for an IMB to continue an SRT execution.

      Current secondary market dynamics have diminished the SRP to the point that the SRT execution is once again attractive for a portion of an IMB’s production. For certain loans, the intrinsic value of the mortgage servicing rights (“MSR”) asset is very near, at, or above the SRP being paid by the correspondent investor (“Aggregator”).


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, and d) must consider all possible investor delivery options. To maximize flexibility and competition in the secondary market, that means (for conventional loans) modeling and analyzing the execution for:

      There is a wide range of implied servicing valuations on display here.  This makes clear that it’s not just the Mortgage Rate, but a combination of the loan level characteristics that drive the SRP and total execution.  It also is true that each investor has its “hot spots” and “cold spots”, and while we omitted the names of investors responsible for each of the prices in the matrix above, we can tell you several are represented. Only a granular best execution analysis will be able to effectively isolate the opportunity to retain servicing, and the results will be a function of the specific originator’s book of business.

      MIAC’s perspective is that the current secondary market offers an opportunity to retain servicing on a highly selective basis with the following benefits:

MSR Valuation and Accounting

      When a mortgage originator executes an SRT transaction in the secondary market, a division of the mortgage loan occurs, and an MSR asset is acquired for their own balance sheet. MSR’s are a fair-value (“FV”) asset, meaning that the asset must be recorded on the originator’s books at a value that reflects what the market would pay for it.  When the MSR is booked, the firm also must choose between two accounting treatments for forward periods: FV or LOCOM (“Lower of Cost or Market”).  Under LOCOM, once the FV is determined, it is recorded as the cost basis for the asset, and amortized over the assumed life of the asset. Alternatively, under FV, the firm will recognize both increases and decreases in the value of the MSR, and those changes in MSR value are taken directly as non-cash adjustments to earnings. 

      Most firms who retain servicing choose LOCOM in an attempt to avoid the potential for earnings volatility represented by FV treatment. However, under LOCOM, the MSR asset can only be “written down” to establish a new book value, and any increase in MSR value cannot be recognized. As a result, earnings can only be adversely affected by any reduction or “impairment” in the value of the MSR. And, since MSR value cannot be “written up”, its benefit as a hedge against P&L losses related to production is eliminated.

      The natural response to this is that firms will choose to originally record the MSR asset at a value that is low enough to avoid impairment, but high enough to satisfy auditors, regulators and other interested parties that it is a close approximation of FV – and therein lies part of the challenge. 

      Some firms solve for this by defaulting to the SRP that would have been paid for the loan in an SRL execution, citing this as an observable mechanism for price discovery.  MIAC’s perspective is that this method is not a reliable means for accurately reflecting the “fair” value of the asset, because SRP is rarely an accurate reflection of the intrinsic value of the servicing asset.  For reasons of their own, Aggregators tend to overpay when rates are high, and underpay when rates are low, indicating that the intrinsic value of the asset is rarely in synch with market price. This dynamic creates an outstanding opportunity for originators of MSR to retain MSR when the fundamental value of the asset is greater than the market price – as is currently the case.

      However, the opportunity for retaining servicing is not uniform across the spectrum of originations. Also, due to cash and capital constraints among IMBs, SRT execution may be limited to a minority portion of their originations. While cash and capital may not limit the opportunity for banks and credit unions, we at MIAC advise all firms to be opportunistic, and to the extent possible, allow the economics of the execution to drive the SRT/SRL execution decision at the loan level. 

MSR in the Pipeline, Inventory, and Portfolio

      Based on SEC Staff Accounting Bulletin 109 (“SAB 109”), mortgage originators who are motivated to make the investment in MSR should consider the valuation of the MSR embedded in the pipeline and unsold inventory. We expect that auditors, regulators, and other interested parties will follow this guidance.  SAB 109:

      “expresses the current view of the staff that, consistent with the guidance in Statement of Financial Accounting Standards No. 156, Accounting for Servicing of Financial Assets, and Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings”

In this context, a “written loan commitment” is analogous to both the locked pipeline and closed loans held for sale.  Essentially, SAB 109:

Mark-to-Model Methodology

      The upshot of SAB 109 is that the firm must assign a value to the servicing for loans that are held for sale that will be carried to the balance sheet as the FV assigned to the MSR associated with that loan. Accurately determining the value of the MSR for portfolio valuation, best-execution, and street pricing purposes is critical to executing the SRT strategy, but is unfamiliar territory for many firms.

      While it is possible for a firm to create its own model for valuing the MSR asset, there are highly cost-effective external valuation services in the market that use fully validated, software applications dedicated to the task. Of course, the results of any model are only as good as the assumptions that are entered into it, so it is imperative that the model assumptions themselves be considered realistic in order for the results to be defendable.

      The catch is that MSR is an illiquid, thinly traded asset, and there is little or no observable market activity to provide for price discovery like there is with MBS.  While there is an obvious downside to this situation, the upside is that FASB has recognized MSR as a “Level 3” asset class, meaning that in the absence of a mechanism for actual market-based or “mark-to-market” price discovery, determination of FV may be achieved through a “mark to model” method.

      Due to the complexity of the MSR asset, MIAC dedicates a great deal of time, energy, and resources to the development of realistic assumptions for all the variables impacting the valuation of MSR. Our GSA (“Generic Servicing Asset”) service entails a monthly survey of the major servicers in the industry using a mock MSR portfolio.  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 that 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.

Other Considerations

      Beyond the empirical best-execution analytics we have discussed above, there are many other issues to be considered that have an impact on the economics of the SRT execution.  These other considerations are directly correlated to the numerous variables that are factored into the valuation of an MSR portfolio: cost of servicing, remittance cycle, interest on escrows and remittances, delinquency and advance obligations, time to foreclosure, and voluntary prepayment expectations.

Subservicing vs. In-house servicing

      Most independent mortgage bankers have little or no experience in servicing mortgages and are unprepared for doing so beyond interim servicing prior to settlement of loan sales.  Servicing is a “scale business”, so building an in-house servicing platform is an expensive and labor intensive undertaking, and achieving economies of scale is critical to making servicing a cost-effective enterprise.  Fortunately, there are several sub-servicing platforms that specialize in providing outsourced servicing of mortgages, and currently their services are in high demand.  Those who are committed to make a significant long-term investment in MSRs and maximizing their franchise value should consider developing servicing capability in-house over time.  Bringing the servicing activity in-house creates a multi-dimensional relationship with the borrower, provides greater control over the performance of the servicing portfolio, and creates a more robust enterprise overall.

 Cash Window vs. MBS Execution Differences 

      For Freddie Mac, the remittance style is the same for their Cash Window execution as it is for their Guarantor or PC execution, as covered below, so there is P&I Float to consider in a Freddie Mac Cash Window execution.

      MBS execution is available for Fannie Mae, Freddie Mac, and Ginnie Mae.  The remittance style for Fannie Mae and Ginnie Mae MBS is “Scheduled/Scheduled” (S/S), and for Freddie Mac PC is “Scheduled/Actual” (S/A).  Under S/S, the servicer is obligated to remit the scheduled interest and scheduled principal to the investor. Under S/A, the remittance obligation is Scheduled Interest and Actual Principal. In both S/S and S/A, the servicer must remit scheduled interest regardless of whether a payment was received from the borrower. Freddie Mac makes available multiple remittance cycles, but under the standard S/A remittance, the servicer is not obligated to remit principal until it is received from the borrower. (Freddie Mac has an accelerated remittance cycle called SuperARC that does require scheduled principal remittance). The “advance obligation” is in effect as long as the loan remains in the pool of loans backing the MBS/PC.  This obligation is offset by the servicer’s opportunity to earn interest on the borrower’s payment (“P&I Float”) between the date the payment is received from the borrower, and the date that the remittance is made to the investor.  Depending on the investor and the remittance cycle, the P&I Float can be up to 45 days. 

      The servicer can discontinue the advance obligation for a given delinquent loan by repurchasing it from the security after it has been delinquent for a certain period of time, or met other requirements as defined by the investor. These advances and other related expenses (like advances for taxes and insurance) are recoverable by the servicer out of REO proceeds, but this can be a significant negative-cash flow burden until the reimbursement takes place. The relationship between servicer and investor has become very fluid and dynamic, so we recommend that you review your applicable Seller/Servicer Guides, Announcements, and Bulletins for details and updates on advances, repurchases, and remittances.

      In favor of MBS execution, the added complexity of the accounting/reporting may be offset by the “float” opportunity on MBS.  Also, the gain-on-sale for MBS is historically higher Cash Window execution, typically by up to 25 basis points, so firms who have confidence in the quality of their product, and who have a command of the accounting/reporting issues (or have outsourced it), will find that this is a better option most of the time. Daily best execution analysis between Cash and MBS execution is an exercise that is important for maximizing proceeds, and for accurate risk management and hedging, as the ability to deliver into the MBS used as a hedge instrument can improve hedging efficiency.

      In summary, as attractive as the up-front economics may be for retaining servicing, the ownership and management of the MSR asset can be very challenging both operationally and financially.  MIAC’s perspective on MSR is that it is strictly for long-term investment and should be carefully considered from many angles.  MSR is not a liquid asset, and we advise against an approach to retaining servicing that relies on trading gains to achieve target returns.  The origination, ownership and management of MSR represents a major shift in the business plan for any firm.  The SRT execution has significant implications for the firm’s balance sheet, earnings, cash-flow, and operations, and may impact investor and financing relationships.

     For an interactive and deeper dialogue on the topic of this article, we highly recommend that you join MIAC and others for an MBA sponsored event in Denver on August 25 titled “Retained or Released Servicing: An MBA Workshop”. The link to the website for this event is below. We look forward to seeing you there.

http://www.mortgagebankers.org/RSWorkshop09.htm

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