Servicing Values Starting to Creep Up Along With Rates

The mortgage industry has plenty of worries right now, with fallout from the subprime crisis continuing to spread and origination volume on the decline.

But fortunately for servicing executives, interest rate risk on mortgage servicing rights has moved off the front burner.

In fact, with long-term rates creeping up in recent months, servicing values have started to firm up. And we've noticed a number of bulk servicing packages being brought to market in recent weeks, a sure sign that MSR owners believe demand for existing mortgage assets is strengthening.

But as we all know from the big refinancing boom that peaked in 2003, what goes up can always come down again. Just because rates are firming up does not mean that hedging is a thing the past.

Still, most big servicers seem to be pretty well positioned to glean substantial value from their servicing portfolios. Forget about the valuations - Countrywide and Wells Fargo are already generating over a billion dollars in fees from their servicing portfolios. That cash stream comes in handy as loan origination volume tapers off. Even more impressively, from a valuation perspective, is the weighted average coupon on portfolios outstanding. Wells Fargo's WAC is below 6%.

That bodes well for the duration of the asset and suggests that the loans outstanding today may be more resistant to rate-induced refinancing than most portfolios of the past. But we've seen the 30-year rate hit too many record lows in the not too distant past to discount the possibility of another rate rally.

And refinancing has hardly gone away. In recent weeks, the MBA's weekly loan application survey has found that refinancing has still accounted for about 40% of home loan applications. Much of it is probably being driven by borrowers with adjustable-rate mortgages who are switching into fixed-rate or other loan products as rate resets loom on the horizon. But clearly in the new world order, borrowers are sophisticated enough to refinance for a variety of reasons, including debt consolidation or to extract equity. While slowing home price growth may diminish cash-out refinancing, lenders will still have to factor that issue into their portfolio runoff assumptions. Freddie Mac reported that while cash-out activity has slowed, 82% of homeowners who did refinance in the first quarter obtained a new loan at least 5% larger than the one they were replacing. Freddie Mac estimates that consumers extracted $70 billion of home equity through refinancing in the first quarter. Economists at Freddie noted that while appreciation has slowed, many homeowners are still sitting on lots of equity that built up as their homes increased in value during the boom years.

Economists, by and large, are not forecasting a sharp increase in mortgage rates. And that's probably a good thing, given the large inventory of homes for sale and the weakness in home prices. In a recent economic commentary, the MBA predicted the glut of homes for sale will not end quickly. Sales contract cancellations and foreclosures are likely to add to the inventory in the coming months, the MBA noted.

And where are mortgage rates headed? Freddie Mac predicts that for the full year of 2007, the average 30-year rate will be between 6.2% and 6.3%, before edging up to 6.5% next year. Other economists echo that general expectation, which would bode well for servicing managers.

But we've seen rates take an unexpected dip before.

Snapshot: Avg. 30-Year Rate Edges Up

Week Rate

5/30 6.32%

5/23 6.23%

5/16 6.13%

Source: MBA

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