MSR Values Heading Up

After two years of steadily falling values for mortgage servicing rights, the recent rise in interest rates seems to be shoring up prices and setting the stage for a comeback in the MSR market.

With the average 30-year mortgage rate exceeding 6.25% in early August, the majority of outstanding loans are no longer "in the money," meaning consumers have a financial incentive to refinance.

By contrast, when rates hit a low in June, Fannie Mae estimated that over 90% of its portfolio was in the money.

Mortgage Industry Advisory Co. here, which has created a model to track servicing values, found that overall MSR values increased by over 50% in July as the result of rising interest rates, which reduced the risk of runoff due to

prepayment. And the value of agency 30-year loans increased 125% in July, according to the MIAC index. After a dismal second half of 2002 and first half of 2003, servicing values - measured as a multiple of the servicing fee - are almost back to their levels of one year ago, MIAC said in its monthly report on the MSR market.

But there is still the question about when an active market for bulk servicing trades will take hold again.

Greg Bennett, president of Hamilton, Carter, Smith & Co., Beverly Hills, Calif., said in the near term, the rise in rates will have little impact on the servicing market. He noted that runoff has been "cataclysmic" for many servicers over the past year.

"No one is willing to make that risky bet that we've seen the bottom of rates," he said. "But if this change in interest rates is sustainable in the long term, then certainly the economic value of servicing would increase."

Whether those gains in economic value translate into gains in market prices depends upon whether anyone is willing to add to their portfolio by purchasing MSRs, he said. Based on previous rate cycles, he believes it will take six to nine months of sustained, higher interest rates for an active buyer's market to develop.

In addition, Mr. Bennett said that the price at which large companies such as Countrywide capitalize MSRs on their books plays a role in the perception of what market prices should be. In order to pay a higher multiple than big firms are using for their MSRs, buyers need to be able to justify that figure for senior executives and the company's board members, he noted.

George Christo of Prestwick Mortgage Group, Alexandria, Va., said mortgage rates in the 6.25% to 6.5% range for 30-year FRMs are causing servicing values to jump.

"Servicing pricing is increasing, and it is increasing fairly dramatically on stuff that was originated a couple of months ago."

Suddenly, a large volume of mortgage loans that appeared to be on the cusp of refinancing appears likely to stick around on the books for a while.

While there haven't been many deals coming to market yet, he said both sellers and buyers are starting to "poke their heads out to have a look around."

But buyers still need a few months after a rate spike before the market will become active, he believes. While consolidation has affected the number of potential buyers for large MSR portfolios, he believes there will still be demand for servicing as potential buyers become comfortable that portfolios are in the money from a servicing perspective.

"There are enough players for not only a viable market, but a vibrant market when conditions dictate that it should be a vibrant market," he said.

He noted that over the past two years, many smaller companies that might have wanted to sell servicing rights have held onto their production because of low prices. With prices rising, they may decide to sell.

Steve Tannehill, executive vice president of Countrywide Capital Markets, said his company recently traded a portfolio of MSRs on a $4.6 billion portfolio (see related story, page one). He said Countrywide Servicing Exchange is also seeing "renewed interest from buyers."

He noted that escrow and float income also rises in value as rates rise. Under current conditions, servicers in states such as California, where they must pay consumers 2% interest on funds held in escrow, are "upside down," meaning they are earning less interest on escrow than they are paying. Higher rates should help improve escrow and float income, he said.

He said the market for MSRs is highly dependent upon current rates being higher than the rate on the loans, noting that rates stayed below 6% from January until rates climbed in July.

"A lot of product has been created that is below the current note rate," he said.

Chuck Klein, president of Charbonneau-Klein, Houston, said that prices for servicing rights sold on a flow basis should rise as rates edge up, especially if lending volume slows. That would force wholesalers to pay higher prices to keep business volume steady as supply diminishes.

If mortgage rates go as high as 7%, that should create a "great market" for MSRs on loans with 5.5% coupons, he said.

In addition, Mr. Klein said he sees evidence that the merger and acquisition market may be poised for a spurt of activity, as mortgage companies with strong balance sheets face the end of the refinancing boom.

"We've seen a flurry of M&A discussions lately," he said.

He expects M&A activity to pick up quickly, while the market for bulk MSR sales may take about six months to develop.

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