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Higher Rates May Renew Banks' Interest in Mortgage Servicing Rights

Fidelity Southern and HomeStreet are suddenly looking smart for their decisions to retain mortgage servicing rights while other banks were dumping theirs.

Many institutions had decided servicing assets weren't worth the trouble — low interest rates meant borrowers paid off the loans sooner, reducing the value of MSRs; and the Basel III accord assigns a punitive capital weighting on MSRs, further tarnishing their value.

The $4.4 billion-asset Fidelity Southern in Atlanta, the $6.2 billion-asset HomeStreet in Seattle and a few other banks took the opposite approach and hung on to theirs, accruing a modest amount of servicing fees while holding out hope rates would rise again one day.

That day appears to have arrived.

The yield on the 10-year Treasury has risen 42 basis points since Nov. 8, closing at 2.3% on Monday, according to the Treasury Department, on hopes that the new presidential administration will usher in more-lenient economic policies for business. Moreover, the Federal Open Market Committee seems poised to raise interest rates soon, a move that would likely lead to slowdown in mortgage prepayments and, in turn, boost the value of MSR assets.

The fate of U.S. participation in the Basel III accord is up in the air, too, according to many industry experts. That could eliminate another reason for banks to dump MSRs, as institutions would not be forced to hold additional capital against them.

The new environment justifies the decision Fidelity Southern made during the financial crisis to beef up its MSR holdings, said Palmer Proctor, the company's president.

"We didn't have a lot of legacy loans on our books, so our servicing portfolio developed at a time of artificially low rates," Proctor said.

Fidelity Southern and several other mid-sized banks with large MSR books could see a nice earnings boost in the fourth quarter, said Chris Marinac, research director at FIG Partners. That's because these companies will be able to report a positive reversal in the fair value of their MSR portfolios after several quarters of downward revisions.

Assuming the 10-year Treasury stays at around 2.25%, the fair value of MSR assets held by Fidelity Southern could rise 19.3%, to $82 million, this quarter compared to last quarter, Marinac estimated. That could generate additional fourth-quarter earnings of 14 cents per share. Fidelity Southern reported third-quarter earnings of $12.5 million, or 48 cents per share.

"All things being equal, they're going to get a lift," he said.

Other banks could see similar benefits. The fair value of MSR assets at HomeStreet, in Seattle, could rise 22.5% to $205 million. The $19.3 billion-asset MB Financial in Chicago could see its MSR assets rise 24.2% to $192 million. And the $13.2 billion-asset Trustmark in Jackson, Miss., may report a 20% rise in its MSRs' value, to $77 million.

A higher value of MSR assets produces higher levels of mortgage banking income, which is reported under noninterest income, Marinac said. An improvement in the value of MSR portfolios will also lead to higher tangible book values at these institutions, he said. However, Marinac cautioned that banks that have hedges on their MSRs could wind up eliminating the benefit of rising MSR values. Banks aren't required to publicly disclose their hedge positions.

HomeStreet may see an ever-greater benefit than other banks that decided to stick with MSR assets, because of the nature of HomeStreet's servicing business, said Mark Mason, chairman and chief executive.

"Our servicing tends to provide a higher return than our peers, because of the very high credit quality [of our loans] and our very low default rate," Mason said. "We also tend to have a higher composition of [Federal Housing Administration] and [Veterans Administration] mortgage servicing and those loans tend to carry higher servicing fees and longer loan lives."

Higher interest rates may make the business of mortgage-servicing somewhat more attractive, but bankers' opinions vary on whether it will outweigh the current impact of Basel III requirements.

The harsh capital treatment of MSRs has forced the $248 million-asset University Bancorp in Ann Arbor, Mich., to seek a buyer for its MSR portfolio, said CEO Stephen Lange Ranzini. University would prefer to retain its MSR book, however, because it's a good way to hedge against rising interest rates and it helps community banks build deeper relationships with customers, he said.

"Often mortgage borrowers build a personal relationship with their community bank that results in a positive two-way relationship," Ranzini said.

Unless the Basel III accord is scrapped, the vast majority of community banks are going to take the same approach as University Bancorp, said Chris Cole, senior regulatory counsel at the Independent Community Bankers of America.

"No one is going back into the MSR market because the Basel III capital rules are such a problem," Cole said, assuming the U.S. continues to participate in the Basel III accord.

But even if the Basel III rules remain in effect, some bankers may conclude the new rate environment and political climate have made it safe to re-enter the MSR waters, said Roelof Slump, an analyst at Fitch Ratings. After all, many banks fall under the Basel III threshold for MSR capital requirements and have room to add at least some of those assets back to their books.

"It may be viewed that holding MSRs is more attractive now, once rates are viewed as more stable or heading higher," Slump said.

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