The largest lenders and servicers have long dominated the mortgage industry, but it's gradually becoming easier for small and midsize companies to do business with Fannie Mae and Freddie Mac.

Greater parity in the guarantee fees charged to large and small lenders has created more incentive for small originators to sell their loans directly to the government-sponsored enterprises.

As a result, the share of loans Fannie and Freddie bought from their five largest lender customers plummeted to 31% in 2016, compared with 60% in 2010, according to Federal Housing Finance Agency data.

Likewise, the share of loans purchased from lenders ranked No. 26 to No. 100 grew to 23%, from 8% in 2010. Lenders outside the top 100 saw their market share grow to 17% in 2016, compared to 8% in 2010.

The same trend has also developed in servicing, but to a lesser degree. Higher costs, regulatory compliance and lower delinquency rates have curbed the decline in servicing market concentration that's long been a mainstay of this notoriously scale-driven business.

Nearly 40% of single-family loans were serviced by Fannie's five largest servicers in 2016, compared with the roughly 50% market share held by the top three servicers in 2010, according to the company's financial disclosures. Meanwhile, Freddie Mac's top five servicers were responsible for 46% of its single-family loans in 2016, down from 68% market share among its top five servicers in 2010.

While the dominance of the very largest servicers has eased, secondary market participants are still concerned about overall concentration risk and are taking steps to open up opportunities for small and midsize players.

At Fannie Mae, new tools are helping connect smaller lenders and servicers to facilitate co-issue transactions at its cash window. And Ginnie Mae is taking steps to bring more subservicers into its sector of the industry, while providing greater oversight and support of all its servicing counterparties.

What's more, the growing complexities in servicing have opened the door for a variety of options to outsource certain tasks and responsibilities and provide servicers more flexibility for how they manage their businesses.

With overall economic conditions improving, the timing of these efforts couldn't be better. The volume of loans requiring costly distressed servicing has declined dramatically, while rising mortgage rates have cut into borrowers' incentive to refinance and made mortgage servicing rights more valuable.

The transition to a purchase-driven origination market last year was marked by rising interest rates and home prices, but an overall decline in loan volume that left many small and midsize lenders strapped for cash.

The decline in originations also cut into the supply of new mortgage servicing rights coming to the market — increasing their value and providing lenders more flexibility to either sell them for an upfront payout or hold onto them and receive an ongoing revenue stream.

But there's a catch. Large aggregators of servicing rights try to avoid buying small packages of MSRs that have less attractive economics. Enter Servicing Marketplace, a sort-of matchmaking portal that connects small lenders and servicers to co-issue loan sales through Fannie Mae's whole-loan conduit, also known as the cash window.

"Some of these smaller players are having a harder time competing on the servicing side and this allows them to have more access," said Renee Schultz, a senior vice president in Fannie Mae's capital markets unit.

Fannie designed the SMP platform using the agile software development method that is aimed at producing quicker, feedback-based rollouts and has been pilot testing it with a handful of lenders, servicing sellers and buyers since last summer. It plans to roll the platform out more broadly this year.

A key feature of the new technology is that it provides an easier way to handle the split of representations and warranties between lender and servicer.

Fannie is "trying to bring more standardization to a co-issue transaction" by doing this, said Craig Freel, a senior vice president in portfolio management at RoundPoint Mortgage Servicing Corp., a company that has tested the automation.

Renee Schultz, a senior vice president in Fannie Mae's capital markets unit.
"Some of these smaller players are having a harder time competing on the servicing side and this allows them to have more access," said Fannie Mae SVP Renee Schultz

Unless the lender opts to sell on a bifurcated basis, where the reps and warrants are separated from the servicing and remain with the lender, the servicer ends up getting repurchase requests and other inquiries associated with origination as they do in more typical situations where the lender also services.

"It's much easier if there is an issue with a loan for it to be resolved by going to the seller as opposed to going to the servicer, and then from the servicer to seller. So if there's an issue, we'd go to the seller directly. It's just a much more streamlined process from that standpoint," Schultz said.

"Both parties like it better, and I think increases the value of the servicing and liquidity around it because there's not as much counterparty risk for the buyer," said Freel.

"There might be people on sidelines right now that weren't comfortable taking on the representation and warranty risk, but now that it's bifurcated, that could change their mind," he said.

"Removing all the friction from a transaction and providing a technology platform to enable a transaction lowers a barrier to entry."

About 15% of the mortgages Fannie purchases involve a third-party servicer. Current market conditions make it likely that percentage could grow going forward.

Outside the box

When big players consolidate in a cost-heavy line of work like servicing, they often outsource anything they can get done more efficiently, so long as it doesn't undermine their core business.

"Large funds that are buyers of MSRs typically they don't always have the operating capabilities to deal with the underlying loans, so they will utilize a subservicer to support the subservicing of the underlying loans on the MSRs that they have bought," said Lee Smith, chief operating officer at Flagstar Bank.

Servicers are even outsourcing types of work they wouldn't normally hand over in the past.

"We're starting to see component servicing in some core areas of servicing, as well as some of the higher-risk areas such as default management, Federal Housing Administration claims, agency claims and even investor accounting," said Nicholas Corpuz, vice president of servicing at Subsequent QC, the quality control audit unit of risk management vendor Mortgage Quality Management and Research.

"I'm constantly amazed by companies' ability to offload to vendors a specific part of servicing that I thought was a core part of doing servicing. What's really unusual is to see investor accounting outsourced. That's kind of getting down to the nuts and bolts of servicing," he said.

Flagstar Bank COO Lee Smith
"To have a profitable performing servicing or subservicing business you probably need somewhere between 175,000 and 200,000 loans," said Flagstar Bank COO Lee Smith.

Investor accounting for Ginnie Mae mortgage-backed securities is increasingly getting outsourced, Corpuz said, particularly among servicers that are more accustomed to managing portfolios of GSE loans.

"Ginnie Mae has some complicated rules for servicing that Fannie and Freddie don't have," Smith noted.

Dispersing concentration risk

Companies that want to service loans in-house don't have to be enormous to be profitable, but they do need a certain amount of scale, said Smith, whose bank both services its own loans and subservices for other MSR owners.

"We've run the numbers on this," he said. "To have a profitable performing servicing or subservicing business you probably need somewhere between 175,000 and 200,000 loans."

The secondary market is wary of servicing concentration risk because overreliance on a few large players could leave the industry without sufficient capacity in the event a company suffers a catastrophic failure. The same applies further down the line for servicers and their vendors.

Even though keeping volume consolidated among servicers and outsourcers offers scale pricing advantages and requires less vendor oversight, it doesn't protect against a counterparty becoming complacent.

"I know on the independent mortgage bank side, they are looking at the vendors they do business with and wondering if it doesn't make sense to work with five vendors that perform the same service when they can consolidate them," said MQMR President Michael Steer. But firms must have enough continuity internally in case a vendor goes under.

As subservicers and other third-party vendors take on more servicing responsibilities, it will be imperative for secondary market participants and MSR owners to keep a close eye on the financial soundness of their counterparties and maintain a diverse stable of partners to work with. The demand to keep concentration risk in check could create more opportunities for small and midsize servicers.

For example, Fannie Mae keeps tabs on the operational health of both servicers and subservicers with peer benchmarking scorecards. Ginnie also uses scorecards to benchmark its issuers on a variety of servicing metrics, and may expand that oversight to include subservicers.

"We are actively looking at this issue and considering changes to the appropriate policy framework to mitigate concentration and other operational risk, in addition to ensuring the necessary enforcement mechanisms are in place to safely manage our program," said Michael Huff, a senior advisor at the agency. "Additional information and specific proposed changes will be announced in the near future."

Quote
"A very small but aggressive fish could eat a big fish."
— Vamsi Mohan, head of mortgage operations, Karvy Computershare

A subservicing scorecard could make the complexities of Ginnie Mae servicing easier to understand and make the opportunity more attractive to subservicers.

"We have found Fannie's subservicer scorecards to be effective and would welcome Ginnie doing the same," said Gagan Sharma, CEO of subservicer BSI Financial. The value lies in the scorecard's peer group benchmarking, he added.

Ginnie works with 307 servicers, said Michael Ehrlich, mortgage community manager at Thomson Reuters. And there are 23 subservicers approved to manage Ginnie Mae loans, according to Huff. The sector is in dire need of more.

About half of Ginnie issuers worked with subservicers last year, with 66% of their loan volume handled by just three subservicers, Huff said. In 2016, there were 19 Ginnie subservicers, with the top three managing 82% of subserviced loans.

Ongoing concerns about the concentration of Ginnie Mae subservicers present an opportunity for new participants. The most strategic thing a small servicer could do to be successful is employ a technological differentiator that significantly lowers costs.

"A very small but aggressive fish could eat a big fish," said Vamsi Mohan, head of mortgage operations at offshore outsourcer Karvy Computershare in Hyderabad, India and a former Bank of America executive.

One such technology a servicer could exploit is optical character recognition, said Mohan. While the imaging technology has never quite lived up to its full potential, the incorporation of machine learning capabilities offers new hope. And a servicer that successfully added enhanced OCR to its processes could differentiate itself in the market.

"There's always a push to lower your costs and if you already do it or you can perform it better using new technology that somebody else doesn't have, you can lower the cost of that production for the client base," said Steer.

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