Lower MSR valuations equals higher consumer borrowing costs

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Next week, we shall join a number of industry professionals at the 8th annual IMN MSR East conference in Lower Manhattan. What does or does not happen to the value of mortgage servicing rights in the next year will be top of the agenda. Right now, we have more questions than answers, sorry to say.

The big query we hear from many industry CEOs again and again is how the stated value of MSRs disclosed by certain public companies can be so out of line with prices for the same assets offered in the secondary market. 

"MSRs are not really a Level Three asset under GAAP," complains the CEO of a large private independent mortgage bank. "We have visible prices in the private markets. The public company valuations for the same MSRs are well-above these actual observations." 

Valuation multiples for conventional servicing are near 6 times annual cash flow for certain public issuers, yet the secondary market bid for servicing assets is generally 25% less than public valuations. The implied yield on the $44 billion in prime, mostly conventional and jumbo bank-owned MSRs, is shown below. Notice that bank servicers slipped into a loss during COVID, but returns have since soared as pandemic-related forbearance has ended and interest rates have risen dramatically.

"Despite the market volatility this year and the prospect of the Ginnie Mae risk-based capital rule, investors and issuers continue to acquire MSRs," notes Tom Piercy, managing director at Incenter Mortgage Advisors.

"With conditional prepayment rates below 5% (one month) and falling, we are somewhat in uncharted waters in terms of valuations," he noted in an interview with NMN. "Model cash flows are exceeding the market bid in many cases, especially for Ginnie Mae assets, but ultimately the value of the MSR comes down to the intent of the buyer."

Another leading MSR valuation advisor tells NMN that MSR prices have softened since the first half of the year, in part because financial buyers have exhausted portfolio allocations.

"Agency MSRs that were trading at a 5.5x multiples in 1Q and 2Q are now trading at 4.8x," notes Mike Carnes, managing director - MSR Valuation Group at Mortgage Industry Advisory Corp.

"This is due to some combination of rising cost of funds, and capital, budget, and bandwidth constraints," he relates. "We anticipate some minor improvement in 1Q as buyers get allocated new acquisition budgets and catch up on the operational constraints plaguing some of the top buyers."

Most industry executives tell NMN that while the outlook for conventional MSRs is still positive, prices for Ginnie Mae servicing rights remain soft as buyers look toward pending capital rule changes, albeit delayed. Home price depreciation may hamper the demand for certain 2022 vintage Ginnie Mae originations out of concern for the potential of a loan slipping into negative equity.

Residential properties in the U.S. collectively lost a record $1.3 trillion or 7.6% of their equity during 3Q, according to Black Knight. These declines represent the largest ever quarterly drop in dollar volume and the biggest falloff on a percentage basis since 2009, says Ben Graboske, the president of its data and analytics division.

"While hitting a record high in Q2, total homeowner equity peaked mid-quarter in May and has been pulling back ever since," Graboske said in a press release. In a recent comment on home equity loans, The Institutional Risk Analyst predicted that many loans written in the 2020 and 2021 period of low-interest rates may see some of all of the apparent equity disappear by the end of 2023, leaving second-liens written in 2020 through 2022 arguably unsecured.

For consumers, the FOMC's policy of massively manipulating down market interest rates presents a huge risk of future default. A conventional mortgage with 20% down written in 2020 could become underwater — that is, no or even negative equity — by this time in 2023. And rapidly falling home prices present the first true credit risk to consumers and lenders alike since the 2008 financial crisis.

By no coincidence, Fannie Mae and Freddie Mac just put aside $4.3 billion in reserves to cover future losses due to falling home prices. As a result, it's no surprise that both GSEs have recently started to put-back performing loans with lower coupons, an indication of mounting liquidity pressure as interest rates rise. Fannie Mae 2.5% MBS, of note, were quoted at 81 bid as this article was written.

As legacy loans prices retreat, pressure is building on mortgage lenders to raise coupons on new mortgage loans in order to restore profitability after months of secondary market losses. With Fannie Mae 6.5% MBS trading at 102 for December delivery, that implies an approximately 8% conventional loan coupon for consumers in order for the lender to actually make money on the sale of the mortgage note.

The big risk facing the mortgage industry, however, lies with the prospect of a selloff in Ginnie Mae MSRs come the start of the New Year. Many lenders and financial investors in Ginnie Mae MSRs planned to sell assets prior to the end of Q4, but the delay in implementation of the new capital rule caused several large holders to put off any potential sales.

Without a total withdrawal of the rule, however, several lenders tell NMN that they will sell both conventional and government servicing assets in order to comply with lower leverage allowed under the Ginnie Mae regime. This suggests that the cost of mortgage credit to low-income borrowers will suffer. Lower MSR values equals higher loan costs to consumers.

"If the value of the MSR falls, then the loan coupon and/or fees on the mortgage must rise," notes a veteran operator in the government channel. "Small and mid-sized Ginnie Mae issuers will be forced to sell MSRs or exit the market entirely. This will be a disaster for low-income borrowers and first-time home buyers. It will also impact people in uniform, who rely upon the VA loan market as a benefit of service."

Another negative factor putting downward pressure on government loan and MSR volumes is the fact that Ginnie Mae gives no credit for net worth calculations to issuers for advances on delinquent government loans. These assets are assigned zero risk weight for banks under Basel III, but not in the brave new world of Ginnie Mae under President Joe Biden. The credit markets are now told that government-insured loans are risky and have no collateral value. How is this helpful?

The good news, of sorts, is that rising interest rates are starting to give a lot of issuers some lift in terms of net interest margin, the same factor that is driving MSR valuations higher. One of the largest government issuers told NMN a while back that MSRs were trading for eight- and nine-times cash flow during the 1990s, a good 25% percent above the most optimistic valuations used by public mortgage companies.  Will the MSR market set a new record in 2023?

The difference between then and now, of course, is that today the Federal Reserve, the Federal Housing Finance Agency and Ginnie Mae all seem to be intent upon inflicting as much damage upon the residential housing sector as possible. With interest rate volatility, unwarranted loan repurchase demands for conventional lenders and absurd reductions in operating leverage proposed for Ginnie Mae issuers, a recipe for disaster is being cooked up in Washington. If all of the above leaves you angry and confused, then be assured you've got lots of company.