As more regulatory scrutiny falls on nonbank servicers of mortgage servicing rights, there may be an incentive for banks to exploit the leveling of the regulatory playing field. If this move fits into banks' capital structure, getting into or expanding their MSR business can create opportunities to sell additional products to the borrowers, especially for banks with servicing portfolios concentrated in their home markets. To do so effectively, banks need to develop a firm grasp of how MSRs are correctly valued.
Expectations of rising interest rates and increasing home prices make MSRs particularly attractive, especially at a time when mortgage underwriting revenue is expected to soften. Recent travails at nonbank servicers, including corporate losses and regulatory probes of MSR accounting, underscore the need for comprehensive understanding of MSR risks and the importance of accurately projecting income streams and MSR portfolio expenses.
Nonagency and Ginnie Mae MSRs require the most scrutiny — and may have the greatest potential for gains in coming years — as buyers of MSRs have increasingly bid up the loan portfolios backed by Fannie Mae and Freddie Mac. Fannie and Freddie MSRs involve more certainty on the expense side because the underlying nonperforming mortgages tend to stay on the books for a shorter time, compared with nonagency MSRs. Furthermore, the portion of nonperforming Fannie and Freddie mortgages is much lower, and tighter credit underwriting standards since the financial crisis have given MSR owners more comfort that default rates will remain low.
Less than 15% of Fannie Mae's book of business, for example, was issued before 2008. From the servicer's perspective, MSRs on loan portfolios issued through the Ginnie Mae program may have more in common with nonagency MSRs than Fannie and Freddie MSRs.
Ginnie Mae issuance expanded dramatically after 2008, and these loans' high loan-to-value ratios, generally lower credit quality than Fannie or Freddie loans, and "program losses" — which are borne by the MSR's owner in the event of default — make Ginnie Mae MSRs substantially more complex than those from Fannie and Freddie. On the other hand, any valuation of Fannie and Freddie MSRs is complicated by the higher premiums they generate at this time.
Decision makers seeking to acquire or divest from MSRs must get a handle on the basics of valuations to assure better outcomes through more informed risk management.
It's easy to underestimate risks by looking at MSRs as an investment, rather than the business that they really are, even when utilizing a subservicer to manage daily operations. More precision in these efforts must also take into account the constant changes in the industry and its regulatory landscape.
For banks looking to enter or expand MSR business, there is a pressing question: Are the best years for MSRs behind us or do current market conditions offer a favorable risk/reward opportunity? The financial crisis of 2008-2009 led to increased scrutiny of bank-owned MSRs. Increased regulatory oversight, updated capital treatment, concerns about reputational risk and high levels of delinquency made MSRs less desirable for banks to hold, resulting in substantial transfers of MSRs from banks to nonbank servicers and an increasing share of new originations coming from nonbanks.
Now the paradigm is once again shifting. Delinquencies are down and nonbank servicers face heightened regulation, which has leveled the regulatory playing field. Generally, this creates more opportunities for banks, but to stay ahead of the pack, banks must understand how to properly value MSRs. Among the valuation points that merit close attention are:
MSRs are best modeled using a discounted cash flow analysis with projections of both servicing revenues and expenses. This modeling can be split into two steps: the performance of the collateral (the underlying residential mortgage loans), and the revenue and expense to the MSR owner.
Voluntary Prepayment Rates
When valuing MSRs, it's important to accurately estimate what percentage of the loans will be prepaid in a given month, quarter or year. With more rate increases expected in the coming months, prepayments are expected to decline, which will further enhance the value of MSRs.
Typical modeling assumes that default rates of currently performing loans will ramp up and then eventually drop down to a low terminal value. Important loan characteristics that affect default rates include modification status, current and historical delinquency status, bankruptcy status, and loan-to-value ratio.
These are based on the loan's delinquency status and published statistics. Liquidation timelines, which have been extended considerably since the number of loans in foreclosure ballooned following the financial crisis, can vary substantially from state to state depending on whether there's a judicial or a nonjudicial foreclosure process. In combination with default rates, liquidation timelines have a strong impact on the expenses incurred by servicers, as loans headed toward liquidation cost significantly more to service. Program losses on Ginnie Mae loans also depend strongly on the servicer's performance during the liquidation process.
Some nonperforming loans in the portfolio can be modified to bring them back into performance by reducing the interest rate and extending the term. Modifications may increase the servicer's long term revenue, though often at a heightened risk of re-default.
Placing accurate estimates on the revenue and expenses of MSRs has never been more important. Revenue from servicing fees, late fees and float interest, as well as ancillary revenue, must be accurately modeled. On the expense side, the cost of servicing the portfolio is only part of the picture. Unreimbursed expenses, especially related to modifications and liquidations, can eat into returns, as can the cost of funding advances for taxes and insurance on nonperforming loans.
For investors who correctly value and manage these portfolios, the returns on MSRs in coming years may be well worth the investment. The devil is in the valuation details. Investors that get this essential part of the process wrong by failing to apply the right expertise may find that profits from emerging opportunities can be especially elusive.
Gunes Kulaligil is a director and member, and Greg VanLear is a vice president, of the financial advisory services business of investment bank Houlihan Lokey.
Statements and opinions expressed herein are solely those of the authors and may not coincide with those of Houlihan Lokey.