Mortgage servicing portfolios are complex and volatile assets that require assiduous financial management and rigorous modeling. There has been a tremendous fluctuation in their value over just the last three and a half years. Accordingly, regulators, creditors, accountants and shareholders all have increased focus on this asset. Basel III implementation may further exacerbate this.
MSR values from the 10-Qs of seven large servicers show an average high of 106 basis points was attained at year-end 2009. The low was in September of 2012 at 63 basis points. This fluctuation resulted in a change of value of approximately 40% or $20 billion dollars. While this sample includes only seven institutions, they make up almost two-thirds of all MSRs in existence. It might be presumed that the rest of the industry experienced a similar volatility.
While most institutions managed this volatility through aggressive amortization/write-down policies and/or hedging strategies, these responses were dependent upon the proper assessment of value, and sensitivity of value to changes in the economic environment.
Modeling servicing portfolios is very complex, much more complex than valuing the underlying loan, and is dependent upon the proper quantification of portfolio characteristics and assumptions:
- Characteristics include escrow balances, monthly payments and service fees. While ostensibly givens, these items are often incorrect. Escrow advances are often included as a separate field on the tape and missed. Monthly payments may not address balloons or fail to address future changes as ARMs adjust and the older payment option mortgages hit their full amortization period. Service fees need to be adjusted to exclude guaranty fees (often on a separate header file), as well as possible correspondent fees and lender paid mortgage insurance.
- Assumptions, by definition, will not be correct. We are trying to predict mortgagor behavior for thirty years. Until the portfolio is paid in full, we will not know how they will behave. We make our best judgment about prepay speeds, escrow growth by geographic area, default projections, among others, and value accordingly. Some projected cash flows are driven by loan count, others by principal balance, and often move in opposite directions over time. They are all effected by prepay speeds; not a trivial set of calculations.
Another complexity is that there is more than one definition of value. Depending upon your objective, you may want to quantify:
- Fair value—Accounting literature defines Fair Value as the exit price, net of all transaction costs, which a sale of the portfolio would fetch in an arms-length sale.
- Book value—Accounting rules require that either you value this asset at the lower of amortized cost or market (LOCOM), or at current market value (Fair Value). LOCOM requires estimates of value reduction (i.e. amortization) as the portfolio self-liquidates.
- Liquidation value—Warehouse lenders and other creditors that use the MSR portfolio as collateral should look at liquidation value. Since Fair Value is predicated on industry standard reps and warrants, a liquidation scenario would normally make these worthless and result in a significant discount from market value.
- Economic value—the value of the portfolio, given cost of funds, administration costs, etc. In today’s environment, economic value is often greater than fair value.
- Expected value—probably the most important value indicator for the MSR financial manager. It assesses the dynamics of the portfolio as economic conditions change. It can either be expressed as a matrix of values based on different economic scenarios, or a weighted probability of these respective values. Because of the negative convexity of servicing portfolios, expected value is usually less than a static value.
Data show MSR values appear to be strengthening. This is confirmed by the increasing number of servicing sales and the increasing competition for them. This market reality also needs to be reflected in your modeling. Accordingly, valuation models are coming under increased scrutiny. Your servicing valuation model, whether acquired from a vendor or home-grown, needs to: properly reflect the dynamics mentioned above; be properly validated; and continuously indexed to market reality.
