Mortgage servicing rights are still considered diamonds in the rough with the potential to provide value for servicing firms and financial institutions.
But for parties that acquire MSRs, the acquisition process requires a great deal of due diligence to insure loan servicing rights acquired will turn into a beneficial book of business as opposed to portfolios of hidden risk.
A mortgage servicing right is essentially a strip of business in which a party acquires the right to service a loan by collecting payments, dealing with borrowers and taking charge of the detailed mortgage servicing process.
MSRs’ potential value became more apparent when mortgage servicing shops Ocwen Financial and Walter Investment partnered on the successful bid and acquisition of $3 billion in MSRs from the bankruptcy reorganization of Residential Capital.
The two firms were even willing to compete for the rights, with intense competition coming from Lewisville, Texas-based Nationstar Mortgage Holdings, which eventually ejected itself from the auction.
But while Residential Capital, the former mortgage lending division of Ally Financial, was one of the more publicized MSR acquisitions of the year, a stream of deals throughout 2012 suggests MSRs are more than an acquired taste.
In November, Irving-based Vericrest Financial signed a deal to buy $2.7 billion in MSRs.
Nationstar Mortgage Holdings acquired $63.7 billion of Aurora Bank’s MSRs in June and ended up seeing its income on servicing fees jump 58% from the second to third quarter, hitting $135.4 million due to a boost from the Aurora acquisition.
Walter Investment in the fall also paid $540 million to buy $50.4 billion worth of mortgage servicing rights linked to Fannie Mae and $183 million in advances. Both of the strands of business came out of the ResCap bankruptcy auction.
WALKING THE TIGHTROPE
MSR investors walk a tight rope as they try to acquire the right mix of servicing rights while still dealing with slim profit margins in a risky environment.
“The margins in mortgage servicing are much tighter,” said Loren Morris, senior vice president at Retreat Capital Management. “The cost to service a delinquent loan is much higher than a current or performing loan, and this industry has quite visibly been focused on the servicing of delinquent loans.”
The rewards of acquiring MSRs come when a servicer has the ability to service a performing or nonperforming loan at a cost that is less than the ultimate value of the loan, while collecting appropriate fees and creating a situation where they can eventually turn the loan into a performing asset, Morris said.
Morris said he’s “seeing a lot of acquisitions,” and what is occurring in the market is mostly a situation where the tier of servicers just below the mega servicing shops are buying the larger firms’ MSRs to provide high-touch special servicing on assets that are distressed or in default, Morris pointed out.
“They develop a platform that can deal with a more delinquent borrower or loan and turn it into a performing loan,” Morris said.
Before jumping on a pool of assets, everything is reviewed from the value of the property, the size of the loan, the loan-to-value ratio and analyst feedback on whether a loan has ever been restructured, Morris explained.
The opportunities to invest in MSRs even prompted national associations representing credit unions to ask regulators to let them in on MSRs.
The National Association of Federal Credit Unions wrote a letter supporting the National Credit Union Administration’s push for permissions to acquire MSRs as investments.
“We think credit unions are well equipped for expanded investment powers,” said Tessema Tefferi, regulatory affairs counsel for NAFCU.
“Unfortunately, they are not allowed to service mortgages that they have not issued.”
Still, Tefferi believes credit unions have the relationship skills to succeed in the space if allowed.
CHANGING LANDSCAPE
Steve Horne, CEO and president of Wingspan Portfolio Advisors, is not in the same mortgage servicing space as the companies that are snatching up large amounts of volume, but he does see the servicing space changing in the wake of the 2008 meltdown.
“I do think that mortgage servicing rights as they have traditionally existed are entering a period of transformation where they are ultimately going to change fundamentally into something else,” Horne said.
Ratings agencies also are following companies’ expansion when it comes to the purchase of mortgage servicing rights. Ocwen has had several headline-making acquisitions this year. Yet, Fitch is concerned about how quickly the company has grown and placed the servicer ratings on negative watch. Specifically, on Nov. 8, Fitch downgraded Ocwen’s long-term issuer default rating to “B” and placed it on rating watch negative.
“Fitch believes the outsized scale of Ocwen’s rapidly growing portfolio relative to the subprime industry and its offshore staffing strategy may pose challenges to an orderly transfer of servicing from Ocwen if a transfer were necessary at some point in the future,” the ratings giant wrote. “The risk of a servicing disruption will be considered in the high-stress and low-probability scenarios used to analyze the ratings of high-investment grade bonds.”
At the same time, Fitch warned that after securing the ResCap bid, Ocwen would still be dealing with new assets from its acquisition of Homeward Residential, which increased Ocwen’s portfolio by 60% alone, according to analyst estimates.
Two key questions a servicer has to ask is: Do they want to focus on increasing their MSR volume and how much is too much?
Diane Pendley, managing director at Fitch Ratings, is one analyst who has pondered this question. She has raised concerns about growing volumes quickly and focusing too much on offshoring the mortgage servicing rights.
Pendley recognizes that servicers “have to have volume to make those (servicing fees) work.” And, she says, some servicers make those fees work by simply sending work overseas to cut overhead expenses. But she says significant risks can surface if the company does not have appropriate home office controls in the U.S. to provide backup and quality control.
On the data analytics side, firms are seeking to provide information to help companies decide whether buying MSRs makes sense.
CoreLogic’s Advisory and Valuation Group realizes the need to provide the right metrics via its mortgage servicing rights valuation model to provide parties with the right information on the MSRs they are acquiring.
The model looks at risk by diving into the loans and pulling up analytics on the potential delinquency status, servicing costs, advances, stop-advance calculations, discount rates and cash-flow outputs associated with different MSR deals.
Scott Sambucci, vice president of advisory and valuation services for CoreLogic Advisory and Valuation Group, says the data is needed to gauge risk since the margins on MSRs remain tight.
These tight margins can become evident all too quickly. Servicer PHH Corp. posted a deeper than expected loss in the third quarter due to fair value changes assigned to mortgage servicing rights, other derivatives and foreclosure-related charges, according the company’s earnings.
The company’s servicing segment alone saw a loss of $205 million due to a $217 million negative change in the fair value of MSRs and $41 million in foreclosure-related charges.
FBR Capital analyst Paul Miller attributed the steep write-down to falling mortgage rates, but said the analyst firm still believes PHH will benefit when mortgage rates level off and the company builds cash at a meaningful rate given a continuation of elevated cash gain-on-sale margins and origination volumes.
Companies like Retreat Capital Management are familiar with the risks and gains associated with mortgage servicing rights. When asked if the firm is shopping for MSRs, the company’s senior vice president Loren Morris did not state a definitive answer. But rather said, “We are like many firms in that we are always looking for the right investment opportunities.”
The push to acquire mortgage servicing rights also comes at a time when Basel III is poised to potentially shift how financial firms holding MSRs can apply them to the firm’s Tier 1 capital requirements. The Mortgage Bankers Association warned the Federal Reserve in October that under the current Basel III proposal to shore up financial institution’s capital reserves, MSRs can only be used to account for up to 10% of common equity when determining a bank’s Tier 1 capital requirements.
“Presently, MSRs are limited to 50% of Tier I capital for banks and 100% for savings and loans, and there is no limitation on the combined total of the three asset classes,” MBA said in a letter to regulators. “Thus, if a bank is at, above or approaching either the 10% or 15% thresholds, it would either stop producing or buying new servicing assets or price the underlying loans to take into account the deduction from capital.”
Sarah Hu, an analyst from Royal Bank of Scotland, explained that “basically under Basel III, the maximum amount of MSR value that you can count towards your tier 1 capital ratio is 10%.”
“As a result, holding higher MSR (value) is becoming more expensive for servicers,”
she added.
Despite those risks, MSRs are still drawing attention with 2012 becoming a year of many MSR acquisitions whether those produce the desire results remains to be seen.
