Retaining Mortgage Servicing Rights: Strategies For Success

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Written by David Fleig & John Sullivan
on January 19, 2015 No Comments
Categories : Blog View

BLOG VIEW: Many mortgage bankers have concluded that best execution in most cases means selling loans directly to the government-sponsored enterprises (GSEs) and retaining mortgage servicing rights (MSRs). Although the economics of retaining MSRs are compelling and favorable tax treatment is available, lenders must do the following things to maximize the opportunity for success:

  • Address liquidity: Retaining MSRs is capital intensive because, by definition, no servicing release premium (SRP) is received; SRP represents most/all of the net liquidity produced on loan sales in today's market. Ways to address this need to add cash including arranging MSR financing, adding mezzanine capital or selling equity. Frequently, a combination of these makes the most sense.
  • Refine your best execution strategy: All MSRs are not created equal in terms of market value – loan size, product type, term structure and geography influence values among other variables.
  • Decide which GSE(s) you want to deal with as an MSR owner: Fannie Mae, Freddie Mac and Ginnie Mae all approach the pledge of MSR differently and the required acknowledgement agreements (tri-party agreement between the mortgage banker, the MSR lender and the GSE) can be a major impediment to securing the financing. Fannie Mae has been the most ‘user friendly’ to date.
  • Hire a subservicer: However, understand that subservicing is not ‘high touch’ and you must have on staff at least a few folks with servicing expertise to monitor the subservicer and supplement their efforts. Seek to retain control over placement of your custodial cash balances (some subservicers insist on controlling where escrow funds are on deposit).

This article will focus on addressing liquidity and refining best execution strategy, as one cannot be properly considered without the other.

Let's start by addressing liquidity. Comments by then-Federal Reserve Chairman Ben Bernanke in April 2013 that quantitative easing was coming to a close rocked the bond market, and cash margins in the mortgage business contracted significantly back to, or below, long-term historical averages. Consequently, independent mortgage bankers (those not affiliated with a bank) wishing to retain MSRs going forward were faced with potentially significant liquidity concerns, a condition which persists today.

By the second half of 2013, many mortgage bankers that had been aggressively retaining MSRs began seeking financing, but options were limited. Several additional banks began offering such facilities in 2014 and quite a few facilities were closed and funded during the year. A few opportunistic hedge-fund-type entities also funded some large MSR loans, but at relatively high cost. A flurry of MSR finance activity is likely in Q1 2015, as mortgage bankers typically focus on strategic planning this time each year, including firms obtaining their first MSR facility – and others expanding on existing capacity.

MSR financing is not nearly as homogeneous as warehousing. What follows are some points to consider when differentiating between providers:

  • Focus on obtaining a facility that permits you to draw funds as needed over the next year or even longer before the loan ‘terms out.’
  • Avoid facilities that mature in one or two years in favor of one that better matches the duration of your MSR asset. Don't bet your business on some bank renewing a facility, regardless of how attractively priced the money appears to be. What if that loan officer leaves – or what if the bank is purchased by an institution that is not interested in MSR lending exposure?
  • Carefully review the margin call provisions of the MSR loan agreement and seek a bit of cushion before a cash payment would be required. How will future value be determined? Also, drawing down less than the maximum available under the facility will also provide some cushion should rates drop significantly after draws are made.
  • Don't forget to consider whether the lenders offer compensation for your custodial bank account balances.

Although MSR financing arrangements may represent the cheapest way to address liquidity, other avenues of adding cash may be available and necessary. For one thing, the advance rate on MSR facilities is not likely to exceed 60% of fair value. Further, for firms with less than approximately $10 million net worth, MSR financing is likely not available at present. Finally, even the largest independent mortgage firms may need to add to their capital stack to convince their existing MSR lender to add capacity to their line. We believe the best alternative for such companies will be adding mezzanine capital, either subordinated debt or preferred stock. Although more expensive than MSR debt, mezzanine capital is still far cheaper than equity and thus should be accretive.

Now, let's move on to refining your best execution strategy. This exercise will require fairly intensive analytics and access to sophisticated modeling tools. The following are key components to this exercise:

  • Pro-forma modeling to understand the future income statement and balance sheet impacts of servicing retained versus release strategy adopted;
  • Retain versus Release Analysis: Compares economic cashflows to market cashflows;
  • Initial Capitalization Analysis: Requires a matrix that considers relevant factors, such as loan size, geography, term structures, product types and par rate adjusters;
  • Incorporate the above into best execution models to maximize gain on sale and retained MSR intrinsic value; and
  • Consider the pros and cons of different accounting methods for MSR.

For those that have not yet begun to retain servicing rights, it is very important to engage in a pro-forma exercise to estimate the impact of this decision on financial performance. It is a healthy exercise to develop projected income statements and balance sheets under a variety of ‘retain versus release’ scenarios. This will provide more insight into the magnitude of liquidity considerations and the impact on financial covenants with counterparties, better preparing your organization to successfully navigate your business plan. Another key component of the pro-forma exercise is rate shock analysis, which will quantify the impact of rate movements on operating results.

To successfully accomplish best execution on new production, it is important to integrate a more sophisticated calculation of MSR fair value into your overall loan sales strategy. Many participants use an average MSR value, which can cause misleading results. All servicing is not created equal, and it is important to consider characteristics surrounding each loan such as loan size, loan type, term structure, product type, geography, loan-to-value, and credit quality at a minimum. All of these factors weigh into the accumulation of MSR fair value in the marketplace.

When considering these factors up front, you are better able to fine-tune which loans make sense for you to retain versus release, enhance bottom line results and avoid unwanted surprises when subsequent mark-to-market analysis is completed. Today's systems are sophisticated enough to integrate a more granular level MSR component when selling loans into the secondary market (whether delivered to aggregators or directly to the GSEs). To accomplish this, an MSR pricing grid with an appropriate level of detail should be obtained from a reputable source.

Lastly, new entrants into retaining servicing should be fully advised on the two methods acceptable under generally accepted accounting principles to account for the MSR asset. There are pros and cons to each method, and careful consideration should be given to ensure desired outcomes.

David Fleig is CEO of Morvest Capital, an investment firm focused on providing capital and strategic solutions to mortgage bankers, while John Sullivan is president of MorVest Analytics, which utilizes state-of-the-art tools to assist its clients with accumulation, disposition and management of the MSR asset. For more information, contact David Fleig at dfleig@morvestcap.com.

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