In the past few months Fannie Mae and Freddie Mac have been exploring the idea of letting servicers retain less than 25 basis points a year of a loan's balance - a minimum that the GSEs set in the mid-1980s.
Such a reduction could profoundly affect the mortgage industry; there is a dizzying array of opinions on how. Plenty of people do not want the change, but many are anxious for it.
The Mortgage Bankers Association plans to bring more than two dozen mortgage lenders and servicers, of different sizes and with different business models, to Washington on Thursday to discuss the change with the two government-sponsored enterprises and others.
There is some indication that the fee floor could fall by as much as half, though there is no guarantee either Fannie or Freddie will do anything, especially after lobbying in 2003 by at least a few servicers for a cut failed. Still, the need for the two GSEs to be more accommodating, because of private issuers' rising share of mortgage securitizations and the GSEs' own political trials, may make the timing right.
And if either Fannie or Freddie acts, the other would probably have to follow suit.
Here are some of the debate's important questions, along with possible answers.
Why would servicers want to be paid less?
Agreeing to collect less over the life of the loan would let lenders sell more of the expected income stream from monthly payments up front. Doing so would mean servicing rights would become a smaller asset on their balance sheets.
As assets, residential mortgage servicing rights are notorious for swinging sharply in value - and potentially producing big earnings hits or gains - in response to changes in interest rates.
Under current accounting rules, servicers must put an asset as large as the value of their servicing rights on their balance sheets when they originate or acquire the rights, and they must record that much income. At each subsequent quarter's end, they must revalue those rights by using market values or, if none exist, internal models.
When rates fall, the likelihood of refinancings increases, values drop, and amortization accelerates. When rates rise, values rise, servicers can recover past impairments, and amortization slows.
Of course, many servicers hedge against the volatility. But hedges come with costs in infrastructure and manpower, and they do not always work perfectly. Accounting quirks, capital-market hiccups, or poor execution can produce headaches.
Another big issue: As an asset, servicing must be financed, and capital must be held against it.
Some servicers find it particularly capital-intensive, though others find it less so. While banking companies' regulatory and other capital requirements can be less onerous than what rating agencies and lenders require of nonbanks, that advantage depends to a certain extent on how much of the balance sheet the rights make up. If that percentage is too large, it requires full equity financing.
These problems also exist for a small asset, but to a lesser extent - though cutting the fee floor in half would not necessarily cut the size of the asset by that amount. Valuations also take into account expected ancillary income, such as float on escrow balances and late fees. And "excess" servicing income is often left over.
What's excess servicing?
It's how much of the income stream from interest payments that a servicer retains above the minimum required fee after a loan is securitized.
For instance, assume a borrower gets a mortgage with a 6.25% rate. Then assume 25 basis points must be set aside for the guarantee fees the GSEs typically charge for taking on credit risk. A lender might pool that loan into a mortgage bond with a 5.5% coupon. Holding back another 25 basis points for the servicing leaves 25 basis points of excess yield.
This excess - which, like the servicing minimum, is similar to an interest-only bond - can be eliminated in two ways. Large servicers often securitize it. More commonly, the excess is sold to Fannie or Freddie as a "buy up" of the guarantee fee, or the fee is bought down, so the loan can be put into a 6% bond.
Why not let servicers collect nothing for doing the work, if that suits them?
At its core, a floor exists for two reasons: to align the interests of servicers with those of mortgage bondholders, and to ensure that if a servicer fails or must otherwise be replaced, another company would want to take on the work.
When it comes to the latter issue, there appears to be a consensus that servicers do not need as much on a percentage basis to make an acceptable return as they once did - and that, in general, 12.5 basis points should be more than enough.
Loans are generally much larger now than they were two decades ago, so there is more revenue but not more work. Meanwhile, technology and the economies of scale created by dramatic consolidation have increased efficiency.
Executives at some large and midsize servicers say they can cover their expenses without collecting any money from the monthly payments. The ancillary income is enough, they say.
Another factor for Fannie and Freddie to consider is that servicing rights act as de facto collateral or leverage in their dealings with lenders, several executives said. Sometimes, when a servicer fails, does a poor job, or refuses to take bad loans under repurchase agreements, a GSE will seize its servicing. A smaller asset provides less protection, which could lead to more formal collateral requirements, such as letters of credit, or higher guarantee fees.
Why would bond investors be concerned about all this?
According to mortgage bond analysts, lower servicing fees could have several effects - most of them negative, but not all.
One fear is that with less future income to lose, servicers would try to refinance more borrowers in their portfolios and make the mortgages' life spans more rate-sensitive. For the same reason, servicers might do less to avoid foreclosures, which increase prepayment speeds but do not pose a credit risk to investors, because of GSE guarantees.
Both possibilities reflect how ongoing fees present an incentive ("skin in the game," as market participants say) for servicers to do their jobs. A counterargument is that servicers' solicitation efforts do not mean so much now when it comes to refis, because borrowers and loan officers are quick to get a loan refinanced on their own.
Another concern is that servicers would be even more tempted to cherry pick: to amass loans that appear the most rate-sensitive in pools with lower servicing fees. (Analysts say it appears that servicers are already doing so, and that prepayment speeds on such bonds are slightly higher.)
Such adverse selection might not be apparent to the investor, as lenders know things not disclosed to investors. A good example of information not disclosed to investors is whether a broker originated the loan - brokers tend to be more aggressive than retail lenders in seeking out refis.
On the plus side for investors, a lower servicing minimum would mean bond coupons would probably be closer to loan yields. That change would slightly lower the refi risk.
Analysts generally say the bond market could accept lower servicing fees, but they offer caveats. They suggest creating pooling rules that would prevent cherry picking, or clearly disclosing servicing fees on all securities.
Why would any servicer not want to lower the fee floor?
For some, general uncertainty over the consequences of a reduction puts a big mark in the "status quo" column.
The current setup also gives some servicers a competitive advantage. They possess more balance-sheet room than other servicers, can get access to cheaper financing, and think they are good hedgers.
There is also a concern that a change would scare investors away from the To Be Announced market, the most common and efficient tool for hedging applications in lenders' pipelines. In the TBA market, mortgage bonds with a variety of characteristics can fill forward sales.
Countrywide Financial Corp. and Washington Mutual Inc. have been the most outspoken in calling for lower servicing minimums - servicing rights make up a relatively large portion of both companies' balance sheets. Wells Fargo & Co., the other top three servicer, is said to oppose a reduction. While many across the spectrum want the change, at least a few other sizable servicers say they are leaning against it.
Another concern is taxes; the Internal Revenue Service might decide to reevaluate the current rules in light of a change.
For accounting purposes, servicers recognize most of their servicing income up front in their gain-on-sale profits. But they have a "safe harbor" to report up to 25 basis points - today's fee floor - on GSE servicing to the IRS as it is actually collected.
A smaller safe harbor would require servicers to pay taxes on more of the gain-on-sale income sooner rather than later. And if the IRS did change its rules, smaller servicers that wanted to sell less of the loan's income stream up front (so they could collect ongoing income to cover higher operating costs) could pay more in taxes right away without even collecting more cash.
What would happen to the servicing industry if the fee floor were lowered?
Getting into (or staying in) the third-party servicing business might make sense for more small companies.
In theory, all mortgage lenders - and banks and thrifts in general - should want to be servicers. If another company services their loans, their customers could be poached.
However, frustration with earnings volatility and hedging costs has pushed many servicers out of the business. At times, shareholders also suspect that valuations are being massaged to meet quarterly targets.
For example, before selling its mortgage unit to Citigroup Inc. last year, Principal Financial Group Inc. irked investors by making several adjustments to its servicing valuation models during the recent refi boom. Hibernia Corp. also got out of third-party servicing last year, and TCF Financial Corp. began letting its book run off; both cited the volatility of the business.
And volatility that stemmed in part from the servicing side drove Cendant Corp. to divest itself of its mortgage operations in a spin off this week.
A smaller servicing asset would presumably ease such concerns, as well as financing and capital issues, and it could reverse the ever-accelerated consolidation in the servicing industry.
What's the flip side?
Another scenario is that consolidation speeds up, or at least continues.
The lower fee floor would let already-large servicers with balance-sheet challenges take on servicing more quickly. And lowering the minimum servicing fee would not eliminate the main challenge for small servicers: small scale.
What do those mortgage banks that sell all their servicing think of the idea?
Some are afraid of lower margins. Many others are not.
If servicers started collecting less on an ongoing basis, how much they would pay for the right to do the work - sometimes called a "servicing-released premium" - would decline. This premium is typically much higher than the amount above par that nonservicer lenders receive for the loan itself.
However, higher loan premiums should offset lower servicing set-asides. In theory, the 12.5 basis points would not vanish; it would simply move to the other side of the equation and produce more income in the form of sales of higher-coupon bonds or excess servicing. As a result, many executives at mortgage companies that do not service loans expect to continue to collect the same amount over all.
But other companies of this type worry that servicers might not get as much value to pass along from loan sales.
Another concern is that competitive pressure could more easily eat away at yield spreads, since they are more flexible, because of the fee floor, than servicing values. (Of course, lenders would still want to maintain their margins.)
In this line of thought, the more cash servicers get up front - rather than accounting gains - the lower the rates they would be able to offer consumers, and the higher the fees they could pay brokers without dipping into future cash flows.
Wait a minute. Didn't the fee floor already drop?
Yes and no.
Both Fannie and Freddie have already created mortgage-backed securities structures with special "prefixes" in which lenders can retain less servicing. (Freddie made its structure available for certain lenders in December. So far, at least one lender - Wamu - is taking advantage of it. Fannie made its bond structure available earlier, and Countrywide has used it in the past.)
However, those pushing for a change are asking the GSEs to make the lower servicing floor the standard. Without that, there is a cost for lenders in using reduced-servicing-fee bonds - lower liquidity that hurts pricing. Also, lenders cannot sell forward unusual prefix bonds in the TBA market.
TBA eligibility rules do not address servicing levels, so the GSEs could let servicers drop pools with less servicing into generic bonds right now. But doing so would no doubt anger investors. And a transition would take a delicate touch, since buyers would want to know ahead of time when they would be bidding on a changed product.
The Bond Market Association, which governs the rules for the TBA market, is publicly taking no position on the idea of reducing the fee floor. It has polled some members but has not released the results.
Didn't Ginnie Mae already do something like this?
After similar lobbying from servicers, the Government National Mortgage Association lowered the minimum servicing fee for its less restrictive pooling program in July 2003, from 44 basis points to 19 basis points.
What would the effect be on consumers if Fannie and Freddie lowered their requirements?
One argument says that mortgage rates would fall in line with servicing fees.
A more widely accepted theory is that rates would fall only enough to reflect the lower costs of hedging and financing the servicing asset.
Another point of view says that the change would raise mortgage rates, because it would leave more prepayment risk with securityholders instead of servicers and hurt mortgage bond prices.
Another potential downside for consumers: Lower servicing fees could force small servicers to cut costs and hurt service levels, or to increase one-time fees (such as those for duplicate statements) in general.
As usual, the GSEs will no doubt be wary of appearing consumer-unfriendly.
