Mortgage lenders, who have devised many methods of dicing up loans for sale to investors, are now poised to repackage a slice of the business they have always retained: the servicing income.
Standard Federal Bank of Troy, Mich., has struck a deal with Fannie Mae to securitize servicing income on $500 million of loans. It is expected to be the first of a number of negotiated deals between lenders and the mortgage agency.
The arrangement will allow Standard Federal to continue administering the loans for a reduced fee, while sidestepping the risk of a decline in the value of the servicing.
Servicing income has long been regarded as a natural hedge that helps lenders to survive when interest rates rise and loan volume falls. Servicing is very profitable, especially for large portfolios, because the fees far exceed the cost of performing the chores.
When rates fall, as they did earlier this year, servicing rights on existing, higher-rate loans shrink as consumers refinance. Thus, servicing rights are no longer a natural hedge and must themselves be hedged - at great expense.
Lenders currently retain a small portion of interest income, typically equal to 0.25% of the loan amount each year, in exchange for funneling monthly payments from borrowers to the holders of the mortgages.
But a new accounting rule requires lenders to recognize declines in the market value of their servicing income on loans they are holding for sale rather than investment. Sale of loans into the secondary market has become increasingly popular with thrifts and banks as a way to keep in the mortgage business through all rate cycles.
But the rule has also left such lenders extremely vulnerable to interest rate swings.
Under the new deal with the Federal National Mortgage Association "we don't have to worry that things are going to get out of control and we'll lose millions of dollars," said Thomas Ricketts, the chief executive of Standard Federal.
Michael Conway, an executive with North American Mortgage Co., Santa Rosa, Calif., predicted that the securitization deals would free lenders to take a more aggressive approach to soliciting refinancings.
They might "send you a letter or call you up and say, 'Gee, I notice your rate is 9%. It certainly looks like it makes sense for you to do a refinance,'" he said.
If more lenders start securitizing servicing income, it could cut into profit margins, some say. In a highly competitive market, the lenders who can reduce their hedging costs on servicing will pass the savings on to consumers in hopes of garnering more market share, said Sam Lyons, senior vice president of mortgage banking at Great Western Bank, Chatsworth, Calif.
Because the lenders will continue to perform the servicing chores on behalf of investors, they will also retain access to their customers for cross-selling.
For all its advantages, the new technique is likely to be restricted to the largest players, particularly those owned by banks and thrifts, analysts said.
That's because Fannie Mae requires lenders to furnish collateral equal to 1% of the loan value, in case they default on their servicing obligation and the agency needs to contract the servicing to another lender.
That is too much money for small mortgage banks to tie up, and even large ones such as North American would have a hard time devoting that much money to collateral, Mr. Conway said. But he said banks and thrifts, which normally have large portfolios of securities, would find the arrangement more attractive.