Normally, mortgage servicing rights would be a cherished asset in a market like this.
Servicing rights rise in value as interest rates climb, largely because borrowers are not refinancing, so fewer loan are paying off. The reliable income stream offsets lower origination income. With the expectation that 30-year fixed mortgage rates will rise to 5% from around 4.5% currently, the value of servicing rights has surged in a short span of time.
Yet after slogging through several quarters of high expenses and shrinking profits, many lenders are now selling servicing rights to raise cash to cover payroll and expenses, industry sources say. Some of these lenders built expensive retail networks and are paying never-before-seen commissions to loan officers. The steep drop in refinances and home purchases is squeezing profits.
"When the market changes, you can never cut your expenses fast enough so some lenders are relying on the sale of mortgage servicing rights to raise cash," says Ron Bergum, the CEO of Prospect Mortgage, a lender based in Sherman Oaks, Calif.
The high cost to originate home loans has forced many mortgage bankers to sell servicing rights just to break even, says Mark Garland, the president of MountainView Servicing Group in Denver. Roughly 75% of all sellers of mortgage servicing rights in the past year were mortgage bankers.
"The problem with production is that lenders are sitting there with branches and a cost structure and are running a smaller number of loans through it," he says. "It's like building a car wash and running four cars through it. Today, if you don't sell the servicing, you don't break even."
Mortgage servicing rights are an esoteric and volatile niche asset that serves as a hedge when mortgage rates rise and lending volumes fall.
Servicers are paid a sliver of interest, usually 25 basis points of the loan balance annually, to collect principal and interest payments from borrowers and remit those funds monthly to investors. Servicers also collect and remit taxes and insurance for some borrowers, and deal with delinquencies and foreclosures.
After the subprime market imploded in 2007, mortgage servicing rights were practically being given away. Many small banks and lenders began retaining servicing because large bank aggregators refused to pay anything for the servicing rights after lax underwriting led to massive defaults and higher costs. At that time, the value of MSRs plummeted in lockstep with interest rates.
Much has changed since then. Tightened underwriting standards and rebounding real estate prices have reduced delinquencies and defaults, making servicing a less work-intensive, more attractive activity.
"There is a sense that the quality of the credit and manufacturing of the loans is at its highest level in 20 to 25 years," says Brian Hale, the CEO of Stearns Lending in Santa Ana, Calif., which has been an active buyer of MSRs originated after January 2012. "If you believe that, you would back the truck up and take as much as you could of MSRs."
Stearns services $26 billion in loans with an average interest rate of 3.7%, Hale says. The company has raised $250 million for the express purpose of acquiring recently minted MSRs.
"Those loans aren't going anywhere," says Hale, since borrowers with such low interest rates are unlikely to refinance, move or default. He estimates a return on investment of 12% to 16% "in an environment where it's hard to find a 5% return."
Such outsize returns, which can be leveraged further, have attracted private equity firms, hedge funds and real estate investment trusts searching for yield.
Investors have bid up the prices of MSRs on the assumption that rates will continue to rise. The cash flow on MSRs now can last from six to 10 years, up from an average of four years, says Dave Stephens, the chief financial officer at United Capital Markets, an advisory firm in Greenwood Village, Colo., and there is room for prepayment speeds to fall further.
"It went from almost no trading happening, to now everybody wants it," says Stephens. "Three years ago, you'd get one or two bids on a $1 billion package of MSRs and you might consider yourself lucky. Today you'll get 15 to 20 bids."
With loan volume down 55% from a year ago, and lenders still laying off employees, "everybody hopes they have some annuity income from servicing built up for this," Stephens says. So even while some mortgage lenders are selling MSRs, "lots of lenders that had not been retaining servicing are now retaining it partly because of the idea that production volume could not last forever."
Though regulators are cracking down on the transfer of mortgage servicing rights, primarily from bank to nonbank servicers, the higher prices for MSRs these days are keeping some lenders afloat.
David Zugheri, the co-founder of Envoy Mortgage, a Houston mortgage bank, says many mortgage lenders that were new to servicing in the past three to five years "didn't realize how cash-intensive it is," and are considering selling some MSRs "to cover operating expenses."
"Some lenders sure would like some cash, so they'll break off a bit and sell it to raise cash to cover bills and make payroll," he says. "It's prudent."
The cash-intensive nature of servicing quickly became apparent during the downturn because servicers are required to advance mortgage payments to investors when a borrower stops paying. That burden, in addition to massive regulatory scrutiny of banks that failed to properly document foreclosures or to reach out to distressed borrowers with loan modifications, led many banks to sell mortgage servicing rights at steep discounts. Nonbank servicers like Ocwen Financial (OCN), Nationstar (NSM) and Walter Investment (WAC), scooped up the assets.
Many banks are still selling MSRs because of the significant restrictions from Basel III rules that were finalized last summer. A provision in Basel III would limit mortgage servicing assets to 10% of a bank's Tier 1 common equity. Assets under the 10% cap would also eventually be risk-weighted at 250%. In addition, combined holdings of mortgage servicing and several other assets are limited to 15%.
The $9.4 billion-asset Flagstar Bancorp (FBC) in Troy, Mich., sold the servicing rights on $54 billion of loans in the fourth quarter, more than 55% of its servicing portfolio. The sale reduced Flagstar's MSR-to-Tier 1 ratio to 23%, from 57%.
"The reason we were a seller was because we had a concentration risk issue," says Lee Smith, Flagstar's chief operating officer.
But Flagstar's a broader strategy shows banks are not entirely exiting mortgage servicing. The company reconfigured its servicing platform last year and plans to generate ongoing revenue as a subservicer without holding too big a concentration of MSRs.
In December, Flagstar retained the subservicing on $40.7 billion in loans that it sold to Matrix Financial Services, a unit of the New York real estate investment trust Two Harbors Investment (TWO). Flagstar teamed up with Selene Finance, a Houston special servicer controlled by the mortgage-bond pioneer Lewis Ranieri, which will service any loans that default.
Despite the Basel III rules, Smith believes banks are better positioned than nonbanks to handle the risks and regulatory scrutiny of servicing.
"Banks have an infrastructure with risk, compliance and legal groups to deal with all of this," says Lee. "We're an originator of loans, a servicer of loans, a seller of MSR assets and a bank as well."
Many banks have been servicing their own loans for years and are paying particular attention to new servicing requirements from Fannie Mae, Freddie Mac and Ginnie Mae as well as regulators.
Breck Tyler, the president of Trustmark Mortgage Services, a division of the $11.8 billion-asset Trustmark Corp. in Jackson, Miss., says he is aware of nontraditional players buying up mortgage servicing rights, and hopes assumptions of MSR values do not become too speculative in the future.
While servicing fee income is going to be "a significant part" of his bank's mortgage revenue going forward, he strikes a cautionary tone.
"We want the desired returns on our servicing but to get to the desired returns you have to be extremely focused on servicing the customer," Tyler says. In the new regulatory environment, "if you are not focused on the customers, you are going to have some issues."