Companies are quietly experimenting with ways to solve one of the biggest headaches to emerge from the refinancing boom: calculating the value of mortgage servicing portfolios.
Servicing portfolios, the contracts requiring borrowers to pay off their mortgages, provide a steady stream of income when origination volumes drop. But when refinancing activity is heavy, as it has been the past 18 months, many of these contracts are canceled as the loans are paid off early. Even contracts not yet canceled are considered less valuable, because the threat of prepayment looms large.
Trading in servicing assets languishes during heavier refinancing. Since there is little or no trading of such assets, companies with servicing portfolios have no information with which to calculate market values.
“When there is a lack of observable trades, it sometimes gets hard to say what is the true value of a servicing portfolio,” said J.B. Long, a vice president at Alliance Mortgage Co., a Jacksonville, Fla.-based subsidiary of Alliance Capital Partners Inc. that has a $26 billion servicing portfolio.
This paucity of market value information has companies turning to theoretical models that spot prepayment patterns in the mortgages underlying the servicing portfolio. But experts say these models are limited.
“Whatever the model or methodology you use, there is always a question mark,” said Sachit R. Kumar, a senior vice president at Mortgage Industry Advisory Corp. in New York.
This uncertainty makes it harder to calculate impairments, develop hedge strategies, and account for these hedges, Mr. Kumar said. Ultimately, it even affects a company’s earnings statements, and that does not sit well with investors and regulators, he said. “If you can’t justify your assumptions for valuing these assets, your auditors [and] your regulators will always come back to question you.”
Luke Hayden, an executive vice president with Chase Manhattan Mortgage Corp., said companies seeking better clarity are developing or buying more robust prepayment models or observing the behavior of interest-only securities and other instruments that respond comparably to interest rates.
Mr. Hayden also mentioned Generic Servicing Assets, a roughly year-old program from Mr. Kumar’s company that creates a hypothetical market to value these assets.
Companies using Generic Servicing pay a fee to bid daily on 188 hypothetical instruments that mimic actual servicing assets. Mortgage Industry Advisory then tallies the bids and tells the companies what the assets would fetch.
“GSA really gives companies a good base for satisfying some of the questions that come from their regulators,” Mr. Kumar said.
Mr. Long at Alliance Mortgage called Generic Servicing one of the best tools for gauging servicing values. “We like to use this approach when we report to our auditors.”
To be sure, this is not as big an issue as it was toward the beginning of the refinance boom.
“We’ve just gone through a quarter of massive impairments or writedowns for most lenders,” said Gary Gordon, a managing director at UBS Warburg. “Even though servicing is difficult to value, when you’ve cut its value by 40% you are going to be a lot more conservative dealing with it now than before.”
