A dispute with a third party over the value of Prudential Home Mortgage Co.'s portfolio of servicing rights on large mortgages shot down its negotiations with First Union Mortgage for the sale of the portfolio and other assets.
Details of the negotiations provide an unusual insight into the intricacies of such deals - and the collapse also underscores a basic problem in the mortgage industry.
Jumbo mortgages - those larger than the $203,150 ceiling imposed by Fannie Mae and Freddie Mac - are much sought-after by lenders because they can be very profitable, though profits on the servicing side are much less predictable. And today, the mortgage banking industry is driven primarily by servicing income.
Had the deal gone through, First Union would have immediately flipped about $30 billion of jumbo servicing rights to a prominent hedge-fund manager, George Soros. But it would have acted as a subservicer for the portfolio, receiving fees for work performed while shedding the risk of declines in the value of the rights.
But once Mr. Soros completed due-diligence on the portfolio, he reduced his initial bid by $50 million. Prudential decided to keep the servicing rights on the jumbos and hand the subservicing to Norwest Mortgage, even after Mr. Soros came back up by $25 million. Norwest is close to a deal to buy the rest of Pru Home.
The stumbling block over the price of jumbo servicing is not surprising to industry insiders, who say less is known about jumbos, making them more difficult to evaluate.
But the experts all agree that jumbo loans prepay faster than conventional loans when interest rates decline.
"Wisdom says they should prepay faster," said Gregg Bennett, managing director at Hamilton, Carter, Smith & Co., a risk-management consultant group. But, he added, there is not enough evidence available to reach a definite conclusion.
With interest rates likely to remain at a low level, all servicing portfolios are losing value because the likelihood is greater that borrowers will refinance, thereby removing the servicing rights from portfolios. Homeowners with a jumbo loan are thought to have more money and are seen as savvier investors who will refinance at the first available opportunity.
Mr. Bennett also said that there is less competition for buyers of jumbo servicing because fewer servicers are equipped to handle the loans. Companies like to compare a prospective purchase to loans they already service, he said, and because few service jumbos, there's little information they can refer to.
GE Capital Mortgage rolled out an underwriting system specifically for jumbo loans in June, called Investment Quality.
Mimi Grotto, senior vice president for investment banking transactions, said GE turned to investment banks, rating agencies and conduits for input on what underwriting issues should be addressed when originating jumbo loans.
"Wall Street wanted to know what they were buying," Ms. Grotto said. A set standard for jumbo originations reduces the cost and time needed for due-diligence, and makes mortgage-backed security issuance a cleaner process if all the loans going into the securities are consistent and underwritten to guidelines, she added.
While it's too soon to tell if the loans originated under Investment Quality's guidelines will be more predictable or of better quality, Ms. Grotto maintains that when jumbo loans are originated to specific standards, they perform better.
Anthony Meli, president of the Mortgage Bankers Association of New Jersey, said jumbo loans are concentrated in the West Coast and Northeast markets, thus providing little information on which to base evaluations.
He said jumbo loans are usually held by the originators in portfolios or put into collateralized mortgage obligations, so they are not tracked for investors the way agency loans are, making information more difficult to come by.
"Security dealers have a better handle on agency securities than on CMOs collateralized by jumbo loans," Mr. Meli said.
The industry generally agrees that jumbo loans prepay faster, making the portfolios more volatile and more difficult to value. And because more capital is invested in the larger loans, the risk is greater than for smaller loans. But some servicers do see them as attractive investments.
"The servicers like the fact that the cash flow from jumbo loans is faster," said Tom Healy, director of the mortgage strategies group at Meridian Capital, Fort Lauderdale. Because there is more cash flow, jumbo servicers are reluctant to sell the portfolios. A servicer does not have to be as efficient to service jumbo loans, making them more attractive to service, Mr. Healy said.